Sovereign Default in the Euro Area Post author By Philip Lane Post date December 3, 2009 This week’s Economics Focus in the Economist takes a look at this issue. Categories In EMU, Fiscal Policy Tags Irish fiscal policy 9 Comments on Sovereign Default in the Euro Area ← Government Revenue Windfalls and Shortfalls → Income Taxes Too High and Too Low 9 replies on “Sovereign Default in the Euro Area” The Economist poses the question; What would happen if a member of the euro area could no longer finance its debt? Buiter has made some interesting observations on this; “Dubai is not systemically significant. If its troubles open our eyes to the likely imminence of the start of the final leg of the journey from household default through bank default to sovereign default, it may do some systemic good, by alerting fiscal policy makers to the vulnerability of their nations’ fiscal-financial positions, and by educating citizens and voters to the urgency of deep fiscal burden sharing.” To me, the inference is that we don’t know what would happen, because up to now it has not been entertained as a serious possibility, but Dubai has changed that. Iceland is no longer seen as an isolated incident. He goes on; “Even if the government of Dubai were to feel morally inclined to make good the losses of its creditors (a strange and unlikely state of mind in any rational economic being, admittedly), it probably does not have the financial means to bail them out. The Dubai sovereign is likely to be in such bad shape that Dubai World is simply too big to save.” I like that “simply too big to save,” it makes a lot more sense to me than ‘too big to fail.’ Edward Harrison who has a BA in Economics from Dartmouth College and an MBA in Finance from Columbia University, is currently a banking and finance specialist at the economic consultancy Global Macro Advisors and previously at Deutsche Bank and Bain Consulting, makes the following observations on this topic; “The worry is that the collapse of Iceland was not an isolated incident, but rather a harbinger of things to come for smaller countries with large financial sectors. Those worries are still with us and with good reason as many countries in Eastern Europe are in or headed for Depression, Latvia being the most obvious example. Here is the crux of the matter: there are a number of banks, which are very large in relation to the size of their domestic economy. In the past, that has meant that they are too big to fail. But, there are also a number of banks with an asset base that is disproportionately large mainly due to many overseas assets. What this means is that the governments where these banks are domiciled cannot make credible guarantees regarding the institutions in question. If we suffer a crisis of confidence and these banks come under attack, they become literally too big to rescue. The long and short of it is: many countries in Western Europe have weak financial sectors with high systemic risk. Which brings us back to Buiters “The sovereign guarantee delusion.” “If the shareholder of Dubai World and of Nakheel believes that a further capital injection makes commercial sense, it will inject additional capital (assuming it can find the financial resources to do so). If, as I suspect is the case with Nakheel, the company is so deep under water that injecting additional shareholder capital would be throwing good money after bad, the company will not be financially supported by the shareholder. That’s how financial capitalism works. It’s called hard budget constraints.” I will allow you make up your own mind as to how all of this might be relevant to Ireland’s current situation. Buitier goes on; “In making a decision as to whether it makes commercial sense to extend financial support to Dubai World and to Nakheel, two considerations will play a role: (1) the impact of a default by either entity on the future ability to borrow of companies owned by the same shareholder and on the future ability of the shareholder to borrow in his capacity as sovereign, and (2) the impact of a default on the wider economy of Dubai. As regards access to future borrowing, there is no better credit risk, from an ability to pay perspective, than someone who has just defaulted on all of his obligations. What better borrower than someone without any debt outstanding.” This, to me, supports the notion of a ‘good bank.’ I agree with Buiter’s and Harrison’s sentiments. I also believe that the situation remains critical for Ireland, Greece, Spain, and Portugal. My answer to the question “What would happen if a member of the euro area could no longer finance its debt? I don’t really know, but I think we won’t have long to wait to find out. I wonder what plans the Finance Ministry have made in relation to this eventuality? “Could a defaulter remain in the euro? It is hard to see how it could leave. A country that had just lost the trust of investors in its fiscal rectitude could scarcely build a credible monetary system from scratch.” A very succinct reiteration of the “hotel California” nature of the euro. Message – sort out the underlying problem. @Cearbhall O Dalaigh This is a superb post. Many thanks. It suggests that the Cowen and the Unionjs are a bit like you-know-who at the end of Downfall – making ‘decisions’ and giving – or not giving – ‘orders’ about resources and forces that don’t actually exist. I believe the vista is a the ‘hard’ bail out suggested by the NY example and the economist. I suspect it will come to an IMF-style programme of reform – including large-scale redundancies in the public sector. The Irish gov’t right now is in the pre-default stage. Whether that default is on sovereign debt or on its ‘obligations’ to pay / employ public servants is the real issue now. Increasing taxes presents much graver problems than that of penalising productivity and annoying people like me. They simply will have no effect. The moment of tru asteroid approaches. @Cearbhall O Dalaigh This is a superb post. Many thanks. It suggests that Cowen with the encouragement of the Unionjs is a bit like you-know-who at the end of Downfall – making ‘decisions’ and giving – or not giving – ‘orders’ about resources and forces that don’t actually exist. I believe the vista is the ‘hard’ bail out suggested by the NY example and the economist. I suspect it will come to an IMF-style programme of reform – including large-scale redundancies in the public sector. The Irish gov’t right now is in the pre-default stage. Whether that default is on sovereign debt or on its ‘obligations’ to pay / employ public servants is main issue now. Increasing taxes presents much graver problems than that of penalising productivity and annoying people like me. They simply will have no effect whatsoever. Take note all you economists who believe that these text book policy choices are either open to us or even have any meaning whatsoever. They don’t now. I mean to think that people are seriously discussing carbon taxes on fuel that is already taxed at levels that are multiples of those advocated by the hardest of hard line Greens in teh USA. Ha! The moment of truth approaches. @Philip Lane I supported Maasticht at the time (1992). But I do remember that the one thing the Irish debate on the Treaty was not about was the Euro. Even the opponents were focused on sovereignty generally. The single currency was certainly not the focus. Most of the coverage was about the (I think)£6 Bn we were going to get from Europe. Although our establishment like to keep things that way I would suggest – to use Mr MacDonnell’s analogy -that the lack of debate contributed to our downfall. For the future we need: A. A plan to adapt to sterling rises. B. Alteration of national wage agreements to allow flexibility for them. As the ECB were instrumental in arranging NAMA financing and possibly, NAMA itself, they certainly cannot afford to have Ireland default. So the repayments will be made even if only by making adjustments to deficits permitted under EU rules. Long term, NAMA makes it more likely that Ireland might need such a cushion. This suggests that there are worse cases than Ireland, else why make it 54,000,000,000 euro worse? The whole point is that ECB are debt pushers. Italy and Greece are very dodgy in terms of their ability to properly account for financial items. No one will get to the bottom of their pit until well into the next but three crisis! They are too practised, although Parmalat does show what can happen. Sadly, it will be Austria. A small country that aimed too high …… ambitious politicians again? Denmark to follow? http://www.independent.ie/national-news/budget/news/eu-saved-country-from-total-collapse-1962416.html BL admitted, nay claimed that Ireland had already collapsed but for the EU! That makes it look as if we were bailed out!!!! Implications for this loose mouth approach? @Pat Donnelly I do not believe the European Commission or the ECB have anything to with NAMA – unless it was the price for support in the wake of the disastrous and inexplicable bank guarantee. The ECB approved NAMA in the context of the Lisbon Treaty. That treaty had to be secured at all costs. If the Irish wanted to make fools of themselves, once again, with NAMA as we already had done with our panic stricken “every bank in Ireland is systemic” type policies. Then, so be it let them put them selves in debt up to their eye balls was the reaction from Baroso if it means we get Lisbon over the line. Now however, belatedly or post Lisbon, we have Nelly Kroes EU Competition Commissioner telling us, state debt levels are a “Time Bomb” and that banks must repay ASAP to avoid the risk of state default on government bonds. Personally, I am still waiting to hear from Ms. Kroes who seems to be very inefficient, on my competition worries re-nama. Believe me it is not easy dealing with our EU public servants and institutions. So our banks have not even got their bailout and the commissioner has finally woken up to the prospect sovereign default. Meanwhile the government here are being primed for further recapitalization. Who has she in mind Greece? Comments are closed.