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SOVEREIGN DEBTAND ITS

RESTRUCTURINGFRAMEWORK IN THEEURO AREA

ASHOKA MODY

Highlights

To compensate for the inflexibility of fixed exchange rates, the euroarea needs flexibility through a system of orderly debt restructu-ring. With virtually no room for macroeconomic manoeuvring sincethe crisis onset, fiscal austerity has been the main instrument forachieving reductions in public debt levels; but because austerityalso weakens growth, public debt ratios have barely budged. Aus-terity has also implied continued high private debt ratios. And thesedebt burdens have perpetuated economic stasis. Economic theory,history, and the recent experience all call for a principled debt re-structuring mechanism as an integral element of the euro areasdesign. Sovereign debt should be recognised as equity (a residualclaim on the sovereign), operationalised by the automatic loweringof the debt burden upon the breach of contractually-specifiedthresholds. Making debt more equity-like is also the way forward forspeedy private deleveraging. This debt-equity swap principle is aneeded shock absorber for the future but will also serve as the prin-ciple to deal with the overhang of legacy debt.

Ashoka Mody is a Visiting Fellow at Bruegel, and Charles and MarieRobertson Visiting Professor in International Economic Policy at TheWoodrow Wilson School of Public and International Affairs, PrincetonUniversity. For their comments, the author thanks George Akerlof,Dorothy Bonjour, Lee Buchheit, Anna Gelpern, Mitu Gulati, ThomasMayer, Atif Mian, Max Watson, participants in a Bruegel seminar,participants in an authors round-table organised by the Oxford Reviewof Economic Policy, and especially Martin Verwey and David Vines.Editorial guidance from Chris Bowlder, and research assistance by

Carlos de Sousa and Verena Jung are gratefully acknowledged.

BRUEGELW

ORKINGPAPER2013/05

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