How Not To Solve the European Debt Crisis
The new legal tools Angela Merkel is touting aren't new and won't work.
Posted Thursday, Dec. 2, 2010, at 1:14 PM
The debt crisis in Europe presents a big political problem: Wealthy countries, chiefly Germany, must either agree to subsidize poor countries or abandon the euro so that Greece, Ireland, and other countries on the verge of default can reduce their debt payments by devaluing their currencies. The first option is politically explosive; the second is politically catastrophic. To duck this unwelcome choice, heads of government like German Chancellor Angela Merkel and French President Nicolas Sarkozy have proposed a variety of legal mechanisms that sound new and enticing. But these proposals are a smoke screen. The reality is that the necessary legal tools already exist, and they're not being used because they would actually make the crisis worse.
When creditors first lost confidence that Greece could repay its debts, the problem appeared to be internal. The Greek government had cooked the books, and once creditors discovered this, they refused to make new loans. Europe stepped in with loan subsidies, but only after a moment of hesitation that planted a seed of doubt for the creditors of other European countries. They realized that if Europe was unsure whether to bail out Greece, it might not bail out other countries in financial distress.
Next came Ireland, with less public debt than Greece, but a banking sector that had massively overlent during a bubble. Because a government can't let its banking system fail, creditors realized that Ireland would have to take on this massive debt, and the Greece crisis repeated itself. At this point, Merkel suggested that in future sovereign debt crises, the creditors should not be paid in full. This proved another serious mistake that pushed Irish banks—and hence the solvency of the Irish government—to the brink.
Now policymakers are working furiously on legal mechanisms for regulating sovereign debt crises in the future. The common theme is that creditors will be told in advance that if the government defaults, they will not be paid in full. An "orderly default mechanism," in the bland Euro-cratese of the Bruegel think tank, will ensure that creditors will take a haircut, but that this will be done fairly. Interest rates will adjust and voters in other member states will not have to pay the bills.
The two main proposals being discussed are a statutory bankruptcy-type scheme for sovereigns and a redesign of debt contracts. Given the urgency in the search for a solution, the statutory option is unlikely. That leaves the contractual solution, which involves putting so-called Collective Action Clauses in future sovereign bonds issued by Greece, Ireland, and all other Euro-zone countries. These clauses give bondholders the right to vote, by supermajority, on restructuring plans, so that they can protect their interests, while preventing a small number of bondholders from holding out for a better deal (which in the past has torpedoed efforts to resolve debt crises). The theory is that voters in countries like Germany will pay for a bailout if they're assured that future creditors are on notice—this pay-off will be the last.
The problem with this fix is that Collective Action Clauses (and other contractual terms with similar effect) are already ubiquitous in sovereign debt contracts—including those of Greece and Ireland. They have been routine for at least two decades. If the clauses did not produce the proverbial "orderly defaults" this time around, why would they prevent future crises?
The usual answer is that governments issue bonds in batches, and different batches of bonds often have different Collective Action Clauses. One clause might require approval of two-thirds of bondholders, while another requires approval of three-quarters or more. Coordinating among these different contracts can be difficult, and the new European proposal would solve this problem. But the difficulty exists only when the bondholders are scattered and anonymous. The bonds of the Eurozone sovereigns, by contrast, appear to be largely held by the European Central Bank and other banks on the continent, which can easily get together. Even in less propitious circumstances, coordination is feasible: Belize recently restructured its debt using Collective Action Clauses.
The real reason why the existing Collective Action Clauses have not been used to solve the current crisis is that the leaders of Europe do not want to use them. Chancellor Merkel caused a bank run in Ireland merely by suggesting that future creditors should share the loss when sovereigns default. If she had said the same thing about current creditors, based on the existing contracts, the financial panic would have been even greater. Without the expectation that governments will ensure that they are paid in full, depositors would have been desperate to withdraw funds from banks.
What's the Collective Action Clause romance about, then? It is legal gobbledygook that sounds like a fresh idea and might fool voters into thinking that further bailouts will not be necessary. But it will not fool the creditors—that's why the contagion has spread to Portugal, Spain, even Italy. And it's why Merkel and company have endorsed a massive bailout fund. There's no painless legal fix for this mess.
Mitu Gulati is a law professor at Duke University.
Eric Posner, a professor at the University of Chicago Law School, is a co-author of The Executive Unbound: After the Madisonian Republic and Climate Change Justice. Reach him on Twitter at @EricAPosner.
Photograph of Angela Merkel by Sean Gallup/Getty Images.