Default as a state of normalcy | FT Alphaville

Default as a state of normalcy

As one senior banker has pointed out to FT Alphaville, it’s very rare for a country to simply grow its way out of excessive debt. Far more common, historically, is a restructuring or straight-out default.

It’s a point famously made by Reinhart and Rogoff — and picked up by Capital Economics on Thursday.

They note that some of the first recorded government defaults occured in Ancient Greece. And in fact, the country has spent a large part of its existence in a state of default. In fact defaults have some benefits, economist Andrew Kenningham notes, including the obvious one of quick-ish debt reduction.

In fact, sometimes not defaulting can be a painful experience. Kenningham cites the example of Romanian dictator Nicolai Ceausescu, who in the 1980s became obsessed with repaying Romania’s external debt. To do so, he instituted a super-strict austerity programme, entailing limited TV channels and erm, starvation. Romania actually ended up accumulating debt again after the 1989 revolution saw Ceausescu overthrown, and a new government that had to pay attention to its people put in place.

So sometimes defaulting can help — though it isn’t, the author emphasises, necessarily painless.

The main objection to declaring default is usually that it can lock a country out of markets for years. Of course, that hasn’t actually been the case for many states, witness, for example Argentina or Uruguay. Up until 2009 or so, Greece itself managed to fund itself just fine — despite that default history. In fact, its chequered record of payments didn’t seem to stop it from entering the eurozone.

Now, however, the eurozone is actually the problem for Greece.

As Kenningham puts it:

A default or debt restructuring within a currency union throws up several unique problems. Firstly, governments within a monetary union have no immediate scope to depreciate or devalue their currency. This removes the risk that depreciation will lead to a large, and sudden, rise in the value of the country’s external debt, measured in domestic currency. However, it also makes it far more difficult for the country to increase its competitiveness. This is important because, historically, a combination of default and devaluation has often proved to be the most effective route out of a sovereign debt crisis.

This lack of flexibility heightens the risk that, even after a default and debt reduction, a country within the monetary union may face years of low growth and high borrowing costs. In these circumstances, the ratio of debt to GDP may rise again, ultimately leading to another crisis some years later.

The second feature of debt crises within a currency union is that risks of contagion are amplified because countries are exposed to the same risk factors, notably common interest rate and credit cycles. There are also likely to be greater cross-linkages in the financial systems given the perception that there is no exchange rate risk within the area.

A third feature of default within a currency union is that it has the potential to affect confidence in public debt of the region as a whole as the liabilities of one insolvent country may eventually be assumed by others, or be turned into debt of the entire area. This could raise the risk premium on debt throughout the region.

Finally, the political links between countries within a monetary union are bound to be stronger than among other regional groups, which will lead to pressure for countries within the bloc to become involved in crisis management. As we are seeing in the euro-zone, this has implications for the regional central bank, for coordination of fiscal policy and for burden-sharing in the event of a sovereign bail-out.

No kidding — and one thing complicating what might have been a straight-forward reversion to the norm (default) for Greece, is the sheer number of players involved in its debt crisis right now. You’ve got Greece itself, and within it politicians, taxpayers, Greek banks, plus eurozone banks, plus the ECB, EU regulators, EMU members and so on and so on. And they all have varying desires and agendas.

It’s modern monetary union, standing in the way of history.

Related links:
IMF bailout of Korea during East Asian financial crisis – Ask a Korean!
Greece and its most grim sovereign-bank loop – FT Alphaville
Make European defaults – not bailouts, think tank says – FT Alphaville
Ask not whether governments will default, but how – FT Alphaville