REUTERS/Daniel Munoz

Bank crisis: Why private creditors should share the burden

The financial crisis has taken a heavy toll on government finances and taxpayers are still footing the bill. Could private investors do more to help out? Mohamed El-Erian, CEO and co-CIO of PIMCO, believes they should. He explains to the OECD Observer.

OECD Observer: Do you think the banking crisis is nearing the end or is the going still too fragile to call?
Mohamed El-Erian: A lot of progress has been made in recapitalising the banking system, de-risking it and identifying what needs to be done to minimise the likelihood of another crisis. These positive developments have come at a significant cost to society, however. And it will take a lot of time to deal with the collateral damage and unintended consequences.

As an illustration, think of the following three issues:

First, governments in many advanced economies found it necessary to step in with their balance sheets, both to offset the disorderly deleveraging of the private sector and to avoid a global depression. Accordingly, the liabilities have been transferred to the public sector, with the result that too many countries now have budgetary deficits and public debt problems.

Second, in some cases, such as Greece, Ireland and Portugal, the sovereign problems are so acute as to result in a full-blown debt crisis together with a legitimate, though previously unthinkable, debate about the possibility of debt restructuring in advanced economies.

Third, the debacle in the banking system has contributed to sluggish economic growth, thus aggravating the structural headwinds facing employment creation– especially in the finance-dependent economies, such as the UK and US, and those with acute debt problems, such as peripheral euro area countries. In the process, income and wealth inequalities are worsening. Because of this mix, the global economy is healing but only in a gradual, uneven and tentative fashion.

A few months ago you went on the record as saying that “a broader burden sharing” involving private creditors would be needed to help with bank bailouts. Could you explain?
In addressing the peripheral debt problem, the EU, ECB and IMF have essentially opted for a liquidity approach now and a solvency approach later. While understandable, this involves significant costs and risks.

Consider the euro zone countries–Greece, Ireland and Portugal–that have received large bailout packages. In all three cases, the burden has been borne by people domestically, who are experiencing severe austerity programmes, and official creditors who have made substantial financing available. Private creditors have been repaid in full, and the vast majority has resisted any renewal of their financial commitments.

This approach essentially piles new debt on top of old debt, while also shifting an increasing share of the liabilities from private balance sheets to taxpayers. It does very little to deal with the debt overhang that is undermining new investment, growth and employment creation.

It should therefore come as no great surprise that so many of the original objectives of the bailout packages have not been met. Consider Greece as an illustration.

Despite over a year of enormous sacrifices on the part of Greek society and exceptional financial support from the ECB/EU/IMF, the country is still very far from regaining economic and financial stability. Greek output continues to collapse, unemployment is rising, the budget deficit remains alarming, the domestic banks are extremely weak, and the already excessive debt burden is increasing further.

Meanwhile, doubtful liabilities continue to be transferred from private creditors, who knew that they were taking risks in lending to Greece and opted for earning a risk premium, to Greek and European taxpayers as well as to the balance sheet of the IMF.

So while the approach has bought time for other vulnerable segments and countries in the euro zone to get their house in better order, it has done very little to re-establish the conditions for growth in the peripheral economies. Meanwhile, the substantial burdens associated with this approach, both current and future, continue to be shifted on to taxpayers.

What are the major challenges you see in the months ahead for the global economy and what advice would you give policymakers in OECD countries and beyond?
The baseline of continued, albeit slow and uneven, global economic healing brings major challenges that should be understood and, in several cases, addressed.

First, the world has to deal with both a negative demand shock and a negative supply shock associated with higher oil prices and Japan’s tragic triple calamity. It is not often that such a combination is in play, and it is even less common to have two sources of simultaneous negative shocks in play at the same time.

Second, if Europe does not adjust its approach to the peripheral debt crisis, the potential threats to the region and the world will grow over time.

Third, the failure to agree to medium-term fiscal reform in the US serves to weaken the outlook for the country and undermines its role at the core of the global system. This comes at a time when the authorities are also contemplating how best to exit from a series of unconventional policy measures, and when the housing sector remains vulnerable.

Fourth, emerging economies must deal with incidences of overheating and, more generally, continue to manage the success associated with their historical development breakout phase.

These risks are manageable, but they require steadfast attention, responsiveness and agility on the part of policymakers. By responding well to the challenges, policymakers have the potential to enable further healing in the global economy and, hopefully, get to a critical mass of healthy sectors that are able to pull up the less healthy sectors. If they fail, the world will face increasingly disruptive, stagflationary winds.


References

BBC News: “Pimco boss: Pain of rescues ‘should be shared’”, 24 November 2010, see www.bbc.co.uk/news/business-11835044

See www.oecd.org/publicdebtmanagement

Visit www.pimco.com


©OECD Observer No 284, Q1 2011




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