A fundamental strategic error at the outset means the eurozone crisis continues to fester
Europe's crisis continues to fester. In large part this is due to a fundamental strategic error at the outset – the failure to restructure the debt of banks and governments.
Ten years ago the IMF revised its rules for handling crises precisely to prevent such errors. But, under short-sighted political pressure, the rules of the game were changed and the IMF was set adrift in dealing with the crisis in Europe.
The debt burdens of the three countries with official bailouts – Greece, Ireland and Portugal – illustrate the problem. Initially, they ranged from 92% (Ireland) to 125% (Greece) of GDP and will rise to at least 112% (Ireland) to 150% (Greece) of GDP by the end of 2012 (despite Greece's recent restructuring of privately held debt).
Previous debt crises pointed to the low likelihood that such large debts could be lowered to sustainable levels through adjustment and growth alone. The IMF failed to insist on these lessons from the past. Rather, bowing to the exigencies of European politics, it cobbled together low-probability assumptions about future growth, how quickly tax systems could be reformed, how rapidly government spending could be cut and when markets would re-engage in heavily indebted countries.
How could the IMF have put tens of billions of dollars into such fundamentally flawed programmes? Ten years ago, a similar question was debated in the aftermath of the Argentine default. Two views were pressed.
The first was that there was no institutional framework for orderly private debt restructuring. This view drove the 2002-03 effort to introduce a statutory sovereign debt restructuring mechanism (SDRM), bankruptcy-type procedures for sovereign restructuring. Creditors and debtors alike rejected the SDRM but settled on a scaled-down initiative – collective action clauses (CACs) in international bond issues – to facilitate restructuring. These set up provisions for creditor agreement on changing the financial terms of bond contracts. Most international bond issues now have CACs.
The second view was that the IMF is fundamentally unconstrained in deploying almost limitless financing even when debt sustainability is questionable. The IMF has always had quantitative ceilings on its loans but the history of ignoring them is impressive. To meet these concerns, four qualitative criteria – parsimonious yet on the mark – that must be met in large bailout cases were established in 2003: (i) the borrowing country must face exceptional balance of payments pressures; (ii) there must be a determination, based on a rigorous, systematic analysis, of a high probability that the country's debt burden will be sustainable; (iii) the country must have good prospects of regaining access to private capital markets; and (iv) the policy programme must have good prospects of success.
Neither innovation was seriously tested during 2003-2009 – a period of reprieve from catastrophic debt crises requiring IMF support. Some relatively small debt restructurings were concluded through "voluntary" approaches, often without activating CACs. The four criteria were mostly honoured in the few relatively uncontroversial cases.
But with the mess in Greece, questions about provisions for restructuring and constraining IMF bailouts need to come back on the table. From the outset, Greece patently needed debt restructuring. The eventual restructuring in 2012 was more costly and less comprehensive than it would have been at the outset. Ad hoc restructuring negotiations were fraught with uncertainty and brinksmanship.
It is debatable whether an SDRM would have made a substantial difference. True, negotiations were not protracted and were ultimately successful in their limited objectives. But debtors and creditors might have been less resistant to restructuring at the outset had an institutional framework for negotiations been in place.
More clear cut, however, was the failure of the four criteria to constrain the ill-fated IMF bailout. IMF staff would not state with confidence that Greece's debt burden was sustainable (that is, Greece did not meet the second criterion for exceptional access), so IMF financing should have been contingent on restructuring private debt. Instead, the IMF changed the rules, amending the second criterion to exclude crises that risk "systemic spillovers".
This punt begged three questions. Would restructuring in Greece have significant systemic spillovers? Why are sustainable debt dynamics not essential when systemic spillovers are at stake? How could a country regain access to capital markets (criterion iii) if its debt dynamics were not sustainable?
Exceptional access for Ireland and Portugal (where debt sustainability also was not affirmed) was similarly justified by the risk of systemic spillovers. These precedents will not be forgotten: the IMF now effectively has no constraint on large bailouts in unsustainable conditions.
Several questions now need answers. How can the highly politicised IMF be constrained from supporting countries with unsustainable debt burdens and increasing the ultimate costs of restructuring? Is a sovereign bankruptcy process needed as a backstop should "voluntary" restructuring fail?
Until these questions are answered and an objective voice for the IMF is secured through respected procedures for handling debt crises, the institution will remain adrift.
• Susan Schadler, former deputy director of the IMF's European department, is currently a senior fellow at the Centre for International Governance Innovation and the Atlantic Council.
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