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Peter spiegel: what can--and will--policy-makers do to resolve the debt crisis engulfing the eurozone? Brussels bureau chief, the financial times.

Since the eurozone debt crisis broke out last year there have been two schools of thought on how to deal with countries struggling on Europe's periphery.


The first was an orderly default for governments overwhelmed with sovereign debt, complete with "haircuts" - or severely cut payouts - for private bondholders

It was a stance that was politically attractive; why shouldn't private investors who made bad bets be forced to pay the price, rather than saddling taxpayers? It also made economic sense: the debt pile faced by some of these countries - particularly Greece -was so overwhelming that unless huge swathes were written off they would never climb out.

But hanging over European policy-makers was the great fear of contagion. To be sure, dozens of other countries have defaulted on their debt - in the past 15 years alone a diverse group, including Argentina, Indonesia and Russia, have done so.

But a eurozone default would raise questions about the entire currency union: if European policy-makers decided Greece could break faith with bond investors, what was to prevent Italy or Spain doing the same? Investors would flee peripherals and plunk their money in safer bets, like German or US bonds, driving up borrowing costs for Rome and Madrid and potentially forcing them into bail-outs, too. The future of the euro would be in jeopardy.

So the European Union embarked on a second course. Countries that could no longer finance their debt on the financial markets would do so through EU-led bail-outs. Greece got a [euro] 110bn rescue package; Ireland [euro] 85bn; Portugal [euro] 78bn. The plan was to tide these countries over for three years until they got their fiscal houses in order and were able to return to the bond market.

Implicit in these deals, however, was that if the bond market was unwilling to welcome them back, loans from the EU - and the International Monetary Fund - would either fill the gap in perpetuity, or a default would come at some time in the distant future. European leaders were criticised for kicking the can down the road, but there was a decent argument for doing so: defaulting during a panic made far less sense than waiting for sounder economic times.

However, there was a more troubling part of that plan. The longer the bail-outs go on, the more debt moves from the books of wobbly European banks onto the balance sheets of public institutions. Voters in northern creditor countries have grown exasperated with their taxes being loaned to the profligate south and countries subject to bail-outs have seen revolts against austerity measures imposed to get their books in order.

In response, Europe this spring began trying to steer a third, middle course: there will be no defaults, but taxpayers won't bear the entire burden either. Instead, private investors would be asked to "voluntarily" delay cashing out on Greek bonds. The problem is, bond rating agencies decided "voluntary" delays are like being a little pregnant: a sovereign is either living up to its commitments or it isn't.

Despite the warnings, European leaders in July decided to press ahead anyway. A menu of roll-over and swap plans were unveiled where banks committed to trade in their current holdings for new bonds that do not come due for another 30 years. Because debt holders are not getting paid back on time and in full, defaults became inevitable - marking the first time an industrial economy will have defaulted on its bonds since just after the Second World War.

This summer will be a time when European policy-makers will be watching the bond market with trepidation. They have insisted that the Greek defaults are unique and will not be repeated elsewhere. But investors clearly feel a Rubicon has been crossed. Borrowing rates for Spain and Italy have risen as panicky investors, fearful that their holdings will be "haircut" too, move their money into Germany.

The deal is expected to lower Greece's debt burden a bit, and it will gain some political points at home. But it could also lead to a panic that engulfs the rest of the eurozone. Perhaps those eye-popping bail-out figures don't look so big after all.
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Title Annotation:Opinion
Publication:Financial Management (UK)
Geographic Code:4EUUK
Date:Sep 1, 2011
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