Although he had a rough ride in Comments here, Lorenzo Bini Smaghi’s London Business School presentation provides a useful official take on the choice between the Plan A of fiscal adjustment and the Plan B of default. (From a narrowly Irish perspective, his identification of the costs of default probably puts too much emphasis on balance sheet contagion and too little emphasis on the reputational damage to an economy that is one of the world’s most dependent on international trade and investment. Understandably, he also does not dwell on possible costs of default for access to ongoing international assistance, not least from the ECB itself.)
However, I would put the case for Plan A in more dynamic terms – a Plan A* perhaps. The literature on the option value of waiting provides a useful dynamic angle on the default decision. This applies to a decision that is costly and irreversible and must be taken under uncertainty that will lessen with time. An outstanding feature of our present predicament is that there is unusual disagreement about whether we can stabilise the debt to GDP ratio and regain market access. There is a good chance that the range of this uncertainty will narrow substantially over the coming year. Four major sources of (diminishing) uncertainty stand out:
1. Growth. It is still an open question as to whether we are finally “turning the corner” or will “bounce along the bottom” for some time. Even if the austerity measures hold back the rate of nominal growth, observers are looking hard for indications of the underlying potential growth rate once the fiscal adjustment is complete.
2. Bank losses. Huge noise has been added to the debate by attempts to add together things that simply can’t be added – actual recognised bank losses, capital injections, the gross cost of asset swaps, secured ELA lending by the Central Bank, etc. Even so, there is real lingering uncertainty about the size of the contingent liability to the State of the banking system. The new more rigorous and independent stress tests should go a significant way to reducing this uncertainty, especially if they provide detailed information on bank balance sheets to the markets.
3. Political capacity to produce a primary budget surplus. The four-year plan, the passing of the 2011 budget and the EU-IMF agreement itself have all reduced the uncertainty about the capacity to achieve the required fiscal adjustment. However, the fact that the adjustment will have to be seen through by the likely new centre–right/centre-left coalition creates additional uncertainty. The failure to produce the necessary adjustment in the mid-1980s by a similar coalition adds to the doubts. Notwithstanding the inevitable election rhetoric, the major parties do appear to understand the importance of demonstrating the political capacity to see the adjustment through. We should have a reasonably good idea of the prospects for the new coalition shortly after the election.
4. The bailout mechanisms. The design of the bailout mechanisms – e.g. high interest rates, de facto official creditor seniority, threats of future burden sharing – are obstacles to regaining market access. Fortunately, both the IMF and EU policy makers seem aware of the flaws and seem willing fix at least some of them. This uncertainty about the future of support should also be significantly resolved after the major EU summit at the end of March.
Of course, the option value of waiting perspective can also provide reasons for a “pre-emptive” default. This week’s very useful analysis from Goodbody made the point that 60 percent of the outstanding unguaranteed, unsecured senior bank bonds will mature over 2011/12. There is a potential cost to delay to the extent the costs of default are lower on this debt than State debt or State guaranteed bank debt.
Needless to say the markets understand the government retains the option of default, which explains the continuing risk premium. Policy and policy debate should be focused on reducing the value of this option and thus the probability it will be exercised. On the banking side, this was the key theme of Patrick Honohan’s January speech to the IIEA, but the point applies more generally. Uncertainty–increasing actions such as the postponement of the €7 billion capital injection so soon after the bailout agreement and also exaggerated (populist) rhetoric about “renegotiating” the agreement come at a cost.
The overwhelming sense in Comments across recent threads is that default is inevitable and we should just get on with it. I think there are good reasons to hang in there.