Euro
Zone Should Look to Brady Plan to Solve Its
Crisis
By Jacob
Funk Kirkegaard
The US Treasury Department
building in Washington. Euro-zone governments
could learn a lot about dealing with the debt
crisis by looking at the US Brady Plan in the
1980s.
After
the Latin American debt crisis in the 1980s,
US regulators lied about the health of
American banks until they were in a position
to take a voluntary haircut on their bad
loans. The Brady Plan holds important lessons
for euro-zone governments looking for a way
out of the current debt crisis
Jean Monnet, the French
economist and public official who is regarded
as one of the architects of European unity,
once famously stated that "Europe will
be forged in crises and will be the sum of
the solutions adopted for those crises."
That dictum also applies to the current
sovereign debt crisis in the euro zone:
European leaders have put in place far-reaching
and beneficial institutional reforms that
have the potential to conclude the decade-long
process of introducing the euro.
Gone is the politically
expedient "no bailout" clause of
the euphoric early period of the monetary
union. At that time, neither policymakers nor
private lenders paid any attention to what
the sources of economic growth in the
periphery were or cared about which sectors
were the destination of large capital inflows.
Today, the fiction has ended. Europe now
knows what happens if economic growth and
fiscal policies are not sustainable over the
business cycle.
For political leaders
facing unpredictable and escalating sovereign
debt crises, the initial imperative must
always be to first confine the crisis before
proceeding to solve it and prevent it from
happening again. Despite the naïve calls
from financial markets for an immediate
comprehensive solution to the crisis, recent
events make it evident that European Union
leaders have, since May 2010, succeeded in
their first task of containing the crisis.
This is true both at the national level in,
for instance, Spain and at the EU
institutional level.
EU leaders should be
congratulated for not wasting this crisis.
They have set up the new IMF-inspired
European Financial Stability Facility/European
Stability Mechanism (EFSF/ESM) system, from
which financial assistance -- tied to tough
conditions -- is now available at short
notice to euro-zone countries in need. These
institutional innovations, combined with the
European Central Bank's appropriately
pragmatic set of crisis-related measures,
represent lasting and politically legitimate
tools that Europe can use to combat future
financial instability.
Misguided Notions
During the initial stage of
the euro-zone debt crisis, financial markets
forced reluctant politicians to gradually
recognize the true extent of the monetary
union's problems. Now, with Portugal's request for an EU/IMF
bailout, that stage
has come to an end. This is clear from the
lack of contagion to, for instance,
neighboring Spain from the Portuguese
announcement -- a development which
effectively restricts the crisis to the
"true" periphery of Greece, Ireland
and Portugal. Those three states combined
accounted for just 4.6 percent of the
European Union's GDP in 2010 (approximately
equal to the weight of mid-size states like
Florida or Illinois in the US economy).
At this point, it is
crucial that Germany in particular is not
distracted by misguided and premature notions
of "burden sharing" between
creditors and debtors in the euro zone. The
German and other AAA-rated governments must
resist concerns over national sovereignty,
which are outdated in a currency union. They
should also not lament the crucial role that
their demands for attaching tough conditions
to financial aid has played in undermining
corrupt and inefficient party and political
systems and growth models in Greece, Ireland
and (soon) Portugal.
Contrary to much short-term-focused
conventional wisdom, the structural reforms
implemented as a result of these countries'
IMF-inspired programs represent the best
opportunity for younger generations in these
countries to share the euro zone's prosperity
in the longer run. The European institutions
now in place are capable of imposing tough
conditions on national governments that fail
to carry out reforms. That fact alone is
testament to Europe's progress during this
crisis.
Yet, while discussions of
burden-sharing have been inappropriate during
the current, initial stage of the euro-zone
debt crisis, it is important that both euro-zone
creditors and debtors realize that this issue
will be crucial as we enter the second, and
final, stage of the sovereign debt crisis.
Financial history clearly tells us that
sovereign debt crises cannot be settled
without genuine burden-sharing between
creditors and debtors at some point.
Banking Crisis Must Be
Addressed
It is also self-evident
that Europe's sovereign debt crisis cannot be
solved without simultaneously addressing the
euro-zone banking crisis. Luckily, the very
fact that the euro zone has a twin crisis in
both peripheral countries and the core
European -- and not least German -- banking
system will in some ways make negotiated
burden-sharing between creditors and debtors
easier to ultimately achieve.
When thinking about how the
euro zone will successfully navigate the
second, burden-sharing phase of its crisis,
an important historical precedent is
fortunately available in the form of the 1980s
Latin American debt crisis. That crisis
principally involved a number of Latin
American country debtors and large, mostly
American creditor banks. In 1982, Mexico and
other large Latin American countries stopped
servicing their large dollar-denominated
debts to US banks, which would have become
insolvent as a consequence if their bad loans
had been valued on the basis of their current
market price.
Crucially, however, in a
bid to protect the solvency of the US banking
system at the time, US banking regulators
adopted a strategy of so-called "regulatory
forbearance" toward American banks that
shielded them from having to immediately
recognize their enormous loan losses. That
move contained the crisis and bought time for
the banks to gradually build up profitability
and sufficient loan-loss reserves. It was
only in 1989, seven years after the beginning
of the crisis, that the Brady Plan began the
second, crisis-resolution stage of the Latin
American debt crisis.
The Brady Plan, which
avoided outright legal defaults against
creditors, consisted of a series of
negotiated voluntary debt swaps and
restructurings (including principal
reductions) between debtor nations and US
creditor banks. What is critically important
here is the fact that the Brady Plan only
commenced at a point in time -- seven years
later -- when US banks had amassed the
necessary loan-loss reserves to be able to
write down the value of their loans to Latin
American debtors without having to realize a
substantial earnings loss in the process.
Stress Tests Are Not
Genuine
There are numerous
parallels with the situation in Europe today.
Just as US banking regulators in the 1980s
essentially lied about the financial health
of their banks to avoid a major banking
crisis, European -- and especially German --
banking regulators are doing the same thing
today with respect to the true health of core-European
banks. It is not surprising that the stress
tests of the European banking system in both
2010 and 2011, while marginally beneficial in
transparency terms, have been designed to, on
the one hand, encourage banks to accelerate
their gradual campaign to raise more core
equity capital, while on the other hand
shield the same banks from having to
immediately recognize the true extent of all
their peripheral loan losses.
Were genuine stress tests
to be carried out in the European banking
system today, they would undoubtedly reveal
capital requirements of hundreds of billions
of euros, most of which would inevitably have
to come from European taxpayers. That is
obviously an outcome that European political
leaders would prefer to avoid, given ordinary
citizens' reluctance to pay for another
"banker's bailout."
However, just because
truthful banking stress tests are impossible
today in Germany and other European countries,
it does not follow that this situation will
persist. During the 1980s Latin American debt
crisis, it took seven years of regulatory
forbearance to nurture US banks back to
health and arrive at a point where burden-sharing
could be negotiated between creditors and
debtors. European governments, however, do
not need to keep telling lies for that long
before they can initiate the burden-sharing
stage of the euro-zone debt crisis.
While it is clear from the
Brady Plan experience that a final negotiated
solution to the euro-zone debt crisis can
only begin once the broader re-capitalization
of the European banking system is further
along, there is much that European banking
regulators can do to speed up this process.
They could, for instance, gradually introduce
more honest annual banking stress tests,
while making it clear to the banks in
question that the government regulatory
protection they continue to enjoy today comes
at the price of negotiating genuine burden-sharing
with creditors in good faith in the future.
Loan Conditions Must Be
Implemented
Moreover, as has been seen
with the Spanish cajas savings-bank
sector, national governments can move
forcefully to restructure insolvent regional
publicly owned savings banks. In Germany, it
is clear that state governments are extremely
unlikely to be able to bear large future
costs associated with the necessary
recapitalization of their Landesbanken
regional state-owned banks. Hence, the German
federal government should either step in
without delay or accept politically that the Landesbanken
in question be liquidated.
But a better capitalized
European banking system is merely a necessary,
but not sufficient, criterion for a
negotiated burden-sharing solution to the
euro-zone debt crisis. Unlike the Brady Plan
participants, creditors and debtors in the
euro zone are linked together in a permanent
currency union. Before any negotiated
solution can happen -- which would avoid a
legal default but which would involve banks
taking voluntary haircuts on the principal
paid for by "participating" bank
shareholders -- it is therefore necessary to
ensure that the structural conditions
attached to EFSF/ESM loans have been fully
implemented by recipient governments.
Not only will this maximize
their debt service capacity and hence reduce
the scale of the negotiated haircuts required,
it will also minimize the risk of the current
sovereign debt crisis being repeated. Only
then will the process of introducing Europe's
common currency be at an end.
from DeSpiegel/Opinion