World Risk Developments March 2010: sovereign debt – how much should we worry?
This month’s issue of EFIC’s newsletter, World Risk Developments, focuses on the sovereign debt problems of advanced economies.
Greece is currently the subject of much speculation about whether it will default or be bailed out in the nick of time. Wider questions are being asked as well. If Greece defaults, will other eurozone governments with large fiscal deficits and public debt – Portugal, Spain, Ireland – be forced to follow? Might the 'sovereign debt crisis' spread even beyond the eurozone’s border?
‘The current aversion towards Greek sovereign risk means that Athens may indeed fail to meet its financing needs’, says EFIC’s chief economist Roger Donnelly. ‘But ultimately, it seems hard to believe that the rest of the eurozone won't come to Greece’s rescue if need be. Maybe even the IMF will play a role. Too much is at stake.’
If, improbably, Greece did default, would it be forced out of the eurozone? This has been the glib assumption of some, but it doesn't necessarily follow.
According to Donnelly, ‘Greece could default and remain in the eurozone, just as Orange County in California defaulted yet remained within the 'American monetary union' in 1994, and as New York looked as if it would do in 1972 (in the end, Washington bailed it out).’
Might Athens seek to leave the eurozone of its own accord? The newsletter acknowledges that this looks superficially attractive, allowing as it would Greece to cut interest rates and devalue to boost its flagging economy, perhaps even to sell bonds to the central bank to finance a fiscal deficit. But on closer examination it becomes clear that the costs of eurozone exit would be prohibitive.
‘It all revolves around the fact that contracts, assets and liabilities are denominated in euros, and leaving the eurozone would require redenomination. It would be an almighty mess that would arbitrarily redistribute wealth and leave many households and businesses insolvent. As such, I doubt that this is an option under consideration’, says Donnelly.
What about the strain that the debt problems are placing on European integration more broadly? Many europhiles look upon the crisis as a chance to press on to a more federal Europe with greater powers in Brussels to tax and transfer – powers that could be deployed to head off future crises. The problem with this hope is that the crisis has turned public opinion against deeper integration. Donnelly says, ‘This means that it may be difficult for Brussels to hang onto some of the powers it has already gained in areas like immigration and social policy, let alone gain more’.
The Greek debt troubles have prompted some commentators to worry about high sovereign debt not just in other highly indebted eurozone countries, but in advanced economies outside the eurozone. The US, UK and Japan are three prominent economies that have come in for scrutiny.
The newsletter notes that given the collapse of private demand in advanced economies and the move of the private sector into financial surplus in the past two years, it is inevitable that governments have gone into corresponding deficit. If they had tried to balance their budgets as private demand was falling, as they did in the 1930s, we could well have seen a re-run of the 1930s, with a Great Depression rather than a Great Recession.
The issue is: will governments restore balanced budgets and shore up fiscal solvency as the private sector slowly gets back onto its feet? If they do, and the markets believe they will, a crisis is unlikely. Only if there is no fiscal consolidation as the private sector picks up do problems seem inevitable.
In other stories, the newsletter looks at rising political risk in two prominent emerging economies – Thailand and Turkey.