Debt restructuring 'feasible and necessary'

Austerity alone cannot solve the eurozone crisis - the only solution is restructuring peripheral debt and recapitalising banks, writes the London School of Economics professor

At heart, the eurozone crisis is a battle over who will ultimately be liable for the billions of actual and potential losses by European financial institutions. As neither Eurobonds nor using the European Central Bank as lender of last resort are immediately available options, the European Union, ECB and International Monetary Fund had initially decided that bank bondholders must be protected at all costs, preferring to impose losses on taxpayers instead – even if this stretches governments' solvency to breaking point.

Because voters' tolerance for bank bail-outs has worn thin, governments are acting covertly: lending huge sums to the periphery – Greece, Ireland and Portugal – so that they can repay German, French and British banks in full. The best solution economically would be a restructuring of peripheral debt and a recapitalisation of the German, French and British banks. The problem is the potential political fallout from such an action.

The refusal to countenance a Greek default is now dragging the eurozone toward even greater crisis. Implicit in this view, of course, is the idea that the current bail-out proposals are operationally unsustainable and will lead to a broader contagion to Italy, which will ultimately afflict the credit ratings of core countries such as Germany and France. The eurozone's problems are not merely the result of profligate borrowing by the peripheral nations. They also reflect earlier profligate lending by the core nations. Can European countries continue with the austerity measures laid out by EU, ECB and the IMF? This is especially pertinent with Greece's inability to meet targets. Imposing austerity on Ireland, Portugal or Greece cannot, on its own, solve the eurozone's problems.

A well thought out restructuring is legally feasible and economically necessary now. Debt restructuring would allow peripheral economies to reduce their debt. Debt restructuring also has to be accompanied by measures to avoid contagion. This is the issue that needs to be addressed immediately. Otherwise, there is something far worse than a debt restructure: the commencement of a successive elimination of countries from the eurozone that will give rise to considerable levels of speculation in the money markets as to who comes next and when.

A debt restructuring plan for the periphery would need to be drawn up and implemented. A significant portion of the current debt would be written-off, to enable peripheral economies to have some chance of attaining solvency. All lenders, private sector banks and investors as well as official lenders, must bear the losses. Debt restructuring should entail lengthening the maturity of debt and renegotiating terms to try to ensure the ability to service the debt. The debts incurred by German, British and French banks having gambled in the peripheral states can only be paid by four sets of people or institutions.

They can be paid by the ECB, the bank creditors themselves, the citizens of the peripheral countries where the banks who owe the money are located, or the citizens of the core countries where the banks who are owed the money are located. Now that the EU leadership has ruled out options one and two, it means that only options three and four are possible. They have forced citizens of peripheral economies to pay the debts of the core banks. The citizens of peripheral economies such as Greece also now direct their anger at the European policymakers. If the EU forces the citizens of the core countries like Germany to pay for their own banks they will also question the benefits of the EU and the Euro. Both outcomes would be bad for the European project, so therefore only options one and two are good for EU taxpayers and citizens.

The optimal solution for the eurozone crisis is that Ireland's, Greece's and Portugal's debts would be reduced solely by the losses of private investors, namely debt restructuring. At the same time, core economies such as Germany would announce measures to support their banks, as required, to prevent losses on sovereign bond holdings from setting off a European banking crisis. Governments would stand ready to subscribe capital to banks or guarantee bank deposits and borrowing. The ECB itself, which is heavily exposed to the peripheral economies, may itself require recapitalisation and financial support.

While the ECB and the European Financial Stability Facility are important in buying time for the eurozone, they lack the financial muscle required to safeguard the euro's future. In the absence of decisive action there is a serious risk of rapid deterioration in financial conditions. This would create a domino effect on countries like Ireland making any recovery near impossible. It would also affect Spain and Italy and it would affect the stronger countries like Germany, France, the United Kingdom and the Netherlands.

Professor John Ryan is a fellow of the Centre for International Studies, London School of Economics