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Talking One's Way Out of a Debt Crisis

7 Pages Posted: 1 May 2016  

Lee C. Buchheit

Cleary Gottlieb Steen & Hamilton LLP - New York Office

G. Mitu Gulati

Duke University School of Law

Date Written: April 28, 2016

Abstract

The policy of Euro-area officialdom in the period 2010-2011 was to avoid, at all costs, a default and restructuring of the sovereign debt of a member of the monetary union. This policy was motivated principally, but not exclusively, by a fear that the international capital markets, if forcibly reminded of the precarious position of overindebted, growth-challenged members of a monetary union, might recoil generally from lending to European sovereigns. In short, they feared contagion.

The only alternative to permitting a debt restructuring, of course, was an official sector bailout. The afflicted countries -- Greece (until 2012), Portugal, Ireland and Cyprus -- received loans from official sector sources sufficient to allow them to repay in full their maturing bond indebtedness. Whenever and wherever the crisis erupted, contagion was thus held in check by the blunt technique of smothering the outbreak -- in money.

The proponents of this policy argued at the time, and argue now, that many European sovereigns in 2010 were far too fragile to endure a bout of market contagion. They argued that an acute crisis needed to be averted in order to buy time for the implementation of a gradual but more durable remedy. Had the intervening eight years been used to reduce the debt vulnerabilities of the peripheral (and even some core) states, this argument would now be powerful, indeed invincible.

Unfortunately, the opposite happened. Average state indebtedness in Europe today is about one-third larger than it was in 2008. Both the member states and the market saw the reprieve as spreading a reliable official sector safety net under their exposure. So they kept on borrowing and lending. Only the zero interest rate policies of the world’s major central banks during this period have kept debt servicing costs at tolerable levels.

Keywords: sovereign debt, contagion, eurozone

JEL Classification: F34, H74

Suggested Citation

Buchheit, Lee C. and Gulati, G. Mitu, Talking One's Way Out of a Debt Crisis (April 28, 2016). Duke Law School Public Law & Legal Theory Series No. 2016-28. Available at SSRN: https://ssrn.com/abstract=2772658 or http://dx.doi.org/10.2139/ssrn.2772658

Lee C. Buchheit

Cleary Gottlieb Steen & Hamilton LLP - New York Office ( email )

One Liberty Plaza
New York, NY 10006-1470
United States

Gaurang Mitu Gulati (Contact Author)

Duke University School of Law ( email )

210 Science Drive
Box 90362
Durham, NC 27708
United States

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