Third, if the government is still running a primary deficit, it will not have the funds to pay for some of its key functions. Fourth, in the euro area the sovereign does not have a domestic central bank that will finance its deficit. Fifth, after a default/restructuring the banking system of the country would be unlikely to pass the stress test and have sufficient adequate collateral to access the ECB’s refinancing operations. What are the implications of this analysis? Imposing haircuts on private investors can seriously disrupt the financial and real economy of both the debtor and creditor countries. It ultimately damages the taxpayers of both the creditor and debtor country. This is particularly the case in a region like the euro area, consisting of advanced economies with highly integrated financial markets – an integration we have encouraged for years. This is why such restructuring should only be the last resort, i.e. when it is clear that the debtor country cannot repay its debts. Incidentally, this is the way the international community has functioned and cooperated since the Bretton Woods agreement, which set up the IMF. Countries are never encouraged to default or restructure their debts unless they are in a desperate situation and have no alternative. This is why there have been relatively few cases of debt restructuring and defaults, and they have affected poor and often undemocratic countries. Where is the problem?
Historical experience has also rejected the Panglossian view that there exists such a thing as an orderly debt restructuring. While some restructurings have indeed been successful and can arguably be said to have occurred in an orderly fashion, they were often on a small scale and executed under specific circumstances. The most striking and oft-quoted case is Uruguay. However, more often than not, restructurings have been disorderly, harmful and fraught with difficulties. The average length of the negotiations is 2½ years6 and it can vary greatly. In some cases, negotiations have taken just a few months (for instance, Uruguay in 2003, Pakistan in 1999, Chile in 1990 and Romania in 1983); in other cases they have taken many years (for instance, Vietnam from 1982 until 1998, Jordan from 1989 to 1993, Peru from 1983 to 1997 and Argentina more recently). Empirical evidence also shows that private investors are likely to penalise a country which has a history of restructuring and to demand higher risk premia.7 When considering a euro area economy, the following points should be kept in mind. First, the domestic financial market would be severely affected by a default/restructuring of the public debt. Large losses would have to be accounted for, as no forbearance would be possible, and recapitalisation of the domestic banking system would require additional public money. Second, given the role of the state as implicit guarantor of many financial and economic transactions, the impact on the real wealth of the domestic population and on the economy would be substantial.