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A Lasting Fix for Europe

Greece’s new government has put Europe’s debt problem back at the top of the agenda. Prime Minister Alexis Tsipras is hoping to renegotiate the terms of his country’s debt to other European governments, while Greece’s creditors are open only to extending loans, not restructuring them.

The Greek stand-off opens a serious, but unpopular, economic question for Europe today: What should creditors do when debtors can’t pay? Absent a clear answer, the Continent’s debt-based financial system will struggle to manage losses in both the public and private sectors, let alone restart lending activity.

Policy makers have so far used monetary policy to deal with debt overhangs. Ultralow interest rates and quantitative easing—a central-bank program to purchase sovereign bonds—reduce refinancing costs for governments and firms in the hope that struggling debtors can eventually repay when economic growth picks up.

This “extend and pretend” strategy has worked at times in the past—for example, in the U.S. after the War of Independence or in Britain after World War II. But it isn’t working in the eurozone, and it won’t. The European Central Bank’s mandate prohibits direct monetization of debt and limits its risk-taking capacity, putting a bound on the ECB’s ability to buy assets. Meanwhile, the economic growth rates required to bring debtors within reach of repaying are implausible. Greece would need a decade of 3.5% annual growth to bring down its debt to a sustainable level. Only Norway and Canada have achieved such a feat before, and then only during a commodity boom.

Monetary policy helps to buy time, but isn’t sufficient. To deal with its massive debt, Europe needs a two-pronged structural approach. It must develop a financial system with deeper capital markets (and less reliance on banks), and a legal framework that makes it easier to recognize losses.

America’s experience shows how important this is. Both households and companies were able to restructure their debts early in the 2008 financial crisis. Bankruptcy and foreclosure laws allowed mortgage borrowers to call time on underwater loans without endangering their other assets. Meanwhile, the fact that so many U.S. companies rely on capital markets rather than banks allowed them to more easily restructure more than $400 billion of debt in bond markets after 2008, equal to 60% of credit losses, according to Moody’s .

America’s deleveraging was painful for global bond investors. But taking losses in capital markets also meant less of a burden on banks and taxpayers. As a result, the U.S. government had more fiscal room for other policies, running a deficit of 10.2% of gross domestic product early in the crisis.

Not so in Europe. Public and private debt have continued to increase since the crisis, and bank balance sheets are more than three times as large as GDP. Yet despite Europe’s reliance on this growing amount of borrowing, its financial system and legal framework allow for little flexibility when it comes to failure.

According to the World Bank, a corporate bankruptcy in Greece lasts twice as long, and in Italy costs three times as much, as in New York State. In addition, 80% of Europe’s corporate funding comes from banks, and restructuring loans takes longer than bonds in capital markets. More than €1 trillion ($1.13 trillion) of nonperforming loans is still on bank balance sheets, equal to 95% of credit-crunch losses.

Carrying these assets increases the amount of capital banks must hold, constraining their ability to lend. And the higher the cost of failure, the lower the incentive for entrepreneurs to take risks and for banks to lend.

Dealing with debt overhangs in the public sector is more complex, but the principle is the same. When debt becomes unsustainable, it is in both the creditor’s and debtor’s interest to reach a mutual agreement to restructure what cannot be repaid today while making future payments on the remainder possible.

Europe must change its financial system and legal framework if it wants to deal with its debt overhang. For the public sector, this means considering a debt restructuring deal for Greece, where current fixed debt could be exchanged for growth-linked bonds. To be credible, such a plan should come with conditionality on reforms, and public officials should be paid in part with the same bonds. To solve private-sector overhangs, Europe must develop deeper capital markets and more efficient bankruptcy laws.

The European Commission is due to present a fast-track plan this month for a capital-markets union. Larger bond markets and securitizations would allow Europe’s credit-starved small businesses to finance through capital markets, relieving banks and taxpayers from some of the risks of a future crisis.

Last month Benoît Cœuré, a member of the ECB’s executive board, said of Mr. Tsipras: “He must pay. These are the rules of the European game.” Eventually, the rules of the debt game must change in Europe, if we want to keep playing.

This article was originally published by The Wall Street Journal on February 14, 2015.

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