Bite the bullet

THE euro zone's strategy for tackling its sovereign-debt crisis is failing. A makeshift scheme was put in place in May to help countries that cannot otherwise borrow at tolerable interest rates. That lowered but did not remove the risk that a country may default for want of short-term funds. But the bond market's nerves have been shredded again by the likelihood that from 2013, when a permanent bail-out mechanism is due to be in place, it will be easier to restructure an insolvent country's debts. More worrying still for private investors, this seems set to give official creditors preference over others.

As a result, bail-outs are making private investors less rather than more keen to hold a troubled country's bonds. As old debts are refinanced and new deficits funded by the European rescue pot and the IMF, the share of such a country's debt held by official sources will steadily rise. That will leave a shrinking pool of private investors to bear losses if debts are restructured. And the smaller that pool becomes, the larger the loss that each investor will have to accept. Bond purchases by the European Central Bank (ECB) aimed at stabilising markets have further diminished the stock in private hands.

This perverse dynamic argues for a restructuring of insolvent countries' debts sooner rather than later. But when is a debt burden too heavy to be borne? A first indicator against which to make that judgment is the ratio of gross public debt to GDP. Most rich economies, including the euro area's most troubled, have large budget deficits and so will be adding to their debts for years. Today's toll is not so important. What matters is how big the debt burden will be when it stabilises.

Column 2 of the table below shows The Economist's estimates of the likely burden for the four most beleaguered euro-zone countries. To keep our projections as simple and objective as possible, we have imposed identical (and thus necessarily stylised) assumptions about growth and interest rates on all. Because all four countries suffer from a lack of competitiveness, a recovery in real GDP in the face of fiscal austerity will probably require a drop in wages and prices. For that reason, we assume that nominal GDP falls before recovering to its 2010 level. The interest rate on new debt is pegged at 5.25%, a bit less than Ireland will have to pay on its rescue funds from the European Union and the IMF.

We assume that it takes five years of tax increases and spending cuts for each country to reach a primary budget surplus (ie, excluding interest payments) large enough to stabilise its ratio of debt to GDP. The required austerity varies: Ireland has already endured a lot of pain but still has most to do (see column 3).

The depth of the mire

To avoid charges of spurious accuracy, we have rounded down our estimate of the stable debt burden to the nearest five percentage points. On this basis Greece ends up with a debt-to-GDP ratio of 165% by 2015. Ireland's projected burden is 125%, Portugal's 100% and Spain's 85%. Only Japan has a larger burden than Greece, and its government can fall back on a big stock of liquid assets and wealthy domestic savers who hold almost all public debt. Even at the subsidised interest rates we assume, Greece would pay 8-9% of its GDP in interest by 2015, mostly to foreigners. For a small country with a shaky economy, that is unbearable: Greece looks bust.

Spain, though, is probably solvent. On our estimate its prospective debt burden is similar to those of “safe” France and Germany today. A worst-case scenario in which the government had to cover enormous losses at the country's banks (see article) would leave its debt burden close to, but not above, the limits of what Spain could sustain at current interest rates.

Ireland and Portugal are less clear-cut cases. A public-debt ratio in three figures might be tolerable at interest rates of 4% or so, but would be too costly to bear at today's bond yields. Two other euro-zone countries, Belgium and Italy, already have public debt of 100% of GDP or more and do not (yet) suffer painfully high yields. But both are quite near to primary budget balance and depend far less on foreign capital than Greece, Ireland or Portugal (column 4). Belgium's economy is small but closely aligned with Europe's strong core. Like Japan, Italy benefits from scale. Its large bond market attracts investors who prize liquidity; its public revenues are backed by a big, diversified economy.

Debt burdens may turn out to be higher. Ireland's government is using its liquid assets to bolster its banks' capital. But if losses on property loans and mortgages are worse than hoped, they could add up to 10% of GDP to our estimate of its debt burden. Portugal says its banks are sound. But the combination of capital inflows and low productivity hints at wasteful investments and a lurking bad-debt problem.

Explore our interactive guide to the euro zone's troubled economies

Greece provides the best example of why it is wise to write down unbearable debts sooner rather than later. Investors typically take losses of one-third to one-half of the value of bonds when sovereign debts are restructured. Greece would need to halve its debts to reduce its burden to a tolerable 80% or so of GDP. If the pain were delayed until the end of 2013 its debts would have to be written down by €185 billion ($239 billion) on our reckoning. Were official creditors repaid in full, private investors would be left with nothing: only €183 billion of the Greek bonds issued before the bail-out would mature after 2013, according to Bloomberg. (That is unlikely. In past restructurings bilateral official creditors, but not the IMF, have taken a hit. Still, the longer the delay the more private investors lose.)

A Greek default would be the first by a rich country since 1948. It would be shocking but feasible. Restructurings by several poorer ones, from Uruguay to Belize, provide a legal case history for how to do it. Two factors may make it easier. First, the bulk of “peripheral” Europe's debts are issued under local law, which some lawyers say can be changed retroactively to add clauses binding all creditors to a deal agreed on by a big majority. Second, the ECB could induce commercial banks to seek a swift agreement by refusing to accept “old” bonds as collateral. The lawyers think a Greek restructuring could be completed in six months. It must be done eventually. It would be better not to delay.

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This addendum provides more details of the working we used to estimate the four countries' debt burdens.