Debt forgiveness only way to end Greek crisis
The Greek crisis, and the speed with which the consequent fear has spread to other European countries - notably Portugal, Spain and, most worrying of all, Italy - seems for many analysts to be unprecedented. It is hard, they say, to know how the crisis will eventually end.
But in fact there is a lot of historical precedent that allows us to make some reasonable guesses about the course of the crisis. There are at least four things we can learn from history.
First, and most obviously, we should always have been sceptical about the survivability of the euro. There is a long history of currency unions from which we can draw two reasonable conclusions. Without full monetary and fiscal integration, currency unions are no more permanent than other forms of monetary integration, such as adherence to gold or silver standards. And when they succeed, it is almost always during periods of rising global liquidity and expanding international capital flows.
No currency union has been able to survive the great monetary contractions that spell the end of a globalisation period. The 19th century's Latin Monetary Union and the Scandinavian Monetary Union were once considered great successes, but both were forced into retreat when global monetary conditions turned sour.
Second, the European crisis will be accompanied by a trade shock. In the early 1980s Latin American countries were suddenly cut off from funding. These countries had been running large current account deficits, but current account deficits require capital account surpluses. When Latin America began to experience capital outflows, its trade deficit necessarily had to become a trade surplus.
Because they, too, have trouble financing themselves, the deficit countries of Europe, with combined trade deficits nearly two-thirds that of the US, will also be forced into a rapid contraction in their trade deficits. This contraction will cause a trade shock that must, one way or another, be absorbed by the very unwilling rest of the world.
Third, the recovery in the countries hit by crisis will not begin until they are recognised as insolvent and receive debt forgiveness from their creditors. Greece, and probably two or three other countries, simply cannot repay their outstanding debt amounts. As long as they maintain the pretence that they can, and struggle with the burden, the resulting distortions in the economy will mean that businesses will disinvest and the country will not grow.
Eventually, as has happened in nearly every previous case, creditors and borrowers will acknowledge reality and will work out a debt forgiveness plan that will allow the economy to return to growth. Until then, expect weak growth, high unemployment and constant battles over debt.
How long will it take for the world to recognise the inevitable? The fourth thing we can learn from historical precedents is worrying.
When most of the obligations of an insolvent sovereign were widely dispersed among a variety of bondholders, market forces acted relatively quickly to force debt forgiveness. Defaulted bonds trade at deep discounts, and it is a lot easier for someone who bought the debt at one-quarter of its face value to agree to 50 per cent debt forgiveness than for someone who made the original loan.
But things are different with Europe's insolvent sovereign loans. The Latin American debt crisis of the 1980s raged on for nearly a full decade - a decade of stopped payments, capital flight, and agonisingly low growth - before creditors formally acknowledged that most struggling borrowers could not repay their debt and thus would need partial debt forgiveness.
Growth returned to most countries only after this happened.
Why did it take so long? Were the banks stupid? No, banks knew full well that they weren't going to get their money back, but to have acknowledged this would have required them to set aside more capital to absorb the losses than most of them possessed. The recognition of the obvious had to wait nearly a decade so that banks could build a capital cushion sufficient to absorb the losses.
So too with the European crisis. Much of the Greek debt is held by European banks, and they simply do not have enough capital to absorb losses on Greek debt, let alone if Greece were to be joined by Portugal, Spain and others.
We are condemned to spend much of the next decade postponing a resolution of the crisis while banks rebuild their capital base. Until they do, we will all pretend that Greece isn't insolvent and that other European countries will not face a crisis.
Michael Pettis is a professor of finance at the Guanghua School of Peking University and a senior Associate at the Carnegie Endowment