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Executive Summary
The PADRE plan starts from the view that several eurozone countries have accumulated unsustainable public debt. Unsustainability here does not imply that the governments are bankrupt; technically, given sufficient time, governments are rarely unable to raise adequate resources one way or another. Some governments may run out of time when they lose market access or face high borrowing costs, which is a case of illiquidity, not insolvency. Unsustainability here means that, once the sovereign debt crisis is over, several governments will face a debt burden that will stunt economic growth, prevent the use of fiscal policy – the only macro-economic instrument left in a monetary union – to deal with cyclical swings and, generally, make them excessively vulnerable to market sentiment. The implication is that public debt must be restructured.
Debt restructuring, however, is highly contentious, to say the least. One reaction is that ‘European states do not default’. This view runs counter to a long history of debt restructurings. More crucially, it ignores the costs of not restructuring and it assumes that any restructuring must lead to dire consequences, including bank crises and contagion. A rational approach must balance the pros and cons of all options. It must also allow for a careful preparation of each option, including a well-planned, non-disruptive debt restructuring.
Other objections to debt restructuring are political. It is pretty clear that the less-indebted countries of the eurozone refuse to pay for the highly indebted countries. Also, all governments are determined not to provoke yet another banking crisis. These constraints are the starting point of the PADRE plan.
The plan involves an agency that acquires at face value a share of existing public debts and swaps them into zero-interest perpetuities. In practice, therefore, the corresponding debts are wiped out. The agency borrows the amount needed to acquire the debts on the financial markets and, as it pays interest on its obligations and receives no interest on the perpetuities, it makes losses. As it rolls over its obligations, its losses are perpetual. This is where the costs of the debt restructuring are borne. Existing bondholders are fully protected, eliminating any risk of a banking crisis.
The agency may be the ECB or another one like the ESM. The ECB, however, must be involved one way or another for three main reasons. First, it is the only institution that can mobilise the required resources (in their main example, the authors assume that half of existing debts are bought and swapped, which amounts to some €4.5 trillion). Second, because central banks do not have to worry about their capital, they have a unique credibility and can sustain large losses. Third, the ECB passes on its profits to eurozone member countries; this applies to losses as well.
The way to eliminate politically unacceptable inter-country transfers is to require that the agency acquires and swaps public debts of all eurozone member countries in proportion to each country’s share of its capital, which determines how profits and losses are passed on to governments. This feature means that, over time, each government will ‘pay back’ the agency, over the indefinite future, the total amount – in the present value sense – of the initial debt cancellation in the form of reduced distributed profits. The debt restructuring thus amounts to a transfer of the debt burden from current to future generations within each country, without any transfer from one country to another or from current debt holders. It is just a restructuring, without any giveaway. The main, and only, merit is that a portion of public debt is not traded anymore. The remaining portion is moderate enough to dispel the threat of a run.
The PADRE plan is not inflationary, because it is not a monetisation of public debts. It does not involve any money creation; the agency borrows to acquire public debt. In practice, the ECB might use its money creation capacity to finance the acquisition of the public debt and then fully sterilise the money created in the first place, but the order of actions is immaterial.
As it finances, directly of indirectly the bond purchase, the central bank profits will be reduced forever, in line with the nature of a perpetuity. However, over time as GDP grows, the costs will become increasingly small. In the mean time, the costs are likely to exceed the regular seigniorage income of the agency. Indeed, under the authors' base case example, the Eurosystem will suffer losses for a long time, measured in decades, but it will eventually return to profitability. The question is whether seigniorage revenues are sufficient to make up for the losses in a present value sense. The authors' calculations show that this is indeed the case, provided that the interest rate at which the ECB borrows is not too high and that economic growth is on a normal path, which occurs under most plausible scenarios.
Then comes the crucial issue of moral hazard. If debt restructuring can be painless, would that not become an incentive for governments to accumulate again and again unsustainable public debts? Moral hazard can be contained, indeed eliminated, if implementation is subject to some conditions. The first condition is a tight and precise covenant. The PADRE plan specifies that, should a country accumulate debt again, the agency is obligated to swap the zero-interest national perpetuities back into interest-yielding bonds. Such an action, which is bound to trigger strong market reactions, should deter governments from sliding again into fiscal indiscipline.
In order to prevent other governments from trumping the covenant in solidarity with a hard-pressed government, a second condition of the implementation also specifies that any such action would require a vote and automatically imposes the resulting agency losses on to the taxpayers of those countries that voted in favour of a relaxation of the conditions.
The plan calls for the full implementation of the Treaty on Stability, Coordination and Governance (TSCG) – the adoption by each eurozone country of a constitutional debt break rule, if possible through a referendum. This stands in contrast with the current situation where a number of countries have modified their constitution and where they adopted arrangements that depart in significant ways from the debt brake solution.
Finally, the plan puts the ECB in the highly exposed position of a fiscal agent. Other institutional arrangements are possible, but if the ECB is recognised as the best-suited agent, it is essential that the decision to undertake debt restructuring be made formally and publicly by governments and that the ECB be free to accept this role. In particular, the ECB must have complete freedom to independently set its conditions.
In conclusion, the PADRE plan offers a painless and efficient way of solving the debt overhang that, if not treated, will haunt Europe for decades to come. The plan stands to effectively bring the sovereign debt crisis to a definitive end and save the euro for good. If the plan is adopted, the market reaction is bound to be enthusiastic, which would provide the boost to growth and the broad political support that the eurozone so desperately needs.