January 13, 2011
The euro zone’s strategy for tackling its sovereign-debt crisis is failing. A makeshift scheme was put in place in May to help countries that cannot otherwise borrow at tolerable interest rates. That lowered but did not remove the risk that a country may default for want of short-term funds. But the bond market’s nerves have been shredded again by the likelihood that from 2013, when a permanent bail-out mechanism is due to be in place, it will be easier to restructure an insolvent country’s debts. More worrying still for private investors, this seems set to give official creditors preference over others.
As a result, bail-outs are making private investors less rather than more keen to hold a troubled country’s bonds. As old debts are refinanced and new deficits funded by the European rescue pot and the IMF, the share of such a country’s debt held by official sources will steadily rise. That will leave a shrinking pool of private investors to bear losses if debts are restructured. And the smaller that pool becomes, the larger the loss that each investor will have to accept. Bond purchases by the European Central Bank (ECB) aimed at stabilising markets have further diminished the stock in private hands.
This perverse dynamic argues for a restructuring of insolvent countries’ debts sooner rather than later. But when is a debt burden too heavy to be borne? A first indicator against which to make that judgment is the ratio of gross public debt to GDP. Most rich economies, including the euro area’s most troubled, have large budget deficits and so will be adding to their debts for years. Today’s toll is not so important. What matters is how big the debt burden will be when it stabilises.
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