A tragedy of small decisions

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Bob Swarup and Dario Perkins look at the latest developments in the euro-zone crisis and warn that while history doesn’t repeat itself, it does rhyme.

Denial – anger – acceptance. There has certainly been no shortage of denials from European leaders about the danger and futility of the last two years of failed austerity policies. And every day across their populace, the anger spreads a little. But on the evidence of the PR disaster of the tax on Cypriot deposits, acceptance is still some way off.

This is alarming because Europe has already tried to deal with one debt crisis using austerity and it didn’t work. As the euro crisis enters its fourth year, the parallels between the European austerity of today and the post First World War reparations fiasco are striking. This crisis may not end in political nihilism but it could end with radicalism fit for the time, with electorates and politicians that turn their backs on Europe.

After the First World War, Germany was in a precarious financial position. It financed the war by borrowing and when defeated, had to pay massive reparations to the Allies (some 260% of German GDP). These were at least partly driven by the Allies’ need to repay their own heavy borrowings from the US. The economist John Maynard Keynes – part of the British delegation at the Treaty of Versailles in 1919 – resigned in frustration and published his polemic The Economic Consequences of the Peace. In it, he argued that the punitive damages being sought and the inflexible attitudes towards war debts would destabilise European economies and culminate in another war. He was right. During the 1920s, the refusal by all parties to forgive German and inter-Allied war debts led to a series of German economic disasters: hyperinflation in 1922-3, a private credit bubble in 1925-8, and austerity coupled with mass unemployment after 1928.

The situation is conceptually similar today: a host of ‘bad countries’ required to make good on their debts combined with the crippling effects of a fixed currency mechanism, resulting in enforced austerity. The irony is that the positions of the main players have been reversed.

Europe’s politicians of 2013 think their crisis is over. The European Central Bank has unveiled its monetary arsenal and reassured financial markets that no country will be forced out of the euro. European leaders hope they can stabilise their economies, reignite growth (through some as yet unspecified mechanism) and rediscover the mantra of harmony and integration.

But hope is not a strategy by itself. Today, Europe finds itself again on a path of national divergence as differing domestic conditions and priorities overwhelm any nascent European identity. As politicians ‘muddle through’ without a comprehensive plan – pursuing austerity policies that actually harm economic growth – much of the region will remain mired in depression. In countries such as Spain or Greece, a quarter of the workforce is unemployed and more than half of school-leavers are out of work. A ‘lost decade’ in Europe cannot be sustained without creating severe social tensions. The European experience of the 1920s and 1930s shows that such dynamics are not politically or socially feasible. Unless current policies change, voters in the euro-zone’s most indebted countries will eventually again embrace populist fringe elements and reject the euro.

The lessons of the past undoubtedly point to the inevitability of much larger debt write-offs for both sovereigns and banks. Europe must be realistic about how much debt its ‘periphery’ can handle and write down the rest.

Europe needs its own Brady bond plan. The Latin American debt restructuring of the 1980s led by the US is a useful lesson in resolving unsustainable sovereign debts. The Brady bonds issued were a mixture of reduced principal and reduced coupon instruments, with various guarantees and call options embedded within them. This allowed creditors – public and private – to restructure to their preference while also providing debt forgiveness.
The restructuring must be Europe-wide in scope and all the core countries – notably Germany – must support it. Market confidence will only return if investors see a strong set of sovereigns (including international bodies such as the IMF) supporting the scheme. Monetary stimulus in the short term and structural reform in the longer term are critical to nurturing and restoring sustainability. The holders of the new debt will only have faith to the extent that they can see tangible prospects for growth and repayment.

The EU won the 2012 Nobel Peace Prize for its efforts in reuniting Europe. But unless it arrests this unveiling tragedy of small decisions, that award will prove premature. In the 1920s, five Nobel Peace prizes were shared between eight people for policies that neither solved the debt crisis nor created lasting peace in Europe. It is a discordant melody few would care to hum today.

Bob Swarup is a principal at Camdor Global, and the author of a forthcoming book on financial crises from Bloomsbury Press. Dario Perkins is a senior economist at Lombard Street Research and a former adviser to the UK Treasury

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