Faced with an increasingly dire financial situation, Portugal has started negotiating a bailout package with the European Union (EU) and the International Monetary Fund (IMF). It follows in the footsteps of Greece and Ireland, two countries where bailouts have proved ineffective. Still, few dare defend the most effective policy option in all three cases: a managed sovereign-debt default.
Such a default would allow the Greek, Irish, and Portuguese governments to push back their accumulated debt obligations, lowering the interest rates they serve, postponing reimbursement, and, if necessary, repaying only part of the capital they owe. Like personal bankruptcy – which allows an over-indebted individual to renegotiate reimbursement terms – a sovereign default allows countries to repay current debts according to future income expectations. A bailout, on the contrary, prioritises lenders by reimbursing them completely and abiding by the initially agreed-upon interest rates and repayment schedules, forcing the government to adjust future income to the weight of accumulated debt.
Bailout proponents continue to sing its praises. By forcing the troubled government to change its economic policy, it supposedly fosters growth and prevents further debt crises. By imposing the majority of the costs on the rescued countries, it purportedly stiffens their fiscal discipline. Finally, by preventing a sovereign default by a member of the eurozone, it allegedly stabilises debt and currency markets.
Upon closer inspection, however, none of these benefits materialise. In Greece and Ireland, bailouts did not stabilise markets, did not encourage economic growth, and did not inspire a change of heart about credit. If anything, these cases suggest that, within the straitjacket of a monetary union, the bailout mix does not work. It requires strict fiscal measures that discourage economic growth and make it impossible to lower the debt-to-GDP ratio.
On the contrary, the conditional bailouts imposed on Greece, Ireland, and, now, Portugal, lead to an insidious cycle of spending cuts and tax rises which produce economic stagnation, social unrest and political turmoil. These countries can expect economic and social agony, imperiling their political situation and easing the push in favour of populism. Is Europe prepared to allow a few of its member states to fall into prolonged economic stagnation, producing social unrest while bolstering fringe parties that capitalise on discontent and undermine democratic processes? In short, do we want to see the problems that led to the demise of Weimar Germany spread across Europe's periphery?
A managed default could bring three benefits.
It would allow troubled countries to jump-start their economic recovery. The immediate debt relief would make space for growth-oriented reforms with visible short-term results. A default could thus save Europe a decade of incipient economic growth, weighed down by the debt-ridden albatrosses in the periphery.
A sovereign default would also give markets a firm signal about the EU's commitment to limit moral hazard. By shifting some of the costs of the debt crisis away from the borrowers, a default would discipline lenders that have continuously supplied cheap money to troubled economies under the expectation that, if necessary, an EU or IMF bailout would guarantee their capital. Whereas a bailout supposedly disciplines the demand side of credit markets, a default effectively disciplines both demand and supply, producing a long-term stabilising effect. A debt restructuring would also clarify the eurozone's underlying tensions by removing speculative pressures and forcing more coherent fiscal policies across the entire area.
More importantly, a structured credit default would limit the political risks associated with the bailout option. It would dampen the rise of populist trends in the troubled countries in reaction to punishing bailout policy mixes. It would also limit the damage to Europe's cohesiveness caused by the perception – accurate or not – that the EU is forcing unfair, asymmetric solutions upon recipient countries.
To be sure, a debt restructuring would have to be carefully designed, with a well-considered mix of lender haircuts, extended loan maturities, and trimmed interest rates. Even the ideal default – one co-ordinated at the EU level – would stir credit markets. German, French (and, in the Portuguese case, Spanish) banks are the main creditors of the debt-ridden governments and would bear the brunt of a joint default. Other countries might witness a short-term spike in interest rates, requiring additional European commitments.
Beyond these manageable issues, however, economic, financial and electoral self-interest have prevented Germany from discussing the default option. Likewise, France and Italy, both of whom possess higher debt-to-GDP ratios than Portugal, have benefited from the markets' focus on Lisbon's problems. The Portuguese firewall has also shielded Spain and Belgium, likely the next targets of the markets.
Pretending the default option does not exist violates fundamental economic principles that will eventually override any political preference. To avoid wasting a decade, the governments of Greece, Ireland and Portugal should force Europe to discuss a debt restructuring. France, Germany, Italy and Spain, for their part, would be well advised to listen. As the economist Irving Fisher wrote in an article on debt during the Great Depression, to assume that under excruciating socio-economic conditions all debts will be repaid is as absurd as assuming "that the Atlantic Ocean can ever be without a wave".
A debt default would dispel the spectre of Weimar, with stagnant – or worse, contracting – economies leading to rising populist tendencies that could undermine democracy in member states and thus imperil European peace. A co-ordinated debt default would not endanger the stability of the euro and the EU. In fact, it might be the best way to preserve it.