Far from being irrational, markets are quite right this time to be concerned about the current crisis in the euro area.
History threatens to repeat itself. The first recorded sovereign default was in the fourth century B.C. when 10 out of 13 Greek municipalities in the Attic Maritime Association reneged on loans from the Delos Temple. Today, it looks increasingly likely that another sovereign default will occur in Greece in the coming years.
How should the euro area prepare itself for such an event? The answer: quickly.
The recent proposal by France and Germany on sovereign defaults stressed the importance of collective-action clauses in euro-area debt contracts. These clauses, which make debt restructuring faster by forcing minority bondholders to accept the terms agreed to by a majority of creditors, are no doubt important to include, but are a distraction from what is likely to be the main issue, namely financial stability.
Collective-action clauses are designed to resolve holdouts, whereby some bondholders try to obtain a better settlement than is on offer. Such problems became serious for sovereign debt in the 1990s.
Most emerging-market sovereign debt was written under U.K. or New York law. In the euro area, much of it is under domestic statute. In Greece, about 90 percent is subject to local legislation. So national governments can act retrospectively by passing a law that makes agreements binding if some bondholders accept the settlement terms.
It seems unlikely that the issues relating to financial stability can be solved as easily. Most banking regulation treats sovereign debt as being risk-free so that it isn’t necessary to hold capital against it. After the 2007 crisis, regulators encouraged banks to hold more government debt to ensure they have sufficient liquidity and can post it as collateral in refinancing operations. Changes are clearly needed. But it may not be desirable to encourage diversification of sovereign debt within the euro area.
Diversification helps to reduce risk, but it also spreads it more widely. In Greece’s case, where the nominal amount of sovereign debt outstanding is relatively low, diversification is probably safer since a default can be absorbed. But for debt issued by larger and greatly indebted countries, such as Spain, it is more dangerous. There is so much Spanish debt around that, if widely held, a default could bring down the entire euro-area banking system.
Careful design of regulation based on the magnitude of holdings within the financial system is needed. This is only the start of the institutional changes necessary.
A sovereign default would need to be done very quickly, otherwise it would trigger enormous capital flows in the euro area from countries perceived to be weak to those seen as strong, such as Germany. It would be hard to stop this kind of occurrence in anticipation of a default, let alone if the bankruptcy process were to take a minimum of six months, as some legal experts have suggested for Greece. Issues relating to priority of claims, deposit insurance and guarantees for other bank-debt holders would need to be sorted out.
There is an alternative to sovereign default in the euro area: A country could simply leave the currency union, possibly temporarily. This would also need to be done quickly to avoid massive capital outflows. A government would have to redenominate overnight all contracts into a new currency, presumably at a 1-to-1 ratio with the original euro amounts. There would still be a market-determined exchange rate between the new currency and the euro.
There would certainly be messy details, but the great advantage would be for the defaulting government to regain control of monetary policy and potentially be able to guarantee the banking system. There would be inflation, but this, together with the devaluation of the local currency, would help the country to grow by boosting exports. A few years after a sovereign nation has brought its budget deficit and debt under control, it could reapply to join the euro.
The financial-stability issues that sovereign default raises in modern financial systems should be the focus of official euro-area discussions. It is somewhat surprising that they have — at least formally — not been so far. There is no easy way out. It’s time to break such taboos.
(Elena Carletti is a professor of economics at the European University Institute in Florence, Italy. The opinions expressed are her own.)