THE CRISIS WILL SPREAD WITHOUT A PLAN B / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING - A MUST READ )

The crisis will spread without a Plan B

By Nouriel Roubini and Arnab Das

Published: April 29 2010 21:58

The past weekend’s spring meetings of the International Monetary Fund in Washington focused on the Greek sovereign debt crisis – the first such crisis in living memory to concern a high-income country, and in the eurozone no less. Even more telling than the shift of focus from emerging markets is the widening divide in the views of those institutions and governments leading efforts to secure an orderly resolution.

Continuing on the path of least resistance – a “Plan A” of official financing banking on a mix of deep fiscal cuts, inadequate structural reforms and hopes that markets will stay open, with growth doing much of the heavy lifting – is a risky bet that is very likely to fail. Already this week, financial markets and credit rating agencies have voted against this approach and started to price in a high probability that Greece will need to restructure its public debt coercively, with contagion to the rest of the eurozone periphery now a serious risk. Augmenting the programme for Greece alone – up to €100-€120bn as suggested by the IMF – will not work either.

Far better to move to Plan B. This would involve a pre-emptive debt restructuring for Greece; a strengthened fiscal adjustment plan in the eurozone periphery; far-reaching structural reforms; a larger IMF/European Union programme to help Greece and prevent contagion to others; further monetary easing by the European Central Bank; fiscal and domestic demand stimulus in Germany; and a co-ordinated effort to address the institutional weaknesses of Europe’s economic and monetary union.

Belgium’s successful fiscal adjustment in the 1990s is often cited in support of the current approach. But Belgium benefited then from a buoyant global economy and falling interest rates. By contrast, Greece and the eurozone periphery today face the challenges of great divergence within Europe, a loss of competitiveness, sharply rising real interest rates and a fragile recovery.

Plan A entails a brutal fiscal retrenchment to restore debt sustainability. It will lead to higher unemployment and social unrest now, but only restore competitiveness in the distant future. It will intensify deflationary and political pressures in Europe’s south and so raise real interest rates over time. If it is not seen to be working right away, real interest rates will continue to rise sharply and quickly as they have this week. It will also exacerbate market fears of subordination: the more IMF support is needed, the larger the haircut meted out to private sector creditors if restructuring is eventually required.

Thus, Plan A risks a disorderly default and financial crisis. The alternative route of a pre-emptive debt rescheduling via an exchange offer has worked where it was tried early enough and supported with enough official financing and political commitment: Pakistan and Ukraine in 1999, Uruguay in 2002 and the Dominican Republic in 2005.
Much time has been lost in denial, but if the following steps are taken it might not be too late to avoid a disorderly outcome. First, use the experience of earlier emerging market “test cases” for sovereign debt restructuring. Second, prepare an exchange offer with a menu of options for the range of private creditors. Third, use some of the planned official support to provide credit enhancements for the new public debt; use the rest to provide financing for the ongoing deficit at reasonable interest rates. Fourth, use the time lent by the stretched maturities and reduced net present value of the debt to implement a comprehensive structural reform programme to boost competitiveness.

All of this must be accompanied by a similar fiscal adjustment and structural plan for other eurozone members on the front line – Portugal and Spain in particular. Such a plan would also benefit from much larger IMF financing, conditionality and surveillance. The ECB must be on-side with refinancing to forestall a run on Greek banks; easy monetary policy to weaken the euro, thus helping to restore competitiveness and prevent deflation; and liquidity facilities for overexposed third-country banks. Ultimately, measures are required to boost aggregate demand in Germany and elsewhere in northern Europe, thereby encouraging a rebalancing of eurozone growth.

Such an approach would have a good chance of success and show that Europe can learn the lessons of the past – even if they come from emerging markets. Unfortunately, while a Plan B is increasingly urgent, it is not necessarily becoming more likely. For now, the official sector is stubbornly sticking with a failing Plan A whose underlying flaws would not be resolved with more IMF support.

Nouriel Roubini is chairman and Arnab Das head of market research at Roubini Global Economics

Copyright The Financial Times Limited 2010