Saturday, May 28, 2011

Why don't they default? The eurozone crisis explained

If you read my last post on the eurozone crisis, then hopefully by now you understand that you should care.

The question I'm going to handle today is; why don't they just default? These countries with extremely high debt burden, like Greece, Ireland, Portugal and Spain, why don't they just pull the plug?

Economically speaking, the sooner you default, the sooner you can stage a comeback - sure it's a tough thing and the economy will suffer in the short term, but if there is no hope of avoiding a default in the long term, then why not just pull the plug now already?

Some people ask me, when I explain this crisis to them, "if it's that bad, how come they haven't already defaulted?". It's as if they refuse to believe it's as bad as I say it is, because then, surely these countries would have given up already.

I think there are a couple of different explanations for this behavior:

1) Pride. Default is a dishonorable thing to do, a black mark on your country's record. Politicians do care about their countries reputation abroad, so that could be part of the answer.

2) Hoping for a miracle. Many debt-burdened countries may still hope for the world economy to turn around, bringing them up in the process. This is what saved Sweden from what may very well have ended in default, after we nationalised the banks in the early 1990's. The national debt skyrocketed as we took on the banks liabilities. But, in the mid-90's, the world economy had recovered and the dotcom bubble had just started, and the booming economy brought up the value of the state-owned Swedish banks. In the end, we sold them for a profit. The problem is that these heavily indebted countries in the eurozone are the very reason (or part of it) why the world economy won't lift - investors want to be sure the euro survives before they make any long-term investments (such as hiring someone).

3) Survival may mean very low future rates. Let's say Ireland somehow manages to stay afloat, despite a crushing debt burden of above 120 % of GDP. Let's say they manage to pay it down to reasonable levels. Then, they will be able to tell investors in the future that "Of course there is no risk our bonds won't deliver what they promise - hey, we even survived the Great Recession when our debt was at 120 % of GDP". Surviving a near-death experience may be good in the long run. Remember, one of the reasons why US bonds have such a low default risk is because the US has survived everything - the War of 1812, the Civil war, the Great Depression, World War II - the US even managed to pay back the debts it took on during WWII, and back then, the US national debt was about 120 % of GDP (compared to 70-80 % today). Investors tend to look at the historical record of a country when assessing risk, which is natural of course, but to be honest this does lead them to underrate the risk of American bonds. If Ireland, and the others, survive this crisis, they will forever be able to point to it when trying to sell bonds in the future.

My underlying view is that the Euro must go. I have always been opposed to it and always will, for both economic and non-economic reasons. Without the euro, the problem wouldn't exist. That so many countries with so different economies try to have a common currency, and hence a common exchange rate, must be the greatest financial folly since tulipmania. Normally, during recessions, a country's currency depreciates and this will then in part make up for the lost domestic demand (because exports are boosted). With the eurozone, this doesn't happen for these struggling countries, because the strength of the euro is a function not only of their economy, but of that of the eurozone as a whole. So, the euro is heavily overvalued for them, and with central bank interest rates set to rise, it will only get worst.

I hope you could follow what I was trying to say. There won't be any miracle I'm afraid, the eurozone will go down, but as countries are still playing for time, this could take a while (a few years).

/John G


Bill589 said...

John. My understanding is not at the level of yours. But this is how I see things and feel about them:

America will have to address entitlement reform and the debt. We have no choice.
Either now when it hurts,
or in our children’s time when it maims,
or maybe in our grandchildren’s time when they have no choice, and it crushes.
But we will address entitlement reform and the debt.

"If there must be trouble, let it be in my day, that my child may have peace." T. Paine

Pablo said...

John, I missed your first piece. But this was very interesting. I think that your third point is the best one and best explains why default is bad. I hope that Republicans here in the United States will not demand default by refusing to raise the debt ceiling. If they do, they will be handing the election to Barack Obama in 2012. There are serious consequences to default and the moral thing to do is to raise the debt ceiling and then deal with the underlying causes.

Anyway, good piece and thanks for your "adult" pieces here at Right Speak.

JohnG said...

Bill, while you are right, I wasn't talking about America but about the eurozone.

Pablo, it sure hurts the international reputation to default. It also leaves a mark in your record that will be there forever. The US has gone 230 years without such marks, therefore the interest it has to pay on its bonds is insignificant compared to many other countries.

Bill589 said...

John - I was hoping you would explain to me I was wrong.

This is a sad thing to be right about.