Debt Restructuring for the Eurozone

The Eurozone Debt Crisis has rekindled the debate on the nexus between currency areas and fiscal sovereigns. After the crisis, much of the intellectual and political debate has been on the benefit of a fiscal union, the idea of creating a common fiscal entity that is well equipped to make state-contingent cross-country transfers within the eurozone. Although the role of a benevolent fiscal union can in theory be welfare-improving for a currency union, it is understood that this is a highly politically constrained option, particularly in the Eurozone. Given this constraint, in this paper, we take the implausibility of fiscal union as given, and argue that debt restructuring can be a close substitute to a fiscal union, leading to welfare improvement. In contrast to a fiscal union that resorts to the government’s visible hand to move nominal resources across countries, the debt restructuring plan designs the bankruptcy rules, but it allows the invisible hand of the markets to make the choice based on context-dependent incentives. Much of the insight in this paper originates from Goodhart, Peiris and Tsomocos (2018) and Wang (2019). The authors show that debt restructuring is particularly vital in currency unions and can lead to significant welfare improvement for both the debtor and the creditor, given a hard government budget constraint. A wider implication of this paper is that for the understanding of modern monetary and financial phenomena, particularly the viability of a currency union, we simply cannot ignore the interplay of liquidity and default.