Europe’s Time to Learn

A Latin American default would have brought down the banking systems of all the major industrial countries, causing something like a replay of the Great Depression. Exposure to Mexican debt alone represented some 90% of the capitalization of major US banks.

The solution that was eventually adopted was considered brilliant at the time, because it avoided formal default by any of the big Latin American borrowers (though Brazil briefly defaulted five years later, in 1987). It involved a combination of three elements: immediate international assistance, through the International Monetary Fund; severe domestic retrenchment, enforced by the highly unpopular conditionality of IMF programs; and additional financing provided by the banks.

There was no institutionalized write-down of Latin American debt until five years after the crisis, when a haircut no longer threatened banks’ stability. It was only at this moment that real lending for new projects could really begin. In the meantime, Latin America remained mired in what became widely known as the lost decade.

The contemporary European solution seems to be repeating the same time-buying tactics of the lost decade of the 1980’s in the developing world. There is the same combination of international support, highly unpopular domestic austerity measures (which are bound to set off major protests), and the apparent absolution of banks from financial responsibility for problems that they produced.

Major European banks – in the United Kingdom, Germany, and France – have, like their 1980’s predecessors, built up a gigantic exposure to what they erroneously thought was safe debt. A substantial immediate haircut on the sovereign debt of the vulnerable eurozone countries would be so destructive that it would set off a new round of bank panics. Recognizing this problem, banks can hold their host governments to ransom. That is why the crisis has become a challenge for the UK, Germany, and France.

The Franco-German initiative unveiled at Deauville in early November, which would require some possible measure of restructuring for debt issued after 2013, tried to avoid the immediate shock of a haircut. But the pre-announcement of possible write-downs still led to a major wave of uncertainty about banks.

A long-term alternative requires some capacity to write down debt where it has reached excessive levels. But it is also necessary to establish an iron-clad guarantee of some part of the outstanding debt, in order to remove fear of a complete write-down.

A mechanism for dealing in an orderly way with sovereign bankruptcy would be a major contribution to global governance, and to solving a longstanding problem of sovereign-debt markets. Such proposals were widely discussed in the 1990’s and early 2000’s, and IMF Deputy Managing Director Anne Krueger pushed a Sovereign Debt Restructuring Mechanism that would have offered a legal path to imposing general haircuts on creditors, thereby ending the collective-action problems that impede the efficient resolution of sovereign bankruptcy.

If Europe could show – in the worst possible scenario of sovereign default – how such a process might operate, uncertainty would be reduced and markets would be reassured. And, in the longer term, we would have a viable international model of how to tackle severe sovereign-debt problems.

Harold James is Professor of History and International Affairs at Princeton University and Marie Curie Professor of History at the European University Institute, Florence. His most recent book is The Creation and Destruction of Value: The Globalization Cycle.

Copyright: Project Syndicate, 2010.www.project-syndicate.orgFor a podcast of this commentary in English, please use this link:

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