OPINION:The most toxic route imaginable towards a fiscal union may be the only one

I THINK I now understand how the European Union is planning to resolve the crisis. As a starting point, I believe that Angela Merkel will honour her pledge not to force debt restructuring until 2013.

The German chancellor agreed this formula with President Nicolas Sarkozy during their infamous walk on the beaches of Deauville in France.

There is an emerging consensus among policymakers that the Greek public sector debt is not sustainable. For this realisation to look consistent with the Deauville pledge, the most likely route chosen will be a voluntary restructuring that involves a maturity transformation of Greek bonds.

A voluntary restructuring is, of course, an oxymoron. The idea is to get a group of large investors into a room and bang heads. The problem is that this will almost certainly not be sufficient.

This was also the experience of pre-default Argentina where some investors agreed to a rescheduling while others stayed outside and took a free ride.

In the case of Greece, debt sustainability would require a large restructuring. Standard Poor’s last week put the necessary size of a “haircut” at between 50 and 70 per cent, given the projected debt level of 160 per cent of gross domestic product.

The main significance of a voluntary scheme is not economic, but political. A token voluntary “bail-in” may persuade the EU and the International Monetary Fund to agree another loan to Greece next year. Greece would badly need such a loan because there is no way it will be strong enough to return to the capital market.

So this could be the sequence: after the initial loan, a token “bail-in” would be followed by another loan. By that time, the exposure of the private sector will be lower than today. The short- term debt will have been fully repaid.

So will there be default on the outstanding amounts in 2013?

I think the same political considerations will apply in 2013 as today. Default would cut the country off the capital markets for several years. It would risk contagion to other countries.

It would require a recapitalisation of the European Central Bank and trigger immediate transfer payments under the rescue umbrellas. My hunch would be that the next generation of political leaders will be just as cautious about default in 2013 as they are in 2011.

They will give Greece, Ireland and Portugal another bridging loan. By 2015, a large chunk of the peripheral debt will be held by the various EU rescue schemes.

This alone will not make the Greek debt any more sustainable, but it allows some flexibility in debt management. The loans may be extended to 50 years and the interest rate cut. This can continue up to a point where the debt becomes sustainable. The rescue mechanism will end up with all the periphery debt. Its own bonds will serve as a proxy for periphery debt.

Over time, I would expect that the European Council will extend the size and remit of the European Stability Mechanism (ESM) from the pure backstop it is now towards a proper debt agency. This may become necessary to stop further contagion.

I expect that Spain’s deflationary adjustment will lead to stress in the housing market, with strong spillovers to the savings banks. I therefore expect a future ESM-IMF programme for the Spanish banking sector.

At that point, the focus will shift to Italy. Italy accounts for 18 per cent of the guarantees. I suspect Italy will not be willing to honour its bailout commitment if and when Spain were to enter the mechanism. Even if Italy were willing, it might not be able to do it, given its own debt sustainability problems.

Once Italy defaults on its commitment, I cannot see Germany and France willing to bankroll the entire system unilaterally. At that point, the intra-governmental approach will break down and the euro zone will make the big jump – towards a common European bond.

But is there not a concrete danger of a break-up? Just think of the political dynamics at each link in this chain. The choice today is between crisis-resolution and putting off making a decision. We are doing the latter. In 2013, the choice will be essentially the same.

When it becomes impossible to delay making the hard choices any further, Germany and France face the choice between an implosion of the euro zone or taking a deep breath and accepting a euro zone bond.

My guess is that, having delayed and then delayed again in making the difficult decision, they will do the right thing eventually. It is not that they want this particular outcome. They will simply make the choice of least resistance at each junction and end up at this point.

There is, I admit, the possibility of a big game-changing unexpected intervention. Merkel may be serious about the Deauville commitment, but a revolt in the German or Greek parliament, or some other shock, may force a default. I cannot deny the possibility that the Greeks will blink first, but I am sticking with this scenario.

Is this a good outcome? If you oppose the euro zone bond in principle, then surely you will be horrified by this sequence. If you support the idea, you may still not like it. It is the most toxic route imaginable towards a fiscal union, but it may be the only one. – (Copyright The Financial Times Limited 2011)