BRUEGEL WORKING PAPER 2013/05

SOVEREIGN DEBT AND ITS RESTRUCTURING FRAMEWORK IN THE EURO AREA

ASHOKA MODY

Highlights
To compensate for the inflexibility of fixed exchange rates, the euro area needs flexibility through a system of orderly debt restructuring. With virtually no room for macroeconomic manoeuvring since the crisis onset, fiscal austerity has been the main instrument for achieving reductions in public debt levels; but because austerity also weakens growth, public debt ratios have barely budged. Austerity has also implied continued high private debt ratios. And these debt burdens have perpetuated economic stasis. Economic theory, history, and the recent experience all call for a principled debt restructuring mechanism as an integral element of the euro areas design. Sovereign debt should be recognised as equity (a residual claim on the sovereign), operationalised by the automatic lowering of the debt burden upon the breach of contractually-specified thresholds. Making debt more equity-like is also the way forward for speedy private deleveraging. This debt-equity swap principle is a needed shock absorber for the future but will also serve as the principle to deal with the overhang of legacy debt.

Ashoka Mody is a Visiting Fellow at Bruegel, and Charles and Marie Robertson Visiting Professor in International Economic Policy at The Woodrow Wilson School of Public and International Affairs, Princeton University. For their comments, the author thanks George Akerlof, Dorothy Bonjour, Lee Buchheit, Anna Gelpern, Mitu Gulati, Thomas Mayer, Atif Mian, Max Watson, participants in a Bruegel seminar, participants in an authors round-table organised by the Oxford Review of Economic Policy, and especially Martin Verwey and David Vines. Editorial guidance from Chris Bowlder, and research assistance by Carlos de Sousa and Verena Jung are gratefully acknowledged.

AUGUST 2013

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