Crossroads (Toward Philippine economic and social progress)
Philippine Star, 20 June 2012


In a much awaited and tension-filled election this weekend, the voters of Greece opted to settle a festering political deadlock. The Greeks rejected the option of leaving the euro zone and possibly saved the Euro currency union from breakup.

The euro problem continues. Whether Greece is in the zone or out, the euro zone problem remains severe. The overhang of debt in some countries of the zone gives the euro zone area a crippling economic base. There are no bright conditions on the horizon to change market expectations overnight.

The prospects will persist for these countries unless the root of the problem – fiscal in nature – is recognized with concrete action. The fiscal solution is not just for the countries in debt to tighten up. The countries in fiscal surplus would need to recognize that fiscal sacrifice on their part is part of the solution.

Mechanics of the debt trap. A country will be able to keep itself away from a debt trap – a situation of rising debt to GDP ratio – only if the rate of interest on its debt is lower than the rate of growth of its economy. (Here we talk in nominal terms, meaning that the interest rate and growth rate include price change and we further exclude devaluation and debt bailout numbers.)

Countries burdened by debt are exposed to market conditions that they cannot control. When their sovereign credit ratings are downgraded, their problem even escalates.

The interest rate could easily rise beyond the growth rate of the economy. Moreover, economic growth is difficult to achieve when debt service requires resources that could be spent on investment and other needs.

Under normal times, it was possible for Greece, Spain and Italy to face reasonable interest rates along with countries that were less debt-burdened. Once their precarious debt levels had been detected as problematic, the borrowing cost on their debt rose.

At current rates of interests today, Spain’s bond yields which signify their interest cost is around seven percent and that of Italy just a little less. Yet, those of less challenged economies in the euro zone have yields much below two percent. If not for the bailout, Greece’s borrowing cost would be even worse. Yet the interest rate on Greek debt is a multiple of Spain’s rate, clearly unsustainable.

In the current world, the countries in high debt in Europe do not see any high hopes about the economic future. As an engine of world growth, Europe is essentially a drag on the world’s economy, which is itself under severe challenge in view of the slow US recovery.

Prospects for growth of the indebted countries are severely limited even in the face of domestic efforts at reform. The growth of their public debt is therefore on an upward trajectory without help from within Europe itself and the world’s financial system.

What is the solution? To remove the systemic problem bothering Europe, it makes sense to move toward fiscal union. This is a political process that cannot take place quickly. Fiscal union would place control of the spending of different countries to a supra national policy rather than through individual countries.

The fiscal union in fact could help to firm up a sensible plan for a debt reduction program for the highly indebted euro zone countries. Debt reduction clearly creates a sharing of the burden of restoring sick neighbors to economic health. The process could help to make way for a debt reduction program based on market solution.

The idea of a pan-European bond issue to guarantee the debts of the highly indebted countries is an interim solution. Initially, it reduces the interest rate faced by the indebted countries.

This would help reduce the burden of bailing out the indebted countries on the shoulders of the economically strong. Of course, the strongest economy is Germany and much of the solution rests on the actions that it supports. The smaller but relatively strong European countries could share in that burden.

The bond issue, mixed with strong reforms within the indebted countries, would bring the debt issue within control. Within such a framework, a sufficiently adequate debt reduction is feasible. The rest of the bank debt could be retired using the market.

Such measures will make the solution to the euro a shared effort. The highly indebted countries have paid their due through economic decline and internal reforms. The other euro zone countries underwriting support of the debt issue suffer the additional cost on their budget. The bank pay through the loss in value of their claims on debt papers that they hold.

In short, all parties to the debt problem in Europe will get their proper haircuts.

It takes a super economic power to help out in this problem. Resolving the debt problem within the euro zone cannot be solved by quarrels and disagreements among equals, or among creditors and debtors alone. It takes supra-national institutions (the International Monetary Fund and the European Central Bank) and the support of the dominant economic power to do this.

When Mexico met with a second debt crisis in 1994 (a decade after its first crisis in 1982), the US Treasury under Bill Clinton’s presidency extended generous loans to tide it over as the IMF then had no more extra resources to lend. The rescue worked. Likewise, when Russia had its major debt problem in 1998, again, the US government used extraordinary powers to consolidate a large rescue package under the IMF.

A decade before, too, under Ronald Reagan, the US Treasury engineered a debt reduction scheme for the highly indebted Latin American countries, through the Brady bonds. The US Treasury floated bonds that guaranteed Latin American debt. (Incidentally, the Philippines benefited from the Brady bonds, although it took in only 2.4 percent of the large bond issue of $170 billion that was floated at the time.)

It is Germany’s turn in the world. In the current face of the world economy, it is Germany’s turn to assume a major role. The spotlight is on Angela Merkel. This happens at a time when the IMF and the ECB have new resources on which to leverage great power action with supportive policies.

Germany’s prosperity, goaded on by a work ethic of saving and investment and fiscal restraint, pushed it to the front of the most prosperous and economically powerful European nation. France might have been its co-axis in this resurgence, but it is Germany’s economic efforts that made it the dynamo of Europe’s growth following the 1960s.