The Great EU Debt Write-Off

Abstract

Background. When one economic entity is both a creditor and debtor to another economic entity, a somewhat obvious and simple resolution is to cross-cancel their debts.

Aim. To give students experience of researching important data and to conduct a policy-relevant negotiation exercise.

Method. We created a classroom simulation in which students were required to research the debt positions of eight EU countries (Portugal, Ireland, Italy, Greece, Spain, Britain, France, and Germany) and then conduct a negotiation exercise with the goal of reducing the total debt burdens of the countries to which they were assigned.

Results. Students discovered that a large amount of the EU debt burden can be written off by cross cancelling interlinked debt.

Conclusion. As students were the focus of the exercise, their engagement and learning outcomes were high. The result is a platform to understand and discuss EU policy decisions and the wider implications of the debt crisis.

Keywords

debt Eurozone simulation

Instructional Objectives

Participants developed their research and data analysis skills, and increased their understanding of the available data on an important topical issue. The simulation exposes the participants to a number of different elements of trading and negotiation strategies. In particular, they gain experience in the complexity of going from bilateral to multilateral deal making, and negotiating from weak positions.

Simulation Objectives

To reduce the debt burden of the country that has been assigned.

Debriefing Format

Class discussion following the conclusion of the simulation.

Target Audience

MBA level students with an interest in European public policy. A basic understanding of finance is required.

Playing Time

6 hours.

Debriefing Time

30 minutes.

Number of Players Required

2-4 participants for each of the eight countries (i.e. 16-32 participants in total).

Participation Materials Included

A data spreadsheet, a powerpoint file containing starting position, and multiple summary sheets.

Debriefing Materials Included

A results powerpoint file.

Computer Configuration

Not necessary.

Other Materials

Photocopier.

Why Use This Game – Background, Results, and Findings

Ever since the downgrade of the Greek government’s credit rating towards the end of 2009, EU member states have found themselves lurching from one sovereign debt crisis to another. Despite an agreement on a bailout plan for Greece and the creation of the European Financial Stability Facility, the crisis has spread. The Irish government received aid from the EU and the IMF in December 2010, Spain’s credit rating was downgraded in March 2011, and EU finance ministers met in Hungary in April 2011 to agree on a bailout plan for Portugal. Due to the fact that these countries are facing increasing debt burdens and worsening growth prospects, these bailouts serve as nothing more than quick fixes for an inherently unsustainable situation.

Figure 1 shows the extent to which interlinked debt suffocates the European PIIGS countries.¹ Countries are keen to prevent defaulting because they understand that one country’s debts are another country’s revenue stream. The possibility of contagion is high, but the sheer scale of this web of debt presents an opportunity. The conventional assumption is that such debts will be repaid via future revenues—even though those revenues are laden by the weight of existing debt. However, if a country is both a debtor and a creditor, it does not need money to settle claims. In such situations, why do countries seek additional funds to deal with choking debt rather than writing it off?²

Figure 1.

The EU web of debt, pre-simulation.

The purpose of this article is to describe an attempt to bring an important topic into the classroom. This serves a dual purpose: firstly, trialing a pedagogical innovation (namely a group activity that uses student-led data analysis as the basis for a face-to-face negotiation exercise); and secondly, exploring a policy innovation (namely the cross cancellation of interlinked debt).

Students increasingly demand that business schools provide practical content, and some teachers therefore suggest that these schools should be more focused on providing professional, rather than scientific, training (Bennis & O’Toole, 2005). In these types of participant-centered methods, students are placed into the context of a realistic problem characterized by uncertainty and ambiguity. The most popular of these methods is the case method, which provides an engaging narrative that leads students to discuss potential solutions (see Barnes, Christensen, & Hansen, 1994; C. M. Christensen & Carlile, 2009; C. R. Christensen, Garvin, & Sweet, 1991; Garvin, 2007; Wolfe, 1998).

An alternative method for bridging theory and practice is a simulation in which an artificial environment is created by the educator (see Bell, Kanar, & Kozlowski, 2008; Doyle & Brown, 2000; Keys & Wolfe, 1990). A simulation is appropriate in this instance because our primary goal is to increase student awareness of the EU debt crisis. Rather than lecture or assign readings, we aim to encourage students to put themselves into the position of one of the EU nations covered by the study. The students know that they will be participating in a simulation, and therefore have a strong incentive to conduct relevant research prior to the event. The simulation itself provides an immersive experience that subjects students to numerous questions and offers them a variety of insights.

Students from ESCP Europe’s Master in European Business (MEB) and Master in Management (MIM) programs took part in the “Great EU Debt Write-off” simulation that took place on May 17, 2011 under the guidance of Anthony J. Evans, Terence Tse, and Jeremy Baker. All of the classroom materials are available to facilitators at www.eudebtwriteoff.com. The results are shown in Figure 2.³

Figure 2.

The EU web of debt, post-simulation.

The main findings were the following (for full results, see Figure 6 in the Appendix):

The EU countries in the study can reduce their total debt by 64% through the cross-cancellation of interlinked debt, which would lower total debt from 40.47% of GDP to 14.58%.⁴

Six countries—Ireland, Italy, Spain, Britain, France, and Germany—can write off more than 50% of their outstanding debt.

Three countries—Ireland, Italy, and Germany—can reduce their obligations to the point that they owe more than EUR 1bn to only two other countries.

Facilitator’s Guide

In this article, we intend to provide a sufficient description of the method such that other educators may replicate the simulation and gather their own findings. The simulation involved three major steps: the preparation, the simulation, and the debrief.

Step 1: The Preparation (Three Hours)

Participants were split into pairs, with each pair assigned a country. In the trial run, we limited the exercise to the five “PIIGS” countries: Portugal, Ireland, Italy, Greece, and Spain. For the actual simulation, we also included Britain, France, and Germany, giving a total of eight countries. We gave a brief presentation to explain the premise of the simulation, after which participants were asked to conduct desk research to achieve several goals.

Validate the total outstanding debt

Using a New York Times (2010) article as a starting point, participants attempted to validate its figures using alternative data sources. All currency conversions were made using the same exchange rate,⁵ and all values were expressed in EURbn (to two decimal places).⁶

Calculate debt on a country-by-country basis

The New York Times (2010) article also indicated the debt owed per country. Participants were asked to validate those figures, such that they had a breakdown of the countries to which outstanding debt was owed and the respective amounts.

Estimate the maturity breakdown of the total

Participants were then asked to split the debt based on its maturity horizon to reflect the fact that short-term debt is valued differently to long-term debt. Participants split debt into three maturities: short (due within one year), medium (due within five years), and long (due after five years). Where necessary, we assumed that the same proportion of maturity debt was held for all creditors. For example, if we know that Portugal owes Ireland EUR 1.2bn, that Portugal owes Spain EUR 19.4bn, and that 20% of total Portuguese debt is short term, we assume that Portugal owes EUR 0.24bn in short-term debt to Ireland, and EUR 3.88bn in short-term debt to Spain.

We recognize that the numbers the participants derived were not accurate. The reason for this is that the assumptions used meant that the data could not reflect the actual debt position of each country.⁷ However, this is a learning outcome in itself—not only is the web of debt suffocating the European economy, but it also exists within a cloud of confusion. Although the data required to write off interlinked debt should not be hard to find, our need to rely on assumptions and estimates reveals the lack of transparency about countries’ debt positions.

After completing step 1, each pair of participants produced a “Summary Sheet” that indicated their country’s position (see Figure 5 in the Appendix) with detailed footnotes explaining the sources of their data. These summary sheets served as the foundation for the actual debt write-off negotiations.

In the process of conducting the research, it became clear that most articles referred to data from the Bank for International Settlements (BIS) (see Weistroffer & Mobert, 2010). We therefore took all country-by-country data from Table 9D (Consolidated foreign claims of reporting banks – ultimate risk basis) of the BIS’s “Detailed tables on preliminary locational and consolidated banking statistics” (Bank for International Settlements, 2011). The currency in the table was in USD, and we therefore multiplied the figures by 0.69 to convert them into EUR. We then split the total debt into different maturities based on two elements:

An estimate of the split among short, medium, and long maturities based on the information generated by the participants (for example the participants focusing on Spain found evidence that 17% of their debts were due within one year); and

An assumption that this split applied uniformly across all debtors (for countries where we couldn’t find estimates).

The BIS was helpful in providing data. However, the organization pointed out that the actual information we required—a breakdown of debt per country and per maturity—is classified. The fact that central banks do not publicly disclose this information is telling because it reveals the difficulty in conducting policy-relevant simulations.

The participants found this process difficult. Facilitators should therefore ensure that attention is given to research skills and time management in order to limit the amount of time spent unproductively. In this regard, we suggest the following:

Limit open brainstorming and the broad web search to the first 30 minutes, and remind participants to keep track of their sources;

Initiate a discussion about the recurring data sources in terms of whether those sources are national organizations (such as the Bank of England), international organizations (such as the OECD), etc. After participants identify the BIS as a key source of information, they should be encouraged to look through the reports published on the BIS website; and

Remind participants that keeping a record of sources and any assumptions made is imperative when compiling data—in theory, an outsider should be able to replicate their findings.

Step 2: The Simulation (Three Hours)

The simulation had three separate trading periods. To begin each trading period the participants were shown an illustrative example of the types of deals to which they could agree. If any particular negotiation lasted more than 10 minutes, the facilitator intervened.

Period 1: Bilateral cross-cancellation

Period 1 focuses on a simple cross-cancellation of debt. For example, according to the New York Times (2010) graphic, Italy owed Ireland USD 46bn, while Ireland owed Italy USD 18bn. The basic idea was to cancel these debts out to leave an outstanding Italian debt of just USD 28bn.

The three rules for period 1 were:

Countries can only cross-cancel debt;

All trades must be bilateral; and

All trades must be of debts with the same maturity horizon.

Participants soon realized that little negotiation was necessary and that this was a simple arithmetic exercise that could be handled by one person. However, this period offered an opportunity to become more familiar with the numbers and gain experience before attempting more complex deals.

Negotiation tables were designated and both countries had to be represented by both of their team members. All trades had to be validated and approved by a facilitator, who updated the summary sheets with real-time information. Having three facilitators helped with this, because the participants were constantly monitored. Therefore, it would be a good idea to utilize participants in the role of helpers when only one facilitator is available. The task of managing the summary sheets was relatively straightforward, and doing it by hand added to the excitement of the class. It would be easier to use a computer but, as Holt’s (1996) work shows, important pedagogical gains are possible through using personal interaction and basic technology.

After a country had negotiated with all other countries, the facilitator signed off on that country’s updated summary sheet. The total was recorded on a “Final Results” table.

At the conclusion of period 1, the updated summary sheets were photocopied and handed out to all groups ahead of period 2. This enabled the participants to see the new debt positions of all of the other countries.

Period 2: Tri-party cross cancellation

The second period begins with an example of how some debts can only be cross-cancelled with the conditional agreement of three member states. As Figure 3 shows, if Italy owes Portugal EUR 1.28bn, Portugal owes Spain EUR 12.29bn, and Spain owes Italy EUR 5.39bn, a bilateral deal cannot be made. However, the three countries can make a conditional deal—Spain can agree to write off EUR 1.28bn of Portugal’s debt if Portugal agrees to write off EUR 1.28bn of Italy’s debt and Italy agrees to write off EUR 1.28bn of Spain’s debt. This would erase Italy’s debt to Portugal, and reduce the total amount of outstanding debt.

Figure 3.

A “before and after” example of a conditional agreement (in EUR bn).

The three rules for period 2 are the following:

Countries can only cross-cancel debt;

All trades must be tri-party; and

All trades must be of debt of the same maturity.

We also permitted countries to divert debt obligations. For example, if Italy owes France EUR 240bn, Greece owes Italy EUR 2bn, and Greece owes France EUR 38bn, then the three countries can agree that Greece’s debt to Italy will instead be paid to France, allowing Italy to reduce its debt to France by the same amount. Thus, after such an agreement, Italy would owe France EUR 238bn, Greece would owe France EUR 40bn, and Greece would owe nothing to Italy. These deals make some countries better off, while other countries are no worse off.

All participants agreed to these types of deal because the emphasis in the simulation was on cooperation rather than competition. These deals are easiest to understand using a diagram showing the flow of debt to each country (see Figure 4).

Figure 4.

A “before and after” example of a diversion agreement.

To organize a negotiation, countries had to submit a meeting request to the facilitator, and each meeting request was recorded on a whiteboard. It is imperative that the participants receive validation from the facilitator for each agreement. We only penciled in trades in the trial run as the order of these meetings can influence the outcomes. As a result, countries could renege, but only in the trial run. After the trading period came to an end the new debt totals were calculated, and the summary sheet was updated, photocopied, and handed out to all participants.

Period 3: Free trading

At this point, participants had a good idea of their relative bargaining power and the countries with which they needed to deal. They also noticed the scope to cross-cancel debt with different maturities. For example, if Greece owes Italy EUR 10bn of short-term debt and EUR 4bn of medium-term debt, while Italy owes Greece EUR 6bn of long-term debt, the potential for agreement is high. Greece might be willing to write off the EUR 6bn of long-term debt if it can reduce its short-term debt to EUR 8bn and its medium-term debt to EUR 2bn. In other words, the two countries can trade EUR 6bn of long-term debt for EUR 4bn of short- to medium-term debt.

A greater level of detail could be achieved by bringing forward all debts using a common discount rate. To do so, participants would need to agree on the discount rate to use. In practice different countries would place different weight on long-term versus short-term liabilities. However, the general objective of the free-trading period is to provide the participants with a genuine negotiation experience and allow them to strike whatever deals they can.

Step 3: Debrief (30 Minutes)

Immediately following the exercise the facilitators canvassed participants to provide detailed, informal feedback. This was incorporated into an extensive debrief between the facilitators that had particular emphasis on how to modify and improve the simulation. Since the exercise was not a component of a course we did not devote significant class time to discussing the events, preferring to allow this to emerge spontaneously. If the simulation were to be used as part of a course facilitators may choose to hold a formal debrief during class time. However, one of the key issues to be addressed is the uncertainty of complex debt negotiations. Therefore, there is a danger that a debrief session could result in the participants seizing on clear takeaways at the expense of confronting the ambiguity that is inevitably present.

A classroom discussion of the policy options open to EU leaders can follow the simulation. We suggest using an Economist article on the Greek debt situation as a pre-requisite reading for this discussion. That article outlines the following options for dealing with Greek debt:

“Fiscal transfers”—simply giving Greece money,

Bail-out loans—lending Greece money,

“Vienna initiative”—allows banks to volunteer to roll over their Greek holdings,

“Soft” restructuring—creditors volunteer to extend the maturities of existing Greek debt, and

“Hard” restructuring—creditors are forced to accept serious cuts on their holdings of Greek debt.⁸

A write-off can be presented as an alternative option and participants should be well positioned to discuss the various options, given their research and experience. Indeed, most participants should appreciate that the problem is not localized to Greece, and they should be able to adopt a broader perspective on the causes and consequences of sovereign debt crises. Facilitators can show the final results from our simulation (Figure 6) and compare with their own results.

The main criticism of writing off interlinked debt is whether it is politically feasible. Even though sovereign EU states are unique economic entities, their actual debt holdings are split among a sizable list of public and private sector organizations, as well as individuals. In the simulation, for example, we completely glossed over the fact that Germany’s Deutsche Bank has no incentive to write off its holdings of French government bonds purely to allow the German public sector to escape its debt commitments to France’s Société Générale. To some extent, the feasibility of the write-off option relies on both a market meltdown and the nationalization of private banks to “merge” private-sector debt. However, as one commentator pointed out, an assumption that this is completely implausible implies that EU governments are not already backing private debt. In fact, events have demonstrated that these debts are more “public” than is officially acknowledged.

This exercise does not solve the problem of the EU debt crisis, and it raises more questions than it answers in terms of data reliability. However, its revelations about how interlinked debt might net out highlight the fact that debt write-offs are a policy option. Indeed, as this exercise leaves some countries with a large amount of remaining debt, it serves to show the true problematic areas. The fact that so much debt is interlinked presents a real opportunity to solve the problem. The web of interlinked debt is too thick to be dusted away by classroom simulations.

In an attempt to address some of these issues, we conducted a follow-up simulation in February 2012. This capitalized on the fact that the January 2012 version of the BIS “Detailed tables on preliminary locational and consolidated banking statistics” contained a new table (Table 9E), which provided a debt breakdown for the public sector, banks, non-bank private sector actors, and those unallocated by sector.⁹ We used the same data as for the May 2011 simulation. However, for simplicity we merged medium- and long-term debt. The numbers were far smaller than in the previous simulation, which made them more realistic, but their estimation was more arbitrary. The results are shown in Figure 7 in the Appendix.

Conclusion

The simulation is a topical way to get students to consider themselves as decision makers and attempt to solve a pressing economic issue. Whilst facilitators can utilize the documents in this article as a starting point, the main aim is to interact with participants in their own efforts to validate or improve on the data. The exercise itself becomes sequentially more complex and so it keeps the attention and interest of participants. It also involves negotiation and other interpersonal skills.

Since publishing the website, the simulation has received widespread media coverage and has even been utilized as a basis for proposed policy changes. Incorporating this coverage into the debrief can help show participants that complex economic issues are a discovery process, and that classroom exercises can possibly contribute to such debates.

Footnotes

Appendix

Acknowledgements

We thank all participating students for their time and efforts in generating these findings. We also acknowledge helpful comments from Philipp Bagus, David Crookall, Ewen Stewart, James Tyler, two anonymous referees, and the editors of this journal; the usual disclaimer applies.

Declaration of Conflicting Interests

The authors declared no potential conflicts of interest with respect to the research, authorship, and/or publication of this simulation/game.

Funding

The authors received no financial support for the research, authorship, and/or publication of this simulation/game.

Notes

Author Biographies

Anthony J. Evans is associate professor of economics at ESCP Europe Business School. He has published in a range of academic and trade journals and is the author of Markets for Managers (Wiley, 2014). He is part of the MOC Affiliate Faculty for the Institute for Strategy and Competitiveness at Harvard Business School, and is a member of the Institute of Economic Affairs’ Shadow Monetary Policy Committee.

Contact: aevans@escpeurope.eu

Terence Tse is an associate professor of Finance at the London campus of ESCP Europe Business School. He is also Head of Competitiveness Studies at i7 Institute for Innovation and Competitiveness, an academic think-tank based in Paris and London. Alongside with his on-going advisory activities with supra-national organisations, Terence has been providing commentaries on the latest current affairs and market developments in numerous blogs, publications such as The Economist and the Finance Times, radio and television shows on CCTV, Channel 2 of Greece, France 24 and NHK. He has also been invited to act as speakers at various events in India, Norway, Qatar and UK.

Contact: ttse@escpeurope.eu

Jeremy Baker is an affiliate professor of Entrepreneurship, Marketing and International business at ESCP Europe London campus. He also lectures on the MBA course at Tongji University Shanghai.

Contact: jbaker@escpeurope.eu

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