There is a simple way to deal with a debt overhang: reduce payments by restructuring the debt. Many firms are able to renegotiate financing terms with their creditors – typically extending the maturity of their liabilities, which enables them to borrow more to finance new, better projects. If such negotiation cannot be achieved voluntarily, US firms can use Chapter 11 of the bankruptcy code, under which a court supervises and approves the reorganization of liabilities. So you would think the same would be true for US households and embattled European governments. But the restructuring of debt has been too little and has come too late. Why?
In both cases, the main argument for not removing the debt overhang came from bankers, who claimed that it would create havoc in financial markets for two reasons. First, banks were the primary creditors, and the large losses that they would face in any restructuring was bound to trigger a domino effect, with waves of pessimism driving up interest rates and ruining other borrowers’ prospects. Second, banks would also suffer because they had sold insurance against default – in the form of credit-default swaps. When these swaps were activated, the banks would incur potentially further crippling losses.
In the case of Greece, international bankers argued long and hard that debt restructuring would generate contagion far and wide within the eurozone – and perhaps more broadly. And yet, in the end, Greece had little choice but to restructure its debt, cutting the value of private claims by about 75% relative to their face value (although even this is probably not enough to make the country’s debt burden sustainable). This was deemed a “credit event,” so credit-default swaps were exercised: anyone who insured against default had to pay out.
Did all hell break loose? No. Banks have not failed, and there is no sign of tumbling dominoes. But that is not because banks prepared themselves by raising more capital. On the contrary, compared to their likely future losses, European banks have raised relatively little capital recently – and much of this has been creative accounting, rather than truly loss-absorbing shareholder equity.
Perhaps the risk that a Greek debt restructuring would cause a financial meltdown was always minimal, and quiescent markets were to be expected. But, in that case, why all the fuss?
The answer should be clear by now: interest-group politics and policy elites’ worldview.