Must one repay one’s debts ?

By Jean Pisani-Ferry

06 June 2011

For months now a row about sovereign debt restructuring has been raging between those who insist that
Greece must continue to honour its signature and those for whom its debt should be partly cancelled. As is
often the case in Europe, the crossfire of contradictory official and non-official statements has been throwing
markets into turmoil. Confusion abounds. Some clarity is needed.

The first question is whether Greece is still solvent. This is harder to judge than for a firm because a sovereign
state possesses the power to tax. In theory, all that is needed in order to get out of debt is to increase taxes
and cut spending. But the power to tax is not limitless. A government determined at any cost to honour its
debts ends up imposing a much higher level of tax revenue than the level of services it supplies, and at a
certain point this discrepancy becomes socially and politically unsustainable.

Among advanced economies, none (except oil-rich Norway) has managed to durably achieve a primary
surplus (revenue less non-interest expenditure) exceeding six percent of GDP. Even if the Greek government
were to succeed in stabilising its debt ratio, it would be at a level (it is set to reach soon 150 percent of GDP)
too high to convince creditors to extend lending. Greece will need to reduce its debt ratio considerably before
it can return to the market, which implies – even under an optimistic scenario – creating a primary surplus in
excess of eight percentage points of GDP. This is too much for a democratic country, and one where the tax
burden is very unequally shared. Greece is in fact insolvent.

The second question is whether it is very serious not to repay one’s debts. One camp notes that no advanced
country has ever ventured to do this for decades and that is the reason for the positive reputation they still
enjoy. It would only take one member of the euro area to embark on this path and all the rest would be under
suspicion. For those adhering to this thesis, contracts must at all costs be respected. But the other camp is
calling for the creditors who triggered the excessive debt to be punished for their imprudence. Lenders must
suffer losses so that in future they price sovereign risk more accurately – in other words so that they make
reckless governments pay higher interest rates.

Both lines of argument are valid, but the fact is that those countries which have restructured their debt have
not found themselves overly blighted by it. Far from being banished from bond markets, they have generally
bounced back quickly, as investors like a sinner who returns to solvency better than a paragon of virtue on
the verge of suffocation. Twenty years ago Poland negotiated a reduction in its debt and came off better than
a Hungary keen to protect its reputation. In this regard, debt reduction is not fatal.

The third question is whether a Greek default would be a financial catastrophe. Two channels are at work, one
internal and one external. First, government bonds are the reference asset for banks and insurers because
they are easily tradable and ensure liquidity. It is therefore obvious that any doubt about the value of such
bonds could cause turmoil. The solvency and access to refinancing of the Greek banking system would be hit.
Externally, in turn, other European banks would be affected. And, especially, contagion would threaten other
countries in a fragile state – at least Ireland, Portugal, Spain.

© Bruegel 2011 www.bruegel.org 1

So we are in a serious situation. This makes it even more difficult to understand the attitude of central banks
which, instead of trying to find a way to cushion the possible impact of such a shock, are raising the spectre
of a chain reaction and invoking the collapse of Lehman Brothers in September 2008. They are threatening to
punish any restructuring by cutting banks’ access to liquidity. But if Greece is not solvent, either the EU must
assume its debts or the risk will hang over it like a sword of Damocles. By refusing a planned and orderly
restructuring, the euro area is exposing itself to the risk of a messy default.

But Europe is not obliged to choose between catastrophe and mutualisation of debt. The best route –
admittedly a narrow road – is initially to beef up the financing programme for Athens while at the same time
trying not to let private creditors withdraw too easily (which looks like happening at the moment). But this
breathing space must be used for more than simply buying time. It should be used, first, to allow other
countries in difficulty to regain or consolidate their financial credibility and, second, to pave the way for an
orderly restructuring of Greek debt. So : yes to gaining time, but let’s put it to good use.

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