Unilateral default vs negotiated debt reduction

24/11/2010 by

Michael Burke took me to task for writing, in our Modest Proposal, that it is “utopian to expect member states to default and remain within the eurozone.” Michael asks: “Why? Local, county and state authorities have all defaulted in the US, without having to flee the US Dollar area. Surely default, partial or otherwise, is an essential part of the necessary debt-reduction programme?”

Michael is, of course, perfectly right that it is entirely possible to have states in default within the USA or within Australia or within a Federation of sorts. Unfortunately, the eurozone is not a federal state. Why is this important? Because private banks fall in the jurisdiction of the member states and are replete with bonds of the member states to which they are attached. So, an Irish default, all other things being equal, will decimate the Irish banks and thus trigger off a chain reaction that will quickly push other banks within Europe over the edge thus causing a 1929-like vicious circle. It is for this reason that default cannot be allowed to happen with the eurozone. In sharp contrast, Wall Street is not threatened by the default of South Dakota or of some municipal authority.

Having said that, Michael is right in concluding that “default, partial or otherwise, is an essential part of the necessary debt-reduction programme”. The question is: How should it be organised centrally and in a manner that deflates the debt-recession crisis, rather than inflame it further (as the EU-IMF’s current efforts are doing)? Our suggestion in the Modest Proposal offers a realistic process of doing exactly that: (1) Reducing the banks’ collective demands over the overall debt owed to them by the heavily indebted eurozone countries in return for guaranteed long term liquidity from the ECB. And (2) conversion of 60% of the remaining – after (1) has been effected – member-state debt into low interest ECB bonds.

In short, the way forward for the eurozone, given that Federation is not on, is to deal a blow against its twin crisis (sovereign debt and bank losses) through (A) a tripartite agreement between the ECB, the members states and the banks, and (B) the transfer of 60% of the remaining debt to the Central Bank. Then and only then will the crisis have been arrested and the EU can safely concentrate on the important, yet secondary, questions of future fiscal discipline and economic recovery.

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