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Wednesday, January 26, 2011

Forever in your debt

One proposal that keeps popping up in the debate on how to restructure the struggling Euro zone economies, is the idea that they be allowed to buy back their own bonds using money lent from the EU.

Reuters notes that the successful bond issue by the euro zone's financial stability fund means that there is a rich vein of cheap financing for the likes of Greece and Ireland to buy back their 10-year debts at a discount, without having to impose haircuts or trigger a 'credit event' or default.

In an earlier blog post, we already wrote about the moral hazard aspects of this idea.

To recap, these sort of "bond swaps" would involve the struggling economies using funds from the EFSF to buy up old, high-priced debt on the open market where it is available at between 70-80 cents on the euro. This is due to the fact that investors are so reluctant to hold onto long term debt from these economies due to the high risk of default. The idea is that this removes the existing debt, both in principle and interest payments, and replaces it with the cheaper more flexible loans from the EFSF.

However Die Zeit economics editor Mark Schieritz notes that this "sounds too good to be true". He poignantly explains that such an action "would increase demand for the bonds, so that the price will rise". Clearly as a consequence of buying back the bonds the price will be increased, most likely to the point where any gains from such an intervention would be minimal! It seems to be a self defeating policy.

The FT also notes that since much of the debt in these countries, Greece in particular, is owned by the ECB and European banks it would simply be spreading the losses around Europe. Yet again this policy essentially comes down to redistributing debt around Europe. Someone always has to pay and moving debt around or replacing old debt with new loans doesn't solve the issue.

Conclusion: no quick fix for Europe's debt problems.

Note: For a formal description of this process see the FT Alphaville blog.

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