Michael Pettis asks:
When do we decide that Europe must restructure much of its debt?
...and answers that this should be done more urgently than Europe appears likely to do. His reasoning is very persuasive and illuminating.
Countries suffering from debt crises never regain growth until debt has been partially forgiven — explicitly or implicitly — and the uncertainty associated with its resolution has either been sharply reduced or eliminated.
This uncertainty is more important than generally appreciated, because:
When uncertainty arises about how sovereign debt is likely to be resolved, all ... stakeholders must alter their behavior to protect themselves from bearing a disproportionate share of the costs. Their effect in reducing growth is what is referred to in finance theory as financial distress costs.
Moreover:
typically the most sophisticated, who are often the wealthiest, are the first to protect themselves, and the least sophisticated are the last, with the result that the distribution of losses is asymmetrical in a way that maximizes the social damage.
This uncertainty is magnified by (Pettis's most-distinctive contribution to public discussion of these issues)
inverted balance sheets
... in which [actual & potential liabilities] are structured pro-cyclically so that they reinforce external shocks by automatically causing behavior to change in ways that exacerbate the impact of the shock (unlike a “hedged” balance sheet, which automatically dissipates shocks).
A pressing example of such pro-cyclical inversion is that:
For the banks in peripheral Europe a substantial share of liquid assets consists of their government bonds, so that any deterioration in sovereign creditworthiness would cause enormous losses for the banks, but because the main source of contingent liabilities for the government is the banking system, losses in the banking system would immediately cause the sovereign creditworthiness to deteriorate.
An even broader inversion affects Europe as a whole because:
As soon as [European Central Bank President] Draghi made the statement to do “whatever it takes” ["to preserve the euro"], markets recognized that the ECB was in effect guaranteeing the bonds of EU member states whose credibility was in question, and yields [and financing costs] immediately dropped.
...[but consequently] European debt is locked into an intensely reflexive process in which the value of the Draghi [promise] is a function of the creditworthiness of the ECB, and the creditworthiness of the ECB is a function of the value of its total obligations, including its implicit guarantees.