European leaders swear a Greek default isn’t in the cards. Their parliaments debate whether to bolster an inadequate rescue facility. The International Monetary Fund sends delegates to Athens to make sure it deserves its next tiny tranche of bailout aid. German Chancellor Angela Merkel regularly declares fealty to the euro.
They’re all in denial. Almost no one believes Greece is solvent, not with an economy -- and tax receipts -- shrinking and debt ballooning to 180 percent of gross domestic product, a burden that no amount of belt-tightening will make bearable. The question now is whether Europe can arrange a controlled and orderly default, or will allow a Greek bankruptcy that is chaotic and destructive to the global economy.
Europe ultimately needs radical change, including a fiscal union and the ability to issue bonds that all 17 euro-area countries collectively would stand behind, much like U.S. Treasuries. But that would require amending treaties, which each country’s parliament must approve. Europe’s voters deserve a say, too. All of that could take years.
No reliable road map exists for managing a sovereign bankruptcy involving $500 billion. Argentina defaulted in 2001 on debts of a mere $80 billion. An orderly default would require immediate restructuring of Greece’s debts, and possibly those of several other countries. That would have to be accompanied by the three S’s: Stopping the contagion, saving the euro and stabilizing the banks -- all at once, euro-area wide, and preferably over a single weekend.
A Resounding ‘Stay’
A controlled default first must answer the question of whether Greece can stay in the euro, or whether it must return to the drachma. The answer should be a resounding “stay,” and not because the euro compact doesn’t allow a member country to exit. Such rules can be finessed.
Expelling Greece from the euro would cause more economic, political and social chaos than the world can bear. The possibilities range from runs on European banks to violent rioting in the streets of Athens -- or even civil war. True, leaving the euro would allow Greece to do something it can’t do now -- devalue its currency -- to be more competitive. But it would also paralyze a drachma-tized economy. One big reason is that companies with euro debts would be hard-pressed to pay them back with a deeply devalued drachma, and would face bankruptcy.
Exiting would also be more expensive than staying. Willem Buiter, the chief economist at Citigroup, says a euro exit would mean a 100 percent write-off of Greek bonds, while staying would mean writing down their value by 60 percent to 80 percent. Greek bonds now trade at discounts of 40 percent to 65 percent of face value.
Greece would need debt forgiveness, in which creditors accept haircuts of at least 50 percent to bring the debt-to-GDP ratio below 100 percent. If bank and other investor losses are tax deductible, the hit to profits would be somewhat softened. Greece would also need to issue new bonds, which the ECB, the IMF and possibly the European Bank for Reconstruction and Development (a public-private financing source) could jointly back to attract buyers and present an overpowering, united front to skeptical markets.
Instead of imposing a tough-love austerity plan on Greece, this troika should peg any new securities to an economic recovery, so that payments increase with GDP growth and decline in a recession. A similar arrangement worked for Latin American countries issuing Brady Bonds in the late 1980s. Jean-Claude Trichet, the outgoing ECB president, is very familiar with that episode: He was the head of the so-called Paris Club of sovereign creditors that negotiated the Brady Bond deals.
A Financial Firewall
To stop the contagion, the ECB must pledge to provide liquidity for as long as it’s needed. But the central bank must do much more by erecting a financial firewall -- one that is impregnable to the market forces that will continuously probe for a weak spot -- around the rest of the euro bloc. Any new bonds issued by Portugal, Ireland, Spain, Italy, Belgium and France would also need guarantees to attract investors at reasonable rates.
This part of the roadmap will not go down easily with Germany. The ECB’s charter directs it to control inflation, and doesn’t allow it to monetize sovereign debts, which is the label some German officials will give such guarantees. But Germany may have little choice: If it left the euro, its exchange rate would skyrocket, exporters’ profits would plummet, and its economy would shrink.
Preventing contagion also means stopping bank runs. The default roadmap must include a plan to reassure all Europeans that their savings and retirement plans are safe. It may be necessary to impose temporary capital controls in Greece and other countries to stop bank runs before they start. Euro-area governments should also guarantee deposits, much the way the U.S. swiftly raised the guarantee on American deposits to $250,000 from $100,000 (now made permanent by Congress) after Lehman Brothers Holdings Inc. collapsed.
Saving the banks would require recapitalizing dozens of European banks holding Greek and other sovereign debt. Once Greece defaults, its bonds and those of a half-dozen euro-area countries suddenly will be worth a fraction of the value at which they are carried on banks’ books. The amount of bank capital needed -- estimates range from the IMF’s $410 billion to Merrill Lynch’s $550 billion -- must be based on realistic stress tests that take sovereign defaults into account.
Many banks will be able to raise private capital. For those that can’t, governments must be ready to inject capital in return for equity, as the U.S. did with its Troubled Asset Relief Program.
Taxpayers on Hook
Who will pay? The European Financial Stability Facility could be the source of capital for a euro-TARP and the ECB sovereign-debt backstop. The bailout fund may soon have 440 billion euros ($600 billion), assuming government approvals of a July replenishment plan take place by mid-October. Those funds could be leveraged with the help of the ECB to build a 2 or 3 trillion euro facility. But there’s no getting around the fact that Europe’s taxpayers will be on the hook.
Economists and analysts disagree on the details for each of the steps involved, but they agree that a prepackaged, well-managed bankruptcy, not unlike the ones arranged by the Obama administration for General Motors Co. and Chrysler Group LLC in 2009, would be better than letting the chips fall where they may.
None of this is to say that an off-the-shelf blueprint will make a default easy. It won’t. The distress will be felt worldwide. But it will be far less traumatic this way. Carpe diem, Europe.
To contact the senior editor responsible for Bloomberg View’s editorials: David Shipley at firstname.lastname@example.org.