Unilateral default vs negotiated debt reduction

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.


  • Although a lot of us share the same views, especially as far as the effectiveness of Greece’s bail-out and how realistic is not to have a contagious/domino situation are concerned, I’m afraid that your analysis disregards two very real system weaknesses:
    a) Politicians (i.e. the governments part) have not proved themselves to be competent crisis managers and
    b) When we refer to banks, we are not talking about an homogeneous body, not even of pure european origin, making their concession extremely complex if not impossible.

    • You are spot on regarding Europe’s real deficit: Liliputian politicians. I have, I must admit, no clue on how that deficit can be dealt with. However, regarding your second point, while it is true that banks are a heterogeneous lot, their collective interest on this matter (of how to minimise losses from the bonds they are holding) will give them sufficient cause to participate as a united front in the tripartite negotiation I suggest.

  • Last months, Greek State took a wise decision to cease the salary payment to 400 public servants. It did this just for tracing them. As far as I know, all of them came into contact with the Administration.

    Given that success, I wonder if it is realistic enough not only to give incentives to the bankers (guaranteed long term liquidity from the ECB), but also force them to join your Tripartite Agreement by airing an “IF NOT” scenario for them.

    Could you please elaborate on the differences between the Federational frame (U.S.) and the Union, like the European, referring to the consequences of a possible default of a State/ member of them. Actually, I understand the complexity of interests and financial bonds in our continent. Yet, I lack US experience.

    • I sincerely think that bankers would love the opportunity to participate in the Tripartite Agreement. They are already well motivated to do so by the prospect of the euro’s collapse and/or the failure of the present efforts to prevent the official bankruptcy of heavily indebted member states. As for the difference with the US, when a municipality or even a State (like California) declare bankruptcy, Wall Street’s exposure to bad State or municipal debts is tiny when compared to, for instance, the European Banks’ exposure to the debt of Italty, Spain or Greece. You may be interested in looking into the way that the bankruptcy of the City of New York was handled in the 1970s. Bondholders were forced to take a substantial haircut while Wall Street effectively took over the running of the City. No contagion, no domino effect there…

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