Debt and diplomacy

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How the eurozone crisis resolves will be a scorecard of nations’ diplomatic powers
October 28, 2011

It’s challenging to get either Americans or policy wonks excited about the European debt crisis. Foreign countries are having problems to which there are no clever policy solutions? I’d rather listen to a panel discussion of Mitt Romney’s hair.

But my fellow wonks should pay close attention to the eurozone crisis — not because it’s big and important, but because it’s a serendipitous natural experiment on the distribution of power between western governments.

The crisis is easy enough to explain. European governments — particularly Greece, Portugal, Ireland, Spain, and Italy — borrowed too much money. The size of these debts are a problem in and of themselves, but their magnitude also has the effect of convincing creditors that they won’t be repaid, which leads to higher interest rates. Higher interest rates, in turn, make it harder for the indebted countries to pay, which begets doubt that the debts will be repaid and produces even higher interest rates. Hence, a debt crisis.

The fact that these countries share a common currency is only tangentially relevant to the problem. European countries with struggling economies would like a looser monetary policy than what might best serve the median state, and as those with massive debt pay their markers by trading in their euros for dollars, the issue will be forced — either the euro will be allowed to devalue and countries like Germany will experience inflation, or debt repayment will have a deflationary effect in the debtor countries.

But such problems plague any monetary union; Europe has had fights over the direction of monetary policy before, as has the United States — Rick Perry’s belief that expansionary monetary policy is “treasonous” is no doubt subtly influenced by his state’s stronger economic performance relative to the national average. And still, during the mortgage crisis, no one argued things would be easier to solve if California operated off a different currency than Texas; the Eurozone crisis is a threat to Europe, the political entity, not the euro, its common currency.

The real issue is that the prospect of Greece and its ilk repaying their debts is highly uncertain. And it’s uncertain for good reason: for the indebted countries, default is likely the solution that best serves their citizens. Such an action has consequences — it’s hard to open up a new line of credit after giving the finger to those who provided the old credit. But historically, sovereign theft works — it gets a nation out of the pesky problem of actually paying its debt, and lenders are not so harsh on deadbeat countries as one might believe. In fact, sometimes a complete default is better than some sort of restructuring — a country that only gets rid of half of its old debt might leave some doubt as to whether it can actually make good on fresh obligations, but a country that starts from a clean slate — so long as doing so doesn’t bring trade sanctions and other punitive responses from its neighbors — may regain effective access to foreign credit markets sooner.

What makes the default of say, Portugal, a touchy political matter for the European Union is that Portugal’s creditors are predominantly other European countries. And so there are two effects: the first is that some members of the union would like to have a free lunch at their peers’ expense — if French banks are the major backers of Portugal’s sovereign debt, then France can avoid financial losses by convincing less exposed union members (say, Britain or Germany) to help bail out Portugal and assume some of the risk of a default. The second is that it is unclear who is actually backing whom — no one is quite certain which banks are holding which bonds, which has contributed to a Europe-wide credit crunch, as lenders are wary of offering loans to European banks that might be reduced to insolvency as soon as a default is announced.

In an ideal world, there would be a bailout, much as there was for U.S. banks. Sovereign bonds and bills are assets with a highly uncertain value, and are paralyzing the European financial system. An international fund could purchase these assets from banks (at a highly discounted value, so as not to lose money on the whole), and thus free up liquidity for private lending. The international fund could be backed by countries in proportion to their exposure (i.e. France would chip in more than Germany) so as to avoid redistribution between states.

In the practical world, this is a massive coordination problem, made nearly impossible by lack of information on where the bad debt lies, conflicts of interest between states on how much each should contribute to the fund, how much of a haircut the owners of the bad assets must suffer, and finally the opaqueness of the risk — the bailout planners in Brussels cannot peer into the minds of Pedro Coelho, Peter Robinson, or Georgios Papandreou and determine whether they plan on honoring their debts. Reaching some sort of modus vivendi with debtor states is a prerequisite to arranging a bailout.

And so, Europe faces two measurements of its distribution of power. The first is in whether, and to what extent, sovereign defaults occur — to the extent they do, it suggests that creditor countries within the union lack the diplomatic leverage necessary to prevent debtor countries from running off with their money. The second is test is in whoever gets the losing side of things in whatever inevitably flawed bailout plan is reached — should one nation pressure its peers to shoulder more than their rightful share of the risk, that country should be judged to wield greater power than its neighbors.

The United States is not exempt from this calculation of relative power. As the prospects of a “reset” with Russia grow ever dimmer, and as Russia reasserts itself in Eastern Europe, the U.S. would find it convenient if Europe remained a coherent political bloc, capable of denying Russian inroads to the west. Though its exposure to European sovereign debt is tiny, if the U.S. cannot, through threat of sanction and other levers, convince debtor countries to fulfill their financial promises, it reflects poorly on American might.

There isn’t any policy Hail Mary to get abuzz about, and there’s very little skin in the fight, but American wonks should get out their popcorn and keep their eyes glued to the Eurozone crisis nonetheless. An opportunity to take as clear a reading of the multi-nation balance of power as this one comes along only once or twice in a generation.


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