Europe’s policy elite – the people who call the shots at the national and eurozone level – are in serious trouble. They have mismanaged their way into a deep crisis, betraying all of the lofty promises of unity and prosperity issued when the euro was created. The currency union may survive, but, for millions of people, the euro has already failed in its mission of sustaining growth and ensuring stability. How did this happen?
The Greek, Portuguese, Irish, and Italian economies are reeling under fiscal austerity – with budget cuts and higher taxes as far as the eye can see. This policy mix will slow their growth, and that of the rest of Europe.
But that is only part of the problem. The bigger issue is the “debt overhang” that has forced European governments to pursue this course. There are strong parallels to what happened in the United States in the past few years: many families felt crushed by their debts, so household consumption fell and has yet to recover. The adjustment will be even more painful in Europe, because a sovereign-debt crisis has a depressing effect on everyone – consumers, investors, and the public sector alike.
There is a simple way to deal with a debt overhang: reduce payments by restructuring the debt. Many firms are able to renegotiate financing terms with their creditors – typically extending the maturity of their liabilities, which enables them to borrow more to finance new, better projects. If such negotiation cannot be achieved voluntarily, US firms can use Chapter 11 of the bankruptcy code, under which a court supervises and approves the reorganization of liabilities. So you would think the same would be true for US households and embattled European governments. But the restructuring of debt has been too little and has come too late. Why?
In both cases, the main argument for not removing the debt overhang came from bankers, who claimed that it would create havoc in financial markets for two reasons. First, banks were the primary creditors, and the large losses that they would face in any restructuring was bound to trigger a domino effect, with waves of pessimism driving up interest rates and ruining other borrowers’ prospects. Second, banks would also suffer because they had sold insurance against default – in the form of credit-default swaps. When these swaps were activated, the banks would incur potentially further crippling losses.
In the case of Greece, international bankers argued long and hard that debt restructuring would generate contagion far and wide within the eurozone – and perhaps more broadly. And yet, in the end, Greece had little choice but to restructure its debt, cutting the value of private claims by about 75% relative to their face value (although even this is probably not enough to make the country’s debt burden sustainable). This was deemed a “credit event,” so credit-default swaps were exercised: anyone who insured against default had to pay out.
Did all hell break loose? No. Banks have not failed, and there is no sign of tumbling dominoes. But that is not because banks prepared themselves by raising more capital. On the contrary, compared to their likely future losses, European banks have raised relatively little capital recently – and much of this has been creative accounting, rather than truly loss-absorbing shareholder equity.
Perhaps the risk that a Greek debt restructuring would cause a financial meltdown was always minimal, and quiescent markets were to be expected. But, in that case, why all the fuss?
The answer should be clear by now: interest-group politics and policy elites’ worldview. Even if the risk to the financial system was minimal, the impact on banks and bondholders was substantial. They stood to lose billions, and many financial-sector employees stood to lose their jobs. Not surprisingly, leading bankers lobbied against debt restructuring, both behind closed doors and publicly.
For example, the Institute for International Finance, a preeminent Washington, DC-based lobbying group for large banks, consistently argues: bail us out, or else face the consequences. But, just as important as their storyline is their political power, which has risen greatly in recent years – to the point that all major policymakers in the US and Europe cater to banks’ fortunes even when there are no wider implications for the economy.
Even now, many of the losses that bankers should have faced are being shouldered by the public sector, including through various forms of direct support and the extraordinary and risky actions of the European Central Bank. The extent of subsidies in this sector is stunning and, under current policies, will only increase over time – thereby primarily supporting the lifestyles of the top 1% of people in very rich countries.
The Greek default has turned out to be the proverbial dog that didn’t bark. The lesson for Europe – and for the US – is clear: it is time to stop listening to what banks say, and start focusing on what they do. We must re-evaluate the distorted political economy of the financial sector, before the excessive power of the few imposes even larger costs on everyone else.
Por Simon Johnson y Daron Acemoglu.