Europe Is Running Fast to Stand Still

PIMCO
Mohamed El-Erian

Enlarging the lending resources of Europe’s rescue fund would do nothing fundamentally to address the unsustainable stock of debt and its adverse impact on growth, investment and employment.

More people are recognizing that the time has come for another approach, one that involves the orderly restructuring of some European sovereign debt on terms that allow a meaningful chance of re-accessing markets in the future at sustainable rates.

This article was originally published on www.ft.com on January 17, 2011.

The sequencing of Europe’s debt crisis is depressingly similar – the plot stays the same, with a slightly different cast depending on the country in the spotlight. Yet, judging by the run-up to the meeting of European Union finance ministers in Brussels on Monday, European officials seem intent on repeating it over and over again.

Last week, higher borrowing costs raised concerns as to whether Portugal could successfully tap the market in a regularly scheduled government bond auction. Fearing that the country would join Greece and Ireland in both losing access to new market funding and facing alarmingly high risk spreads on existing debt, the official cavalry jumped into action.

Portuguese officials sought to reassure the markets of their fiscal credentials. The EU talked of enhancing the flexibility of its rescue funds. The European Central Bank stepped up its market intervention, buying millions more Portuguese bonds. To make absolutely sure that the auction would succeed – and it did – China and Japan signalled their willingness to buy European debt instruments.

This is the same game plan that was used for Greece and Ireland. The probability of success is the same – very low.

You do not solve a debt problem by adding new debt on top of old debt. Yet it seems that European officials are fixated on this approach. How else would you explain the two main proposals discussed ahead of today’s meeting – namely, to enlarge the lending resources of the rescue fund and enable it to buy existing debt?
If implemented, this would do nothing fundamentally to address the unsustainable stock of debt and its adverse impact on growth, investment and employment. Instead, it would facilitate an even larger and quicker transfer of debt from the private sector to the public sector.

Rather than fantasise that a liquidity approach can overcome a solvency problem – and it will not – European officials should spend time discussing the cost of their “active inertia”. In doing so, they would quickly identify four issues that are further complicating the region’s debt crisis.

Continuing with an ineffective approach turns regularly scheduled bond auctions into dramas. It accelerates the private sector’s exit from peripheral debt markets, meaningfully limiting future demand. It pushes creditors to ask who is next, fuelling the migration of disruptive contagion up the European credit quality curve. It gradually weakens the integrity of the ECB and is likely to intensify the recent under-performance of German bonds.

More people are recognising that the time has come for another approach – what this week’s Economist magazine calls “Plan B”. This involves the orderly restructuring of some European sovereign debt on terms that allow a meaningful chance of re-accessing markets in future at sustainable rates. This would be accompanied by measures to enhance growth prospects in highly indebted European countries; ring fence the other, fundamentally sound economies; and push banks and other institutional holders of restructurable debt to raise prudential capital.

It is not easy to design such a plan. Nor is implementation success guaranteed. But this should not be used as an excuse to fixate on an approach that has repeatedly failed, and that will end up making Europe’s debt crisis even worse.