Sovereign debt restructuring and the euro crisis

The eurozone came with fine aspirations: according to article 127 in the consolidated version of the Treaty on the Functioning of the European Union ‘the primary objective of the European System of Central Banks (ESCB) shall be to maintain price stability’; and, by article 130, the monetary policy decision-making of the ECB and all national central banks shall be free of political influence.

From the outset, those precepts were compromised. The overriding commitment to a political union allowed a blind eye to be cast upon the failure of euro aspirants to meet all five economic convergence criteria. Luxembourg was the exception. Unfortunately, the perceived prudence of the ECB, when combined with creative national income accounting and brass neck deception, produced a myopic view of the prospective impact of chronic fiscal deficits. Sovereign debt crises were but a matter of time.

First Greece, then Ireland, now Portugal. With further serial contagion in prospect, the increasingly expressed view, that one size (interest rate) cannot fit all, inter-links with a lament for the lost exchange rate option. These are not independent: arbitrage determines the interrelationship between relative currency values and interest rates. Where, say, a domestic rate is unilaterally cut by one percent, arbitrage sets domestic currency at a one-year forward discount of one percent. Even so, many argue that, if only Greece or Ireland or Portugal had a currency to devalue or (essentially the same thing) a domestic interest rate to lower, by that one leap they would all be free.

With vast resources and political capital having been sunk into establishing the eurozone, with a constitutional block to the re-introduction of any sovereign currency and with debt re-restructuring taboo, periodic bailouts have become the norm. In principle, a bailout can buy time to allow the remedy of fiscal consolidation to become effective; but, for some eurozone nations, no feasible configuration of expenditure cuts and tax revenue flows could bring sovereign debt to manageable levels. Debt restructuring – the exchange rate option in different guise – then remains.

The exchange rate option was used many times after the Bretton Woods agreement (1944). Sovereign currency values were pegged to the US dollar; but, in the face ofpost-war uncertainties, initial par values were so arbitrarythat currency devaluations of up to 10% required no formal approval. The epoch was one in which the direction of currency adjustments was clear well in advance. Yet, given the extensive use of direct controls over trade, capital movements and banking activity, devaluations were dramatic and disruptive. Most notably, froman initial post-war rate of 119.1 (to the US dollar), the French francbumped down many steps to 493.7, at which level the nouveau franc was introduced (at 100 times the value) in 1960. Sterling’s limited status as a reserve currency demanded greater monetary prudence but, as pressure lines burst in 1967, a mendacious assurance was offered to holders of sterling: ‘It does not mean that the pound here in Britain, in your pocket, in your purse or bank has been devalued’ (Prime Minister, Harold Wilson).Contrary to that assurance, devaluation delivered a haircut – a 14.3% ‘trim’ – to those holding wealth in the form of sterling securities.

In delivering (i) a reduction in the purchasing power of domestic wages and salaries, (ii) a write-down of the value of sovereign debt and (iii) a revaluation of foreign exchange reserves, the exchange rate option resets all the relevant monetary parameters. By creating more austere living standards and in treating creditors with disdain, economic ‘recovery’ becomes more readily achievable through devaluation, in essentially the same manner as might now be achieved by accepting that Greece, Ireland and Portugal need to ‘restructure’their sovereign debt.

If the impact is deemed likely to be greater than any post-war currency devaluation, it is because the eurozone authorities have permitted toxic debt to fester so long.

2 thoughts on “Sovereign debt restructuring and the euro crisis”

  1. Posted 20/04/2011 at 14:37 | Permalink

    This is an important and valuable analysis. Some ‘defenders’ of the Eurozone — such as Sean Rickard,
    at the Cranfield School of Management — foresee a scenario of “fiscal centralization” in the Eurozone,
    as the fiscal policies of the periphery EZ countries, and then others, become under more centralized
    control ( by the European Commission, fronting for the likes of Germany and Finland).Whilst this may
    go on to a degree — via the imposition of bail-out conditions — “full” fiscal centralization is a complete
    non-starter: it does not even obtain in the USA( which has a federal constitition).
    The scenario outlined in Dr. Steele’s blog is far more realistic and likely: debt “restructuring” as a
    substitute for devaluation. I also agree that it will mimic the Bretton Woods system, involving
    substantial, but irregular, debt write-downs.

  2. Posted 26/04/2011 at 11:54 | Permalink


    “Where, say, a domestic rate is unilaterally cut by one percent, arbitrage sets domestic currency at a one-year forward discount of one percent.”


    “Where, say, a domestic rate is unilaterally cut by one percent, arbitrage requires domestic currency to be at a one-year forward premium of one percent. This is achieved by an immediate drop in the spot rate and/or by an immediate rise in the forward rate (that is, by any combination giving the required exchange ratio).”

    Argument: unaffected

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