Partial Defaults…

and why they might be the best alternative.

Crossposted from The Stars Hollow Gazette

I found this a thought provoking piece.

David Apgar: Could Germany Be Right about the Euro?

Naked Capitalism

Sunday, December 4, 2011

What if there are good reasons for the preternatural calm of German Chancellor Merkel’s inner circle as the English-language media (based, after all, in the investor capitals of London and New York) light their collective hair on fire about the euro’s imminent immolation? Surprisingly, you can make a decent argument that the euro zone is at no risk of breakup – unless someone secretly switches its purpose from facilitating European trade to providing investors an implicit guarantee against losses.

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Suppose, however, the feasibility of Mediterranean austerity – austerity at a scale big enough to impress the bond markets – is not what Merkel’s team is counting on. Suppose instead the Germans are really counting on the feasibility of a series of orderly partial defaults.

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The big unasked question is not whether austerity might be tolerable but whether defaults would be as intolerable as the bond media insist. Here’s why Merkel’s team could have quietly concluded that the costs of a series of partial defaults are unavoidable even without any defaults, that some of those supposed costs may in fact be disguised benefits, and that the alternatives to selective debt relief are probably unsustainable.

As far as costs go, massive European bank restructuring comes to mind, especially following a cool €300 billion or so of losses on government bond holdings. It’s hard to say anything nice about bank restructuring, but at least we know how to do it. We know, for example, how to split good banks from bad banks. (Hint: rank balance sheet assets by quality and liabilities by seniority and draw a line across the balance sheet after the last asset of reasonably determinate value.) That’s handy when you need banks with systems in place ready to restart lending. And we know these transactions work when free from political interference as they were in Sweden in 1992. We also have institutions like the ECB ready to fix broken banks – unlike broken governments.

Less widely discussed, massive European bank restructuring may be unavoidable even if Europe somehow enlisted enough ECB printing presses, enough future earnings of all those carefree northern European taxpayers, and enough future benefits of all those docile southerners to plaster a smile on the face of every bond portfolio manager at BNP Paribas and Commerzbank. The scale of the bailout needed to avoid further investor losses as of today – much less tomorrow or next week – would entail cross-border consolidation or de facto nationalization of a significant portion of the euro banking sector.

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The alternatives to partial defaults by countries that can’t afford to pay rising interest rates, furthermore, may be unsustainable. The most popular alternative has the ECB stepping in to buy bonds every time investors try to cut their exposure. At first blush, it looks clean – no forced austerity, no messy investor losses and bank restructurings, no burden on taxpayers in creditor countries like Germany. The only problem is that it would be inflationary.

And that inflation turns out to be quite a problem. With such ECB generosity on offer – and with euro zone inflation looming – why would any bond trader with a pulse stop after dumping her Greek, Portuguese, Irish, Italian, and Spanish exposure? Why not get rid of the French and German paper in the vaults, as well? Get rid of it all. Well, maybe not the Estonian bonds. But the ECB would be buried.

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Ironically, the ECB purchaser-of-last-resort and eurobond alternatives probably would break up the euro zone. The inflationary strains of the former, and the accountability problems of the latter, would never survive the next referendum in a euro zone state. The purpose of the euro is to facilitate trade and commerce – not facilitate government borrowing.

This, then, is the impasse euro zone bond investors have reached. To avoid losses, they clamor for alternatives that could disrupt the currency itself – one of the few things that might actually make them worse off in real terms than they are right now.

Frankly there is no reason to believe that the Euro crisis is causing anything but kneejerk neoliberal responses from elites who are bound by faith alone to policies and doctrines that are factually proven failures.

Still, it does make you think.