Collective Action Clauses: Das Opium des Volkes

Europe is the lead story of the 2010 Crisis Yearbook.  It holds the promise of radical legal innovation in financial crisis management:  it may yet become the birthplace of the first-ever sovereign bankruptcy regime, and the first-ever initiative to standardize sovereign bond contracts issued under the domestic laws of different states.  But for now, Europe is mired in CACology. 

How I Stopped Holding My Breath for a Greek Restructuring and Learned to Love Illiquency Support

Leading economists and editorialists say Greece will restructure its debt (here, here, here, here and here are just a few examples).  Many say so because they see so much in common between the spiraling European crisis and past crises in the emerging markets.  The analogy has merit, and until recently, I too subscribed to it.  Now I am not so sure.  This is because the benefits of restructuring now are oddly remote, because Greece has the legal leverage to extract a deep debt haircut if and when it can maximize its benefits, because the EU needs time to get its act together and seems willing to pay for it—and because, as a descriptive matter, the global political commitment behind the no-restructuring option is without precedent.  And sovereign debt is nothing but political commitment.  I elaborate below.

Contracts and Crises

The tussle over AIG bonuses brings back a familiar crisis meme: the sanctity of contracts.  It is a red herring – sort of.

Any financial collapse worth its salt runs into contracts that might have been a good idea in good times, but now look disastrous because they threaten either widespread economic distress (mortgage and securitization contracts), or gross political embarrassment (bonus commitments).  Every government fighting a crisis thus faces a choice whether to enforce such contracts.  Enforcing contracts where private parties have no money means either suffering default and firm failure, or using public funds to pay up on the parties’ behalf.  The alternative is using government power to rewrite the contracts.