Over the weekend, global financial institutions officially bailed out Ireland. $90 billion in loans will go to the Irish government, which in turn will use most of them to bail out the banks, leaving little left over for upcoming emergencies. Felix Salmon has already called the amount "underwhelming," and he's right -- if history is any guide, this "package," as the IMFers call it these deals, will not stem growing concerns about sovereign debt, nor will it be a reprieve for other European countries teetering on the edge of default.
The harsh conditions imposed on Ireland, which has already drastically cut its budget, are supposed to restore discipline to the markets. But as we learned during the financial crises of the late 1990s, imposing austerity on the borrower nations while not forcing creditors to restructure loans is a recipe for failure. A series of bailout packages to various countries helped restore some stability but didn't halt the crisis. What resolved it were secondary efforts in Korea and Brazil to force investors to take losses and restructure their debt, sharing the pain with troubled countries -- "bail-ins." Paul Blustein's account of the crises notes that "private-sector involvement was a major element in the rescues that ended triumphantly, whereas it was absent (or instituted too late or half-heartedly) in the rescues that fizzled."
And in Ireland, there will be no losses for bondholders. However, the European Union did agree that bonds issued by member countries, beginning in 2013, will include restructuring clauses. That's a good step forward, but it won't help with the current debt loads countries are finding unmanageable.
A decent analogy to sovereign default is bankruptcy without bankruptcy court, or in fact any rules at all. Most of us understand that it's more beneficial for an entire economy if a person who has become swamped in debt can start over, restructure their debts and get back to contributing to the system, and we expect our courts to find a way for that to happen fairly and consistently. Internationally, we don't have any courts or strict rules -- it'd be like if a bankrupt citizen just kept getting more ad hoc loans from his neighbors who make increasingly strict, if difficult to enforce, agreements about their spending. After the crisis of the '90s, many people supported the creation of a Sovereign Debt Restructuring Mechanism (SDRM) -- bankruptcy court for states -- but the politics proved impossible. The problem was nicely summed up by Lael Brainard in 2002:
It is genuinely difficult, given the absence of an international bankruptcy regime, to develop a set of general rules that would help investors make better risk assessments while minimizing creditor panic at moments of financial weakness. A variety of useful proposals, such as mandating provisions in bond contracts for collective action or automatic rollover, do go some of the way in facilitating a suspension of debt payments, known as a "standstill." ... Since 1999, private-sector involvement has been a part of most stabilization programs, and it is playing out today in the touch-and-go context of Argentina's stabilization. IMF Deputy Managing Director Anne Krueger's proposed creation of a Chapter 11-style international bankruptcy procedure would institutionalize a fundamental shift in this direction, but it remains to be seen whether countries such as the United States and the United Kingdom will approve laws permitting such sweeping changes in creditors' rights.
Today, Brainard is the top Treasury official dealing with global financial problems. You can read about her efforts during the Greek crisis in this profile and her background, like many of the current economic team, dealing with sovereign debt flare-ups during the Clinton administration. Unfortunately, it looks like we're once again learning the lessons of financial crises -- the private sector needs to share a much larger burden of losses -- too late. Hopefully, Brainard will be able to use her position to advance the EU's move toward bail-ins.
-- Tim Fernholz