The Day After Russia Attacks
What War in Ukraine Would Look Like—and How America Should Respond
Since the outbreak of the financial crisis in 2008, the German government has been fixated on the dangers of moral hazard: Berlin has resisted calls to foot the bill for the reckless spending of its profligate counterparts in Athens, Rome, and elsewhere. However sensible it might sound, this outlook has fed the German public’s opposition to bailouts of weaker EU countries, precluded a robust European response to the crisis, and fanned bond market contagion. Just look at the collapse of Italy’s government over the weekend.
German Chancellor Angela Merkel sorely needs a new agenda, one that allows her both to satisfy the demands of her reluctant electorate and salvage the eurozone by containing the sovereign debt crisis. The recent “Greek haircut,” in which eurozone officials brokered a deal to cut bondholder claims on Greek debt as part of a bailout package, offers just such an opportunity to shift the political climate. Merkel should present a plan to the euro group whereby debt-ridden countries such as Ireland, Italy, and Portugal would reissue their debt backed by collateral from the eurozone, while private bondholders (mostly large French and German banks) would write down existing holdings in exchange for new, more liquid and secure bonds. Only if all those with a stake in the future of Europe -- including the governments in the core and the private sector -- share the responsibility for its rescue, will a return to growth and prosperity on the continent be possible.
Germany has so far made fiscal support to its neighbors contingent on severe austerity cuts, fearing that unconditionally bankrolling the lavish spending of others would create moral hazard. This position stems from the view, expressed by German Finance Minister Wolfgang Schäuble in a recent interview with the Financial Times, that “whatever role the markets may have played in catalyzing the sovereign debt crisis in the eurozone,” it is mostly a result of “excessive state spending.” This is a dangerous attitude, as it blurs the shared responsibility for the crisis, undermines German political support for the region, and risks the economic stagnation that imposed austerity could cause Europe.
The eurozone crisis is not a simple story of sinners and saints. Overleveraging -- the excessive borrowing practice at the core of the crisis -- is itself a perverse and direct consequence of the unified currency. The introduction of the euro and the inflation-fighting mandate of the European Central Bank caused credit-rating agencies to lower interest rates across the eurozone. Greece, Ireland, and Italy suddenly found themselves with Germany’s credit score, and their citizens and governments went on borrowing sprees. Current account deficits exploded in the periphery, as German and French banks loaned money to Greeks and Spaniards to buy German and French products. Fantastical financial products pushed by Wall Street, London, and Frankfurt further fueled the consumption binge, since they allowed individuals to take out even larger mortgages and revolving credit.
All was well until the financial crisis dried up revenues and forced governments to transfer the costs of risky private borrowing to the public through bailouts. Banks are once again making record profits, but taxpayers are stuck with the hangover from the party. The sovereign debt crisis, then, is not merely a result of individual states’ irresponsible fiscal decisions but part of a systemic failure in the flow of European credit.
For Merkel, speaking about the moral hazard of a rescue plan was a short-term strategy to navigate the domestic politics of the crisis. Unfortunately for Europe, it has boxed her into a corner. Playing a game of chicken over bailouts has inflamed bond markets, which exponentially increased the size of the Greek bailout and brought Italy to the brink of default. But the calls for austerity that accompanied Merkel’s politics of moral hazard have little chance of solving the fiscal woes of the peripheral countries. As wages and government spending fall, local recessions deepen further, gutting the potential tax base that could be used to pay off sovereign debt. And for Germany, austerity in other European countries would collapse critical German export markets, guaranteeing a double-dip recession in Europe and Germany.
On the domestic political front, German voters have been repeatedly warned about irresponsible spending by their neighbors. But now the continent is asking them to be the lenders of last resort. The German people see little justification for their shared sacrifice; bailout fatigue abounds on the streets of Berlin, Cologne, and Hamburg. It is no wonder that the Merkel government has lost a number of regional elections as the crisis continues.
In recent weeks, however, there have been signs of a shift in Merkel’s approach to the crisis. The chancellor demanded that bondholders take a 50 percent “haircut” in the Greek sovereign debt bailout, meaning they would only receive half of the money they initially invested. For the first time, Merkel acknowledged that individual governments were not solely responsible for their fiscal problems and that the private sector would have to bear part of the costs of the recovery. Then, earlier this week, she called for a stronger political union in Europe, saying that the continent was facing its “most difficult hours since the Second World War.”
This could mark a German about-face toward a response to the crisis premised on shared responsibility. Europe’s leaders could push the private sector to contribute more to the periphery’s rescue and treat the crisis as a systemic failure of the private and public sectors alike.
Drawing on the lessons of the Latin American debt rescheduling of the 1980s, Europe should invoke a kind of Brady plan, the debt restructuring initiative spearheaded by the George H.W. Bush administration that broke a vicious cycle of insurmountable debt and uncertain investments. Under the European plan, countries encumbered with debt would exchange their old debt for new bonds underwritten by core eurozone members through the European Financial Stability Facility. Working with bondholders, the eurozone would negotiate a voluntary reduction on behalf of the banks in exchange for the new debt.
The resulting sacrifice would need to be shared: Investors would give up significant portions of their original investments, eurozone members would own the crisis by backing the new debt, and bailed-out countries would have to tighten their belts as much as they could while still permitting a return to growth.
For investors, this is not merely a Robin Hood scheme. They would lose part of their investment, but in return they would gain the security and liquidity of the new debt collateralized by the eurozone. In order to save the European social market, some private-sector pain will be necessary. Financial services benefited tremendously from and contributed to the bubble during the boom and now cannot run away from the consequences during the bust. Disaster would be averted, and Europe could start to clean up the mess wrought by the crisis.
Clearly, voters in Germany and France will need to be sold on this bold vision. But it should be sellable: The risks associated with further contagion far exceed the costs of a big, quick intervention. German politicians need to explain their own country’s complicity in the crisis and build solidarity among their voters for a collective response. Similarly, investors will resist large write-downs. In the end, however, the Institute of International Finance, which represents financial institutions globally, can be expected to cooperate on a fair and workable solution, as it is doing in Greece. Merkel needs to set aside her cautious tendencies -- with growing risks of widespread default in Europe, only a big move can stabilize the continent and, in turn, the entire global economy.