Wednesday, August 3, 2011

Eurozone defaults: From unthinkable to mandatory

“I expect that [in addition to Greece] other euro area sovereigns, most likely Portugal and Ireland, will experience ratings defaults. The new European Stability Mechanism (ESM) that will replace the European Financial Stability Facility will have a sovereign default resolution mechanism. For sovereigns deemed insolvent, debt restructuring will be a pre-condition for access to ESM funds.
Private sector creditors share the burden of sovereign debt restructuring. Private sector involvement, so far on a supposedly voluntary basis, is on the map. I expect that before the end of the Greek programme, there will be deep coercive debt restructurings for Greece and other periphery sovereigns – without that it seems inconceivable their debt burdens can be lowered to solvency-consistent levels.”
--Wiliam Buiter, Citigroup Chief Economist, in the FT

There is a lot of really disturbing information in that paragraph. One year ago, we were told (condescendingly) by the EU and the ECB that defaults by eurozone members were unthinkable, and that any (Anglo-Saxon) discussion of the possibility was ill-informed and irresponsible. Everything was under control; it was just that foreign economists “don’t understand Europe”.

Well, it turns out that the foreign economists did understand Europe, because they knew that even the EU cannot suspend the laws of gravity and simple arithmetic. They did not drink the “Europe” Kool-Aid. Europe thought that if everyone would just shut up, the “market” would miraculously “believe in Europe” and credit spreads would retreat as fiscal austerity took hold.

Now we learn that eurozone default is no longer unthinkable: it is now a mandatory precondition of further bailouts. But the “market” is still expected to remain open to these issuers out of a sense “responsibility” or “solidarity”.

Well, the “market” consists of fiduciaries investing or lending other people’s money: their clients and depositors. It would be the height of irresponsibilty for an institutional investor to lend his clients’ money to risky countries which are expected to default. Which means that there is going to be only one source of bids for these countries’ debt: the EU and its various organs.

This means that the public debt markets will remain closed for Greece, Portugal and Ireland, and that they are rapidly closing for Spain and Italy. Either the ESM (Germany) will have to become their sole source of funding, or as Buiter implies, they get the ESM funding on the condition that they default and partially repudiate.

Once a country has defaulted (and partially repudiated), the capital markets will remain closed for a long time. Is the ESM going to be willing to fund the peripherals’ fiscal deficits (as well as their maturing bonds)? It might try to impose harsher austerity to force budgets into balance, but the political consequences would be dire. If they remain in deficit and the ESM says “no mas”, then the peripherals will have no choice but to balance their budgets (and their external accounts) while still defaulting on their maturing debt.

Developing countries have done this before, and developed countries did it in 1931-33. But the political consequences were in every case, a shift to the left or to the right. The political center did not hold because it had lost legitimacy.

I would hold out a little bit more hope for Ireland making it through because it is a Northern European country, it is competitive and has an educated and industrious workforce. Finland did it in the early nineties, they did not default and they are AAA.
And Eire is very small, so a bailout won’t break the bank, the way it would for Spain or Italy.

Can the US remain immune? Perhaps, especially if the economy grows and the fiscal trajectory becomes sustainable. Despite all the hoopla about the US having lost "global credibility", it remains the ultra blue chip in the debt market. Throught the latest crisis, Treasury prices have continued to be bid up. An S&P downgrade to AA+ may cause a blip, but I think it can be accommodated, just as it was in Japan, Canada, the UK and New Zealand.

But the outlook for the PIIGS is about as bad as it could be. The eurozone is not only a failure, but also a catastrophe which will play out over the next five years.

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