Greece, Then Ireland, Then Portugal, Then Spain…
How Germany's proposed debt remedies could drive many European countries into default.
Posted Tuesday, Nov. 16, 2010, at 3:40 PM
German Finance Minister Wolfgang Schäuble likes to criticize other governments, including that of the United States, for their "irresponsible" policies. Ironically, it is the German government's loose talk that has brought Europe to the brink of another debt crisis.
The Germans, responding to the understandable public backlash against taxpayer-financed bailouts for banks and indebted countries, are sensibly calling for mechanisms to permit "wider burden sharing"—meaning losses for creditors. Yet their new proposals, which bizarrely imply that defaults can happen only after mid-2013, defy the basic economics of debt defaults.
The Germans should recall the last episode of widespread sovereign default—Latin America in the 1970s. That experience showed that countries default when the costs are lower than the benefits. Recent German statements have pushed key European countries decisively closer to that point.
The costs of default depend on how messy things become when payments stop. What are the legal difficulties? How long does default last before the country can reach an agreement with its creditors? How much more must it pay for access to debt markets later?
The benefits of default are the savings on future payments by the government—especially payments to nonresidents, who cannot vote. This obviously depends in part on the amount of debt outstanding, the interest rate, and the country's growth prospects if it continues to pay.
Countries that are near the point where "can't pay" becomes "won't pay" have high interest rates relative to benchmark "safe" debt issued by other governments, because even small shocks can shift the balance for decision-makers toward default. But these interest-rate spreads make the benefits of nonpayment greater, so the same shocks can send a country quickly into default.
Seen in these terms, it is clear why the German government's proposed debt-restructuring mechanism immediately shifts weaker Eurozone countries toward default. As Chancellor Angela Merkel and her colleagues promote their well-defined plan—which comes in addition to a plan for bridge financing while in default—the cost of default falls. Moreover, the benefits rise, because the restructuring clauses required for new debt, together with Germany's highly visible efforts to avoid future government bailouts, raise the interest-rate spreads that weaker countries must pay today.
Bond-market participants naturally turn now to calculating "recovery values" —what creditors will get if countries default today. For example, Greece's debt stock, including required bridge financing under the IMF program, should peak at about 150 percent of GNP in 2014; much of this debt is external. If a country can support debt totaling 80 percent of GNP (a rough but reasonable rule of thumb), then we need approximately 50 percent "haircuts" on this existing and forthcoming debt (reducing it to 75 percent of its nominal value).
However, of this 150 percent of GNP, at least half is or will be official in some form. If it is fully protected, as seems likely (the IMF always gets paid in full), then the haircut on private debt rises to an eye-popping 90 percent. And this leaves out government spending that may be needed for further recapitalization of Greek banks.
For Ireland, too, sovereign debt, including bridge financing, will rise close to 150 percent of GNP by 2014 and is mostly external. But a sovereign default would require a much larger bank bailout than in Greece, potentially leaving private debt almost worthless if official debt has seniority. Total haircuts don't happen historically—except in the wake of Communist takeovers—but it is hard to imagine that private creditors won't suffer huge losses in net present value.
Given this, we should expect Greek debt yields to rise further, despite the current IMF program. Likewise, an IMF program for Ireland—which seems increasingly likely—will not bring down domestic bond yields and reopen credit markets to any kind of Irish borrower.
Peter Boone, chairman of Effective Intervention at the London School of Economics' Center for Economic Performance, is a principal in Salute Capital Management Ltd.
Simon Johnson is a professor at MIT’s Sloan School of Management and the co-author of White House Burning: The Founding Fathers, Our National Debt, And Why It Matters To You.
Photograph of Wolfgang Schäuble by Daniel Roland/AFP/Getty Images.