How Europe can avoid a lost decade

Author: | Published: 30 Nov 2012
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Lee Buchheit
By 1983, Latin America faced the gruesome pas de deux of mountainous debt and a policy response that was to condemn the region to it's so-called lost decade. To Cleary Gottlieb Steen & Hamilton's Lee Buchheit, it is clear Europe now faces a similar future. Here he outlines the policy reforms that would enable the eurozone to better cope with its crisis

The 1980s were, to Cleary Gottlieb's Lee Buchheit, something of a baptism of fire into the world of sovereign debt.

What began in 1982 with a call for Cleary Gottlieb's help from Mexico's finance minister, escalated rapidly over the course of the decade with similar mandates from across the region. In time, Cleary Gottlieb became the go-to firm for countries seeking debt relief, and Buchheit, the legal mastermind of choice for presidents and finance ministers seeking help to call off creditors when their governments run out of money.

It is all the more worrying, therefore, that today Buchheit's sense of déjà vu is growing by the day. It is, he says, as if Europe's policymakers have learned nothing.

"I'm hearing all the same things I heard in 1983," he tells IFLR. "There is an irresistible tendency at the outset of one of these crises to believe that it will be all over soon. In fact, there hasn't been a debt crisis in my lifetime where the people in charge have not adopted that mentality."

Certainly, it was true in the 1980s. Had you announced in 1983 there was just a chance the Latin American debt crisis would not have been over by 1985, you would have been branded a defeatist and banished from Manhattan Island.

That tendency for policymakers to jump straight to short-term fixes led to the rolling over Latin America's debt with no haircut to principal, a rising interest rate, and consequently a mountainous debt stock to get pushed down the decade.

"The same is true in Europe today, except the mountainous debt stocks are getting even more mountainous," Buchheit says.

"The dilemma that policymakers face is that their stated objective is to return these countries to voluntary market access as quickly as possible," says Buchheit. "To that end, they are insisting on massive austerity and fiscal adjustment and all the rest of it. I thought they were moving away from this practice of enabling debtor countries to pay their existing bondholders in full and on time and legislating for themselves preferred creditor status, but I no longer think it now."

Buchheit insists this idea that the official sector will assume all of these liabilities by lending, as part of bailout packages, a gross amount of money to repay everyone else in full and on time is seriously misguided.

"If there is any chance – and come on, we all have to admit there is a chance - that a debt restructuring is going to be necessary at some point in order to return the countries to a sustainable position, the one thing the official sector did right in Latin America was not to take on it owns shoulders the private sector debt," he says.

There are, he believes, many lessons Europeans should have learned from Latin America circa 1980, but for various reasons these are not being followed.

Lesson one: stop with the fairy dust

It is now up to the EU to determine how to bridge the period between today and the point at which the eurozone periphery stands a fighting chance of becoming competitive and growing again.

To that end, he believes, the principal mistake European policymakers have made is assuming liabilities that may well someday need to be restructured.

"That has to be the first lesson learned: there are no painless options," he says. "The belief that you can sprinkle fairy dust on this problem and no one will suffer is fatuous."

"I don't see how anyone can say that no debt restructurings will ever be required for these countries," he says. "They said that about Greece in May 2010, and 21 months later Greece had to write off half of its private sector debt stock."

Policymakers should not assume that the restructuring of debt stocks is never going to happen and therefore should not take on their own shoulders liabilities that may at some point down the road need to be restructured. Because then its taxpayers that will suffer that restructuring rather then the people who actually lent the money.

"Hold the commercial creditors in place. Don't force them to write anything down now," he says. "But whisper in their ears that they should be putting something aside for a rainy day."

Lesson two: accept the risks of linking banks to sovereigns

A second change that Buchheit believes needs to occur relates to the linking of European banking sectors with their sovereigns so that domestic banks could buy sovereign paper and hold it on their books at zero risk weighting.

EU policymakers now profess to understand that there are fatal risks associated with this activity.

But, says Buchheit, the solution that they are pursuing will aggravate that very problem.

"When the European Central Bank pumps €2 trillion into the hands of European commercial banks, they are doing it with the hope and, frankly, expectation that that money will go back into buying the bonds of the sovereigns, bolstering the demand, reducing the yield and hopefully keeping the sovereigns with an appearance of market access," he says.

"They profess to have recognised the weakness of this activity in the past but I'm afraid that they may now be further aggravating the issue."

Lesson three: the emerging markets can't help you all

Finally, Buchheit advises, Europeans would be wise to contemplate the possibility that the crisis will linger for much longer than people hope it will.

"It's fanciful to believe that all of the EU periphery will return to growth and competitiveness and effortless market access if they are still carrying debt to GDP ratios of 120 to 150%."

"You've got to be a congenital optimist to say this whole thing is going to blow over in 18 months," he says. "I'm fearful that it may be a number of years before these countries are really in the position of sustainable growth."

He would feel differently, he insists, if we were talking about one or two countries in difficulty. "The problem here is that nearly the whole world ex-China is in recession," he says. "And everyone one of them, from Germany to the US, is saying the same thing; export more and import less."

"How does any one country prosper by exports if every other country is trying to prosper as well by exports? How much do you really think the emerging markets can buy?"

What's next?

For now, Buchheit believes one of two eventualities inevitably awaits the EU; either the eurozone periphery economic adjustment programmes will succeed, the affected countries will return to credit worthiness and effortlessly resume market access. Or, they won't.

If the latter, some restructuring of the debt stocks of these countries will be necessary to make them presentable to the market. And if those debt stocks have by then migrated into the hands of the official sector, then the taxpayers of those countries must feel the pain of the restructuring.

For more of IFLR's 30th anniversary coverage see

More IFLR articles by Lee C Buchheit:

Restructuring a nation's debt 

The coroner's inquest 

We made it too complicated 

The sovereign view