Pierre P?ris/ Charles Wyplosz
The eurozone?s debt crisis is getting worse despite appearances to the contrary. Eurozone bond rate spreads have narrowed?leading some to think that the crisis is fading. Yet the narrowing is not due to an improvement in fundamentals. It happened after the ECB announced its Outright Monetary Transactions (OMT) programme. Mario Draghi?s, ?Whatever it takes?, did the trick; investors believe the ECB could and would counter rising spreads in the medium term.
But this means that the information in the spreads is muddled:
*Spreads no longer show us what investors think about debt sustainability.
*They reflect a mix of debt-sustainability expectations and forecasts of ECB reactions.
This is yet another instance of Goodhart?s Law?a variable that becomes a policy target soon loses its reliability as an objective indicator.
How to gauge the eurozone debt crisis
This leaves us with a coarser measure?the evolution of public debts?as a ratio to GDP. Spreads were clearly better indicators before OMT. There are plenty of problems with debt-to-GDP ratios:
*Gross debts are gross, i.e. they ignore public assets.
*Gross debts ignore unfunded public liabilities such as pensions and healthcare.
In most countries the unfunded liabilities?which include the potential costs of bailing out banks when and if they fail?are vastly bigger than the public assets that can be disposed of.
*GDP is a static measure of the ability to pay; GDP growth also matters.
Noting that eurozone growth seems to have slipped into a go-slow phase, the GDP denominator is likely to grow slower than it did in the 1990s.
The three points taken together suggest that debt-to-GDP ratios of the 2010s paint a more optimistic picture of sustainability than the same levels in the 1990s. Be that as it may, the accompanying figure displays the public debt to GDP ratio for the eurozone as a whole, along with the highest and lowest member country ratios (ignoring the two special cases of Estonia and Luxembourg).
*Even including optimistic forecasts for 2013, the figure can only confirm that the situation is getting worse.
If public debt seemed likely to be unsustainable in 2008, the likelihood is even higher now. Strikingly, this holds even for Greece, in spite of the restructuring of its public debt in 2011, which was large enough to bankrupt the Cypriot banking system. Put differently, not only the initial problem has not been solved, it has also been made worse.
There can be no surprise here. Budget stabilisation cannot work during a recession as was pointed out at the outset of crisis.
What are the options today?
The debt problem cannot be avoided or hoped away. When debt is unsustainable it will not be sustained. The only question is how and when the crisis comes. Here are the five options that can address the debt quagmire.
1: Long-term debt reduction through budget surpluses.
2: Sales of public assets.
3: Classic debt restructuring.
4: Debt forgiveness.
5: Debt monetisation.
How the ECB could deal with the debt
For debt monetisation to allow for relief, the debt must be somehow eliminated once it has been acquired by the ECB. One way of achieving this goal is as follows:
*First, the ECB buys bonds of a country, say for a value of 100 euros.
*Second, it exchanges these bonds against a perpetual, interest-free loan of 100 euros.
The loan will remain indefinitely as an asset on the book of the ECB but, in effect, it will never be paid back (unless the ECB is liquidated).
The counterpart of this operation will appear on the liability side of the ECB?s balance sheet as a 100 euros increase in the monetary base. This is the cost of the debt monetisation.
Debt monetisation has a bad reputation, which is justified by the fact that it has often led in the past to runaway inflation.
Under current conditions, this is most unlikely to be inflationary. Given the icy state of credit markets, increases in the money base do not translate into increases of the actual money supply; in effect, the money multiplier is about zero.
In addition, high unemployment has created a deflationary environment. But, hopefully, the credit market will be revived one day and the recession will come to an end. At this stage, the money base will have to be shrunk. This is the exit problem. An alternative is to raise reserve requirements to reduce the size of the money multiplier. Either way, the balance sheet expansion need not lead to inflation.
One solution is for the ECB to sterilise its entire bond buying under this programme by issuing its own debt instruments, leaving the size of the money base unchanged. This can be done at the time of bond purchases or later, when exit will be undertaken.
Of course, the ECB will have to pay interest on its debt instruments, which will reduce profits and seigniorage to all member countries, both the defaulting ones and the others. This transfer ?in the right direction? is the way all member countries will share the loss inherent to debt restructuring.
As always, we have to accept the tyranny of numbers. Today?s balance sheet of the ECB amounts to 2,430 billion euros. The big bang example examined above would add 1,200 billion euros, an increase of 50%. This is huge, but not unprecedented. In July 2007, the ECB balance sheet was 1,190 billion euros?half of what it is today.
At the end of the day, except for Option 1, which is the classic virtuous approach, and Option 2, the disposable of public assets, none of the other options is appealing.
But if Options 1 and 2 are impossible, one has to choose among bad options.
Option 3 is clearly the least desirable because it would shake the markets and possibly take down large segments of the banking system. Option 4 is not just politically explosive; it could trigger a debt crisis among the countries currently perceived as healthy. This leaves us with Option 5.
Of course, defaulting through the ECB is merely a fig leaf to hide the cost of debt restructuring. In addition to spreading the impact over the long run, it has the advantage that the non-virtuous countries will share the costs in the form of reduced profit transfers from the ECB over the long run.
Obviously, debt cancellation entails a huge moral hazard that needs to be dealt with. Here it bears to emphasise that bringing the crisis to an end requires two conceptually different actions:
*One is dealing with the legacy of unsustainable debts, which is what the options presented here do (note that it is proposed to deal with the debt stock legacy, not to finance on-going deficits. A once-for-all action is far less dangerous than a permanent moral hazard).
*The other is to make sure that it will never happen again.
This calls for the adoption of a rock-solid fiscal discipline framework. Solutions other than the ineffective Stability and Growth Pact exist, but this is not the topic of this article. The ECB must require that this be done, and done well, before stepping into the quagmire.
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