Last weekend Europe took a step towards fixing a key structural problem underlying the euro: a future debt restructuring mechanism for insolvent members. Far from perfect, but a very decent effort nonetheless. It sets the stage for what could be an orderly debt restructuring (potentially avoiding an actual default) of a country’s debt if deemed unsustainable by the EU. Here are a few pros and cons of the approach and the likely implementation.

A credible mechanism that would only allow the EU to help a country if it goes through a debt restructuring that brings it back to solvency has a few very positive features. It can produce orderly and successful debt restructuring swaps without the need for a messy default or a lengthy post default crisis. This is how some of the most successful and less traumatic debt restructurings occurred (e.g. Uruguay 2002/2003, where the credible third party threat was provided by the IMF). A well-designed system along these lines would also work towards preventing a country’s debt from getting to be too high, as it would reduce moral hazard (i.e. investors buying debt expecting a bailout if the worst case scenario materialized).

The current debate is focused on ‘collective action clauses’ and other features of the new debt contracts. This is correct and necessary to facilitate efficient debt restructuring swaps reduce the incentives for holdouts to try to prevent such an event. But it is not the central element of the mechanism. What matters the most is a credible central authority that would only come in to provide liquidity financing if a serious step towards solvency is taken through an ex-ante negative NPV debt restructuring swap (as it happened in the case of Uruguay).

Unfortunately this is not the best of times to debate such system. Saying that this system would only be in effect for debt issued after 2013 is not enough to calm today’s debt holders. What if 2-3 years are not enough to help Greece and Ireland become solvent again, or if debt issued during 2013 under the new scheme cannot be repaid during 2014? Will the EU allow a country to have a stock of defaulted debt and keep paying the pre-2013 debt? Not really. This debate, though a correct and necessary step to improve the euro, it does tell bondholders that there is now a non-trivial and explicit probability of a debt restructuring in one or more of these countries.

This is one good step, but it is not the major reform that would make the euro a reserve currency capable of competing with the dollar. There is still a need for a more formal central fiscal authority, as opposed to an uncertain combination of rich country politicians deciding on whether and how much to spend to preserve the credibility of its currency. The euro is still the sum of its parts at each point in time, which depends on local politics among other things. A formal centralized fiscal agreement is not realistic in the short-term, but a more structured (hopefully rule-based) debt restructuring mechanism is a step in that direction.

A difficult question to answer would be: if this is such a good system, why not implement it right away, decide who is insolvent, and make the bailout contingent on debt restructuring? Part of the answer is that if it was applied to country A and B, but not country C in the domino, investors would flee countries C, D and E expecting the same ‘burden sharing’ type of restructuring to affect them. As we said last week in “How do we get to the Spanish dilemma?“, this is really about Spain, then the euro itself. The rest of the answer relies on the fact that at this point in time the global economy is still too weak to surprise markets with such an approach. Thus, designing a system and announcing it with a few years in advance is different than imposing it during a crisis, as it can be seen as a change in the rules midstream. The EU did not have actual government guarantees, but cross subsidies have been the name of the game since inception, and markets were working under the assumption that the Union would not let a member state fall through. As I said, it is not an easy question to answer, though German politicians might have to pretty soon.

What seems clearer these days is that markets have the capacity and tendency to bring the future closer to the present. At the current funding rates for the troubled economies, their private sectors are less likely to help produce the economic recovery that is needed to accompany fiscal adjustments in restoring solvency. Unless the EU authorities work faster, more pro-actively, instead of reacting to each bond selloff, 2014 will be here sooner than we think.