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The Eurozone countries will emerge from the crisis with very high public debts. They Geneva Reports on the World Economy Special Report 3 S3 face the choice between a long drawn out reduction process, likely to last decades, and a one-off debt restructuring. Nobody likes debt restructuring, but the cost of a gradual reduction cannot be dismissed summarily. Debt restructuring, on the other hand, is perceived as dangerous and a source of moral hazard. Yet, debt restructuring can be managed in a safe way and the moral hazard can be mitigated, if not eliminated. The PADRE (Politically Acceptable Debt Restructuring in the Eurozone) plan presented in this report is designed to be safe and to deal with moral hazard. As important as economic effectiveness is political acceptability. There is no appetite in the Eurozone countries for sharing the current debt burden. The proposed plan allows for a deep debt restructuring without any cross-country transfer. PADRE works as follows. An agent buys on the secondary market and at face value a pre-defined sizeable share of existing public bonds, preferably maturing bonds that it rolls over. The agent then swaps the bonds that it has acquired into zero-interest perpetuities. The corresponding debt is effectively wiped out, removing at once the threat of bank runs. In order to finance its purchases of bonds, the agent issues its PADRE own debt. All bondholders are made whole, which eliminates the risk of a bank or financial crisis. Of course, there must be a cost somewhere. It is borne by the agent, which borrows Politically Acceptable Debt at market rate and lends at zero rate over the indefinite future as it rolls its own debt over. These losses must be financed, year after year. The Eurosystem, drawing on its loss-absorbing capacity, will provide the financing. This is possible as long as the losses Restructuring in the Eurozone are smaller in present value terms than the present value of the central bank seigniorage income. The report shows that this is generally the case. Thus the PADRE plan amounts to the securitisation of seigniorage income. This will reduce the ECB’s profits, which are rebated to member governments in proportion to the capital key. If the agent buys national public bonds in the same proportion, each country fully bears the cost of its debt restructuring. There is no cross-country transfer, only within-country transfers from current to future taxpayers. Pierre Pâris and Charles Wyplosz Moral hazard is contained by a strict covenant designed to enforce fiscal discipline. The covenant includes the right for the agent to swap the perpetuities of a delinquent government back into interest-yielding bonds as an enforcement mechanism. It also requires the inscription into each country’s constitution of a watertight budget rule, as mandated by the Treaty on Stability, Coordination and Governance (TSCG). Centre for Economic Policy Research 3rd Floor • 77 Bastwick Street • LONDON EC1V 3PZ • UK ICMB INTERNATIONAL CENTER TEL: +44 (0)20 7183 8801 • FAX: +44 (0)20 7183 8820 • EMAIL: [email protected] FOR MONETARY WWW.CEPR.ORG AND BANKING STUDIES PADRE Politically Acceptable Debt Restructuring in the Eurozone Geneva Reports on the World Economy Special Report 3 The main idea behind this report was initially circulated in Pâris and Wyplosz (2013). Helpful comments from Alan Auerbach and members of the Bellagio Group are gratefully acknowledged. We thank Mark Amsellem for excellent research assistance. International Center for Monetary and Banking Studies (ICMB) International Center for Monetary and Banking Studies 11A Avenue de la Paix 1202 Geneva Switzerland Tel: (41 22) 734 9548 Fax: (41 22) 733 3853 Web: www.icmb.ch © January 2014 International Center for Monetary and Banking Studies Centre for Economic Policy Research Centre for Economic Policy Research 3rd Floor 77 Bastwick Street London EC1V 3PZ UK Tel: +44 (20) 7183 8801 Fax: +44 (20) 7183 8820 Email: [email protected] Web: www.cepr.org ISBN: 978-1-907142-73-4 PADRE Politically Acceptable Debt Restructuring in the Eurozone Geneva Reports on the World Economy Special Report 3 Pierre Pâris Banque Pâris Bertrand Sturdza Charles Wyplosz The Graduate Institute, Geneva, ICMB and CEPR ICMB INTERNATIONAL CENTER FOR MONETARY AND BANKING STUDIES CIMB CENTRE INTERNATIONAL D’ETUDES MONETAIRES ET BANCAIRES International Center for Monetary and Banking Studies (ICMB) The International Centre for Monetary and Banking Studies was created in 1973 as an independent, non- profit foundation. It is associated with Geneva’s Graduate Institute of International Studies. Its aim is to foster exchanges of views between the financial sector, central banks and academics on issues of common interest. It is financed through grants from banks, financial institutions and central banks. The Center sponsors international conferences, public lectures, original research and publications. It has earned a solid reputation in the Swiss and international banking community where it is known for its contribution to bridging the gap between theory and practice in the field of international banking and finance. In association with CEPR, the Center launched a new series of Geneva Reports on the World Economy in 1999. The eleven subsequent volumes have attracted considerable interest among practitioners, policy-makers and scholars working on the reform of international financial architecture. The ICMB is non-partisan and does not take any view on policy. Its publications, including the present report, reflect the opinions of the authors, not of ICM or any of its sponsoring institutions. President of the Foundation Board Thomas Jordan Director Charles Wyplosz Centre for Economic Policy Research (CEPR) The Centre for Economic Policy Research is a network of over 800 Research Fellows and Affiliates, based primarily in European universities. The Centre coordinates the research of its Fellow and Affiliates and communicates the results to the public and private sectors. CEPR is an entrepreneur, developing research initiatives with the producers, consumers and sponsors of research. Established in 1983, CEPR is a European economics research organization with uniquely wide-raning scope and activities. The Centre is pluralist and non-partisan, bringing economic research to bear on the analysis of medium- and long-term policy questions. CEPR research may include views on policy, but the Executive Committee of the Centre does not give prior review to its publications, and the Centre takes no institutional policy positions. The opinions expressed in this report are those of the authors not those of the Centre for Economic Policy Research. CEPR is a registered charity (No. 287287) and a company limited by guarantee and registered in England (No. 1727026). Chair of the Board Guillermo de la Dehesa President Richard Portes Director Richard Baldwin Research Director Kevin Hjortshøj O’Rourke About the Authors Pierre Pâris, a graduate of EM Lyon and the Wharton School (MBA), first joined Bain & Co in London and then in Paris. He then became a Director of Baring Brothers Co. Ltd in London as well as the Managing Director of Barings France. Ten years later, he joined Morgan Stanley as Managing Director, taking an active role in important M&A and capital markets transactions. In 2001 he took the helm of UBS Investment Bank in France and in 2007, he was appointed Vice Chairman of UBS Wealth Management Western-Europe. In 2009 he co- founded Banque Pâris Bertrand Sturdza SA. Charles Wyplosz is Professor of International Economics at the Graduate Institute in Geneva where he is Director of the International Centre for Money and Banking Studies. His main research areas include financial crises, European monetary integration, fiscal policy and regional monetary integration. He is the co-author of two leading textbooks and has published several books and many professional articles. He has served as consultant to many international organizations and governments and is a frequent contributor to public media. Contents About the Authors v Executive Summary 1 1 Introduction 3 2 Economic Rationale for Debt Restructuring 5 2.1 Growth and the debt burden 6 2.2 Sensitivity to shocks 6 2.3 Financial market instability 7 2.4 The special case of the Eurozone 7 2.5 Low debts are required in a monetary union 8 3 Political-Economic Principles 11 3.1 Governance 11 3.2 No redistribution 12 4 Policy Options 15 4.1 The PADRE proposal made simple 15 4.2 Application to the Eurozone: Key elements 16 4.3 The base case 19 4.4 The plan without the ECB 24 5 Variants 27 5.1 Smaller restructuring 27 5.2 Transfers across countries 28 5.3 The opt-out clause 29 5.4 Recouping savings from lower interest rates 30 5.5 Lower interest rate through financial repression? 31 6 Caveats 33 6.1 Bond acquisition price 33 6.2 The aftermath of debt restructuring 33 6.3 Moral hazard 34 6.4 Treatment of the new balance sheet items 35 6.5 The size of the ECB 36 7 Conclusions 37 Appendix 1: Adjusted shares of ECB capital 38 Appendix 2: The arithmetic of seigniorage income 38 References 39 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 macroeconomic instrument left in a monetary union – to deal with cyclical swings and, generally, make them excessively vulnerable to market sentiment.

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