Willem Buiter: Eurozone crisis demands swift debt restructuring

In his Financial Times column, Willem Buiter, chief economist for Citigroup, observes that the eurozone crisis demands swift private and public debt restructuring.

Why does he think that the debt must be restructured?

Because until the deleveraging process is complete and the financial system is purged of the excess debt, it holds back demand and the potential for economic growth.

Regular readers are familiar with this argument as it is simply a restatement of why the Swedish Model works to end a bank solvency led financial crisis.

Under the Swedish Model, banks are required to absorb up front their losses on the excess public and private debt in the financial system.  This protects the real economy as capital that is needed for growth, reinvestment and supporting the social contract is not diverted to making debt service payments on the excess debt.

Modern banks are designed to absorb these excess losses as they have the unique ability to continue to operate and support the real economy even when they have negative book capital levels.

Banks can do this because of the combination of deposit insurance and access to central bank funding.  With deposit insurance, taxpayers effectively become the banks' silent equity partners while the banks are retaining 100% of their pre-banker bonus earnings to rebuild their book capital levels.

Balance sheet obstacles to sustained demand growth mean the European Union faces two or three more years of recession and tepid cyclical recovery, even if EU policy makers enact the right measures as fast as their glacial decision-making process allows. 

The balance sheet recession is caused by excessive leverage: zombie banks throughout the EU, excessive sovereign debt and deficits in the periphery, and excessive household indebtedness in many countries.... 

The deleveraging will not come through growth, as growth will not return until deleveraging is completed. 

It will not come through inflation because the European Central Bank will not inflate. 

The debate between Spendarians and Austerians has little relevance as only Germany is in a position to provide a significant discretionary fiscal stimulus.... 

The main instruments of deleveraging will be debt mutualisation and restructuring.... 

Instead, there will be some limited ex-post mutualisation, as the outstanding debt of troika programme countries to their sovereign creditors is gradually converted into a zero-coupon perpetuity, promising to pay nothing forever. 

There will also be some more mutualisation of sovereign debt and of bank losses when the ECB takes losses on its exposure to likely insolvent sovereigns and to likely insolvent banks that have offered substandard collateral. But this will not suffice to deleverage quickly. 

In line with the agreement reached to manage the Cyprus crisis, the new template for bank resolution bails in the existing shareholders followed by all unsecured creditors, including if necessary the non-insured depositors. Domestic taxpayers are no longer subordinated to senior unsecured bank creditors.

I happen to disagree with the new template for bank resolution bail ins.  The first source of repayment for the losses should be future bank earnings.

Only banks that after recognition of all their losses have interest income greater than interest and operating expenses should be allow to continue in operation.  Other banks should be resolved with depositors protected.

Once the single supervisory mechanism for eurozone banks comes into force, the European Stability Mechanism will be able to directly recapitalise banks. ...

The European Stability Mechanism should not be used to recapitalize banks.  If banks cannot recapitalize themselves through future retained earnings, they should be resolved.

ESM should instead be used to stand behind each EU country's deposit guarantee.

The ECB will soon start a euro-area Asset Quality Review that is likely to be conducted by independent experts, without excessive interference by captured national supervisors. 

By the end of this year, the informational and institutional toolkit to dezombify the euro area banking system could be in place....

The only way to do an asset quality review that the market will believe is to have the banks disclose their exposure details to the market.

The market has the expertise to assess the assets.  The market also has the ability to exert discipline so that the losses each bank is exposed to are realized.

Without transparency, market participants will see a big red flag waving saying that not only did captured national supervisors hide the truth about EU banks, but so too is the ECB.

After all, if the banks are coming clean about all their bad debt then they should have nothing to hide and transparency is a way to demonstrate this fact.

Early resolution is preferable to economically costly and politically unsustainable additional austerity and pointless concessional funding. 

The inherent disruption is minimised through early, co-ordinated and simultaneous debt restructuring of banks, households and sovereigns, of sufficient size to convince markets there will not be an early repeat of the exercise. 

It is not size that convinces the market that there won't be a repeat, but transparency into each bank's exposure details.  With this information, the market can assess what is going on and knows that there won't be a repeat.

Losses would be less than those created by further delay.

As your humble blogger has been saying since the beginning of the financial crisis, the losses from not adopting the Swedish Model have been incredibly large and are only continuing to grow as policymakers delay adopting the Swedish Model and ending the financial crisis.

Easy, really.

I have been saying all along how easy this crisis is to end.  It is nice that Mr. Buiter agrees.