Europe needs debt relief, not decades of austerity

? Greece and Ireland may have to be allowed to default gracefully
? Demand grows for independent audit to separate public from private debt

From Donegal to the Algarve, to the streets of Athens, voters on Europe's "periphery", as economists dismissively call it, are slowly waking up to a sobering truth ? they face years of austerity, yet wage cuts, job losses and crumbling public services will not extricate them from financial crisis. In fact, by driving their economies into an ever deeper slump, it may even make things worse. The pain could just bring more pain.

Paul Krugman, the US Nobel prize-winning economist, calls it "the austerity delusion". As Ed Miliband said of the coalition's austerity policies last week: "It's hurting, but it's not working."

The Irish would certainly agree with that ? Dublin has been widely praised for its draconian spending cuts, but the latest official figures, released on Thursday, showed that the economy has now been in recession for three years. Domestic demand is 27% lower than during Ireland's Celtic Tiger heyday. Investment is down by 60%, exports are falling, and, as any cash-strapped homeowner could tell you, when your income shrinks, it gets harder to service your debts.

This "debt trap" is familiar to campaigners who spent years fighting for the cancellation of Africa's multibillion-pound loans from the west. Millions of taxpayers in wealthy countries were moved to sign petitions and march on their capitals as part of the Jubilee 2000 movement.

The plight of Portuguese nurses or Irish homeowners can hardly be compared to the grinding poverty of Africa's indebted millions, but the stark logic of the situation is the same. Adopting the harsh deflationary policies imposed by international lenders, and meeting punitive interest payments, sucks the life out of already fragile economies, and that makes repayment even tougher.

Nick Dearden, director of Jubilee Debt Campaign, points to the case of Zambia. It was bailed out by the International Monetary Fund in the early 1980s, to prevent the government defaulting on the debts it owed to western banks, which had been on a reckless African lending spree. Zambia compliantly took the medicine the IMF prescribed, including severe spending cuts ? but these simply drove the country into a deeper and deeper slump, making its debts ever more unsustainable. By 1995, Zambia's economic output had contracted by 30%, but its debt-to-GDP ratio had doubled, to 150%. It's hard to argue that it wouldn't have been better for the country simply to have defaulted on part of its debt.

What creditors were eventually forced to admit in the case of much developing country debt was that, in practice, there was absolutely no likelihood of getting their money back; and morally, it was wrong for the debts to be honoured when many of the loans should never have been made in the first place. It's time for more people to start making the same argument in Europe.

The backlash is already under way: in Ireland and Greece there are increasingly noisy public campaigns demanding an independent audit of these countries' debts, so that voters can see exactly who owes what to whom ? and by implication, who precisely is being "bailed out".

Andy Storey, the University College Dublin economist involved in the Irish campaign, says: "The reason the bailout was instituted was because European banks wanted to get their money back."

Much of the increase in Dublin's deficit results from huge bailouts of its clapped-out banking sector ? and by implication, the bondholders who backed the banks. "In Ireland, an audit would be about separating the private from the public debt," Storey says. "How much of this is actually going to reimburse speculators, who shouldn't get their money back because they were stupid enough to invest in a bank with a very bad business model?"

Drawing a line between the money owed to the banks' bondholders, and the cash Ireland has borrowed to meet the costs of the recession ? in increased welfare payments, for example ? could pave the way for some of the private sector debt, at least, to be written down.

Illegitimate

In Greece, Costas Lapavitsas, the London-based economist who is involved in the debt audit campaign, says part of its task would be to identify whether some of Athens' debt is actually illegitimate. He insists that, as in developing countries, there are moral as well as economic issues at stake.

"Is it morally or economically acceptable to destroy the welfare state, and to destroy schools and destroy hospitals to pay off these debts?" he asks. Like Storey, and a growing number of economists, he believes a default is only a matter of time ? so it would be better to face it now. And he believes it won't be long before the Irish people follow their Greek cousins on to the streets: "My view is that Ireland is about six months behind Greece in terms of mood."

Although few dare to say it aloud, European leaders seem to agree that they need to open the door for countries to default gracefully, at least on their future borrowing.

When they cobbled together the so-called Euro Plus Pact in Brussels last Thursday, including a commitment to plough money into a giant permanent bailout fund to be known as the European stability mechanism, they specified that all new bonds issued by eurozone governments will in future have to include "collective action clauses".

These clauses should make it easier to negotiate a dignified exit when the burden of debt has become unsustainable, because they force creditors to negotiate. If the defaulting government can win over a majority of its lenders to accept a "haircut" ? a reduction in the value of what they are owed ? the rest are bound by the deal. That prevents rapacious bondholders delaying a restructuring by holding out for a better agreement; but debt campaigners say that it won't be enough to prevent future crises.

Dearden, together with many other international campaigners, argues that there needs to be an international "debt court" ? an independent, formal arbitrator which would oversee something like a bankruptcy process, but for sovereign states. The court would decide which debts should be honoured in full, and which creditors must take a haircut, or lose out altogether. Financiers loathe the idea, arguing that allowing default creates the problem of "moral hazard" ? countries might have an incentive to borrow recklessly, in the knowledge that they can always turn to the debt court if times get hard.

But it would hardly be an easy way out for a government to publicly declare itself bankrupt to the rest of the world: it would be acutely embarrassing, and any country that did so would find it painfully hard (and expensive) to borrow in the future.

And it's simply a fact that countries sometimes do default - Russia did in 1998 and Argentina in 2001, for example. The consequences would be much easier to assess, and almost certainly less painful, if investors knew what would happen next.

Legacy

None of this helps Portugal, Ireland or Greece, however, which are still left wrestling with the legacy of the boom years. So far, their populations have largely accepted the harsh strictures of the EU and IMF, because governments ? and the bond markets ? insisted there was no alternative. But they could be signing up for many years, perhaps decades, of austerity. The social consequences will be severe, and even then, the medicine may not work, and the debts may still be unsustainable. An independent debt audit for each country would be a good first step towards making the right decision about which debts are worth enduring that kind of pain for.

The Irish prime minister, Enda Kenny, who came to power promising to abide by his predecessor's pledges of austerity, is beginning to turn his fire on the financiers who have been some of the main beneficiaries of the bailout. "It is grossly unfair to expect the taxpayer to have to pay 100% for the reckless lending practices of banks which caused this in the first instance," he has said.

Markets and voters across the eurozone have grown wearily accustomed to watching the cycle of a looming fiscal crisis as bond yields rocket, followed by just enough action from Brussels to jolt investors out of panic mode, followed by another bout of the jitters as they realise the rhetoric from euro leaders isn't matched by reality.

As Steen Jakobsen, chief economist at Saxo Bank, put it in a note on Friday: "It's clear that the electorates are beginning to realise that all solutions offered by the policymakers are based on the promise to do something in the future, and never right here, right now."

But time is running out, and Europe has two choices. It can continue hammering the economies of Greece, Italy and soon Portugal deeper into crisis, while their already furious voters become increasingly resentful about the pain being imposed by their European "partners"; or it can accept that the scale of debts has simply become unsustainable, and open negotiations now about an orderly default.