FOR a few weeks over the Christmas holidays, Europeans put theirsovereign-debt crisis on hold. Now they are facing grim reality oncemore. Bond yields are spiking in an ever broader group of countries,just as the euro zone’s governments need to raise vast sums from themarkets. On January 12th Portugal was forced to pay 6.7% for ten-yearmoney—better than feared but a price it cannot afford for long. Yieldsfor Belgian debt have jumped, as investors fret about its load of debtand lack of leadership. Spain is hanging on.

This mess leads to a depressing conclusion: Europe’s bail-outstrategy, designed to calm financial markets and place a firewallbetween the euro zone’s periphery and its centre, is failing. Investorsare becoming more, not less, nervous, and the crisis is spreading. PlanA, based on postponing the restructuring of Europe’s strugglingcountries, was worth trying: it has bought some time. But it is nolonger working. Restructuring now is more clearly affordable than itwas last year. It is also surely cheaper for everybody than it will bein a few years’ time. Hence the need for Plan B.

The initial response, forged in the rescue of Greece in May 2010,has been undone by its own contradiction. Europe’s politicians havecreated a system for making loans to prevent illiquid governments fromdefaulting in the short term, while simultaneously making clear (atGermany’s insistence) that in the medium term insolvent countriesshould have their debts restructured. Unsure about who will eventuallybe deemed insolvent, investors are nervous—and costs have risen.

Theleast-bad way to deal with this contradiction is to restructure thedebt of plainly insolvent countries now. Based on this newspaper’scalculations (see article),that group should start with Greece and probably also include Portugaland Ireland. Spain has deep problems, but even with a big bank bail-outit should be able to keep its public debt at a sustainable level (see article).Italy and Belgium have high debt levels but more ample private savings,and their underlying budgets are closer to surplus. There is, thus, areasonable chance that, handled correctly, euro-zone sovereign defaultscould be limited to three small, peripheral economies.

The perils of procrastination

This newspaper does not advocate the first rich-country sovereigndefaults in half a century lightly. But the logic for taking actionsooner rather than later is powerful. First, the only plausiblelong-term alternative to debt restructuring—permanent fiscal transferfrom Europe’s richer core (read Germany)—seems to be a politicalnon-starter. Some of Europe’s politicians favour closer fiscal union,including issuing euro bonds, but they are unlikely to accept budgettransfers big enough to underwrite the peripheral economies’ entiredebt stock.

Second, the dangers from debt restructuring have diminished even asthe costs of delay are rising. Eight months ago, when euro-zonegovernments and the IMF joined forces to rescue Greece, theirdetermination to avoid immediate restructuring made sense. There werereasonable fears that default could plunge Greece into chaos,precipitate bond crises in the euro zone and spark a European bankingcatastrophe.

Explore our interactive guide to the euro zone's troubled economies

But the European economy, as a whole, is now in better shape. Bankshave had time to build up more capital—and palm off some of theirholdings of dodgy sovereign bonds to the European Central Bank. Greeceand other peripherals have shown their mettle with austerity plans.Europe’s officials have created mechanisms to stump up rescue moneyquickly. And lawyers have been thinking about managing an “orderly”default. A sovereign restructuring could still spook financialmarkets—fear that it would spread panic makes Europe’s politicians shyaway from it—but if handled correctly, it should not spawn Lehman-likechaos.

At the same time the costs of buying time with loans have becomepainfully clear. The burden on the countries that have been rescued isenormous. Despite the toughest fiscal adjustment by any rich countrysince 1945, Greece’s debt burden will, on plausible assumptions, peakat 165% of GDP by 2014. The Irish will toil for years to service rescueloans that, at Europe’s insistence, pay off the bondholders of itsdefunct banks. At some point it will become politically impossible todemand more austerity to pay off foreigners.

And the longer a restructuring is put off, the more painful it willeventually be, both for any remaining bondholders and for taxpayers inthe euro zone’s core. The rescues of Greece and Ireland have increasedtheir overall debts while their private debts fall, so that a growingshare will be owed to European governments. That means that thewrite-downs in any future restructuring will be bigger. By 2015, forinstance, Greece could not reduce its debt to a sustainable level evenif it wiped out the remaining private bondholders.

How to change course

A cost-benefit analysis, in short, argues in favour of carrying outan orderly restructuring now. The debt reduction should be big enoughto put afflicted economies on a sustainable path. Greece may have tohalve its debt burden. Ireland’s may need to be cut by up to a third,with some of this coming from writing down bank rather than sovereigndebt.

All creditors, including governments and the European Central Bank,will have to chip in. New rescue money will also be needed: to funddefaulting countries’ budget deficits; to help recapitalise thesecountries’ local banks (which will suffer losses on their holdings ofgovernment bonds); and, if necessary, to recapitalise any hard-hitbanks in Europe’s core economies. The ECB and others should stand readyto defend Belgium, Italy and Spain if need be.

If Europe’s leaders stick to plan A, the debt crisis will continueto deepen. If they get on with restructurings that are eventuallyinevitable, they have a fighting chance of putting the crisis behindthem. Plan B will require deft technical management and politicalcourage. Thanks to its emerging-market expertise, the IMF has some ofthe former. It is up to Europe’s politicians to find the latter.

http://www.economist.com/node/17902709

http://www.economist.com/blogs/multimedia/2011/01/plan_b_euro_zone