The price of solutions to the debt crisis

Madis Müller
Madis Müller
Deputy Governor of Eesti Pank

Every choice we make has its consequences and a price. The current debt crisis in Europe is a direct result of past economic policy decisions. The price of possible solutions will include extensive changes in the decision-making process of the European Union and will be felt in areas that most of us consider to be far from finance.

We should look back at least twenty years in order to better understand the nature of today's problems. According to the Bank for International Settlements (BIS), the debt burden of developed economies as a share of GDP has grown from 167 per cent in 1980 to 314 per cent at present. This includes not only the debt of governments, but also that of households and companies. Long periods of economic success can easily lead to excessive optimism and expectations of ever-growing wealth in the future. Coupling this with cheap and easily accessible credit will result in a toxic mix that has proven to be similarly irresistible to both governments and most people when budgeting for their expenses. As a direct consequence of the growth in long-term indebtedness, the cost of new borrowing for several EU countries has now reached a level that cannot be sustained.

What are the consequences of an excessive debt burden? If debts are allowed to grow faster than income for a long enough period of time, one will sooner or later reach a point where adding new debt and refinancing existing loans is no longer possible. This is more of a logical axiom than a theory that needs to be proven. Once a debtor reaches that point, none of the remaining options are easy or painless. The ability of debtors to service their loans is to a large extent determined by the cost of debt; i.e., the interest rate. However, interest rates have a tendency to rise at the most unsuitable moments for debtors, exactly when their ability to service loans has already been hampered as a result of a heavy debt burden and their credit risk has increased in the eyes of creditors. The well-known relationship of cheap credit being easily available only to those who do not really need it and vice versa also applies to the sovereign debt market. This is an important argument in favour of a conservative fiscal policy.

What are the remaining options for a government, when the excessive debt burden has led to difficulties with servicing or renewing the country's debt? Reducing government expenditures along with introducing reforms that strengthen the long-term economic growth potential of the economy would be the most logical and responsible steps to take. "Growing out" of the problem with the help of structural reforms and favourable external economic conditions would be the best way to get rid of the heavy debt burden. In other words, the curbing of government expenditure in countries with a heavy debt burden is certainly necessary, but this alone is usually insufficient for creating a long-term solid foundation for public finances.

Debt restructuring or declaration of national insolvency would be worse solutions. At first sight, such actions might seem relatively painless as no assets can be seized from the state - contrary to the situation for individuals and companies - as a loan guarantee in case of a national bankruptcy. The loss would be more indirect, but most certainly not smaller. The restoration of confidence is a long-term process and interest rates would be high for both the government and domestic companies. It is very probable that commercial banks as traditionally important investors in the government bond market would also face serious problems. This may lead to the need to recapitalize systemically important banks, which can be very costly, but it is essential for the functioning of the economy. All in all, access to funding would be effectively cut off for both the government and companies, forcing even faster and more painful cuts on public spending than would have been the case under the first option.

An inflationary reduction of debts would be the last and an especially expensive solution to the debt problem. The independence of central banks from their governments is considered a cornerstone for modern monetary policy for a reason. Once the inflation genie is released from the bottle, it is very difficult to rebottle it. Inflation increases the cost of credit, weakens the currency and acts as a tax that eats away private savings and hits the hardest the less privileged segment of the population. Of course, given the common monetary policy in the euro area, no Eurosystem country can eliminate its debts through inflation. The possibility that the Governing Council of the European Central Bank ignores its mandate under the EU Treaty to ensure euro-area price stability and jeopardises the necessary credibility for a successful monetary policy is also out of the question. Ensuring price stability is a priority for euro-area central banks in respect of citizens, and inflation has to be kept in check in order to support long-term growth.

However, it is worth clarifying the question why a government should save commercial banks. The helping out of banks seems to be unfair at first sight and this is a fundamental issue that has not been sufficiently addressed when explaining to the general public the various steps taken to contain the crisis. It is certainly a valid position that banks must have made carefully deliberated investment decisions when purchasing government bonds and therefore the responsibility for possible losses also lies with bank managers and owners and not with the taxpayers. Nevertheless, it is clear that the government cannot allow the entire banking sector to collapse in a situation where it is impossible for the state, after the declaration of insolvency, to access foreign funds on reasonable terms. The government should ensure the functioning of the so-called systemically important banks, even if it forces bank owners to forgo their investments. The saving of banks in this context should not mean the saving of bank owners' money or bank managers' jobs. In general, it is necessary to ensure the functioning of a bank as an institution in order to avoid a larger crisis and the domino effect. Not all financial institutions deserve public support, although the provision of conditional support to selected banks is inevitable in a crisis situation. Stronger capital requirements and other new regulations applied to banks imply that we can expect a separation of wheat from the chaff in the European financial sector in the upcoming years.

As to the cost of the various solutions to the debt crisis, we should not forget that a loan agreement always has two sides. As accountants say, every debt is someone else's asset. Thus, when discussing the possibility of restructuring or writing down a loan, we are also talking about "writing down" someone else's asset. The majority of government bonds of the European countries are owned not by overseas speculators, but by European commercial banks, funds and insurance companies that operate with private pension savings or amounts that back up insurance contracts. Talking about "private sector involvement" in the restructuring of Greece's debt may give a false impression that the private sector refers to foreign banks and somehow does not concern European taxpayers.

The European economies are closely integrated, so a crisis in some countries also affects others. If other governments tried to avoid putting any of their own resources at risk in solving the crisis, we would cause even larger potential losses for all the European countries down the road. Of course, the public finances of a country can only be fixed by its government, but problems in one end of the euro area will pretty soon become - as a chain reaction via the financial sector - the problems of all other countries as well. Tensions in the banking sector bring along a tightening of financing conditions, thus increasing general uncertainty and hampering investments and consumption.

The current diagnosis of the situation is ultimately the following: the confidence of bond investors in the ability of several European countries to service their loans is rapidly fading. This has paralysed the inter-bank loan market and as a result, governments may not be able to provide necessary services and banks may not be able to grant loans to companies and households on reasonable terms.

What is the solution? The Stability and Growth Pact, which introduced limits to both government deficits as well as to the debt burden, can no longer act as a sufficient guarantee for the credibility of the euro area. Since 2003, the whole entire euro area as well as Germany and France have been exceeding the public debt limit (60% of GDP) set by the Pact. At present, there is a need for faster solutions in order to restore confidence in money markets so that systemically important banks are able to survive this crisis and continue to pursue lending activities necessary for the normal functioning of the economy. Towards that aim, decisions have been made at the Head-of-State level, but they have not yet been fully implemented.

The central banks of the Eurosystem have a certain role and tools to ensure the functioning of the financial sector, and these tools are currently being utilised to their fullest extent. Specific measures that most certainly are not part of the traditional monetary policy toolbox are being implemented; e.g., direct interventions in bond markets through supportive purchases. This was triggered by the assessment that money markets in some countries are no longer functioning effectively and the transmission of monetary policy decisions to the real economy is not working without additional extraordinary measures. Any emergency measures designed to solve the debt crisis should, however, be aimed at supporting those in need only under specific conditions. Otherwise, it would not be clear whether the assistance really helps to solve the problems or just tries to buy more time. Importantly, it would also be difficult to convince creditors that a government under stress is really bringing its public finances to a viable basis and will be able to service its future debts without outside help. In order to achieve the latter, it is inevitable that countries that have encountered problems cut government expenditures, but also implement structural reforms that support growth and reduce the costly privileges that have been granted to different interest groups in many countries throughout history.

The EU Summit on December 9 focused again on finding solutions to the debt crisis. The compromise decisions made were probably as good as possible from the perspective of Estonia. The Heads of State agreed, inter alia, on implementing stricter budget deficit restrictions, applying almost automatic sanctions to those who violate budgetary rules and allocating, through bilateral loans, additional funds to the IMF, which should be ready to play a more important role in Europe considering its mandate. The adoption of more ambitious plans (e.g., the issuance of Eurobonds jointly guaranteed by euro-area countries) would have implied a more extensive sharing of risks and liabilities when solving the problems of an individual Member State. Fortunately, there is a sufficiently strong opposition to proposals that would mean more or less automatic and unconditional financial support to governments that have failed in financial matters.

If the liability for debts is even partially shared, then governments should respectively also be willing to give up some of their independence in spending. The problem so far has been the national implementation of decision taken at the European level. There have been too many summits declaring decisive solutions to the crisis, which have had only short-term effects. Still, the situation is certainly not hopeless, and the recent change of governments in Greece, Italy and Spain has created a positive foundation to reassure creditors. At present, the solution depends on the governments and parliaments of the countries that are situated in the epicentre of the crisis, and we can be rather sure that they understand their responsibility.

The current crisis in Europe concerns primarily the financial and the economic policy. This is the area where future arrangements will certainly be different from what we have had so far. Firstly, it is clear that the coordination of economic policy and national budgets must be stronger. Secondly, we can be sure that even if governments and central banks are successful in managing the current crisis, the cost of loans for Greece will not be as close to that of Germany as was the case in the first half of the last decade. This could even be a positive development and force the governments to pursue more prudent fiscal policy in the long run. Furthermore, it is clear that there will be other areas besides finance that are directly affected if a country has to cut its government spending and public services from the levels that the population has already grown used to.

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