Wolfgang Münchau has an interesting take on the bailout/default debate that is relevant to recent posts (see here).
Drawing on the international literature on the costs of default, newly elected Fine Gael TD Paschal Donohoe has written an interesting pamphlet on the option of a unilateral default (see here). Whether you agree with his conclusion or not, it is great to see people of Paschal’s calibre in the new Dáil.
The pamphlet is referenced in Daniel McConnell’s article today in the Sunday Independent (see here). Daniel comes out strongly for a default-now position. He draws heavily on the Prime Time programme on default in supporting this position. One of those quoted is Philip Lane. Not too surprisingly, the short snippets that could be used in the report do not do justice to Philip’s nuanced position. If you haven’t had the opportunity to view Philip’s interview, I think it is well worthwhile to view in full. While recognising the seriousness of the situation, I think he gets the balance just about right (full interview here).
The first-order policy challenge the new government faces is to restore the creditworthiness of the State and the banks. Without market access, Ireland becomes effectively a permanent ward of the international community, continuously vulnerable to withdrawal of support, and thus in a persistent state of insecurity that undermines recovery.
To say that Ireland is not creditworthy is really just to say that markets put a high probability on an Irish default. At the moment, the cost-benefit analysis does not look favourable to a pre-emptive unilateral default, not least because of the likely backlash by official creditors including the ECB. But the high probability markets are placing on an Irish default means that the markets believe the cost-benefit calculation will shift. This could be because the perceived benefits of a future default are relatively high (say because of the high marginal cost of austerity measures), or that the costs of future default are relatively low (say because the official funders will condone and even facilitate future debt restructurings).
This places us in a bind. If it turns out that we do later have to default, it is best that it comes with as low a cost as possible. But the potential for a low-cost future default makes it impossible to raise longer-term funding now, effectively trapping us outside the markets.
Suppose, however, we could somehow raise the social costs of default (say by offering collateral on any new borrowing). This would be a double-edged sword. It would help us to credibly commit to avoid default and thus lower the market risk premium. But it would leave us facing a worse outcome in the event the benefits of default turn out to be high and the default decision is the sensible course.
But now suppose we introduce a political cost of default – costs that fall specifically on the politicians who make the default decision. This allows for a more credible commitment to avoid default while not imposing unnecessary additional social costs in the case where default actually occurs. For reasons similar to those for appointing an “inflation nut” to head a central bank, it could make sense to appoint a “default nut” as finance minister — someone who sees massive political (or even personal) cost in defaulting. The credibility of the anti-default stance could be enhanced by a promise to resign in the event default occurs – or even better to join a monastery/convent should the terrible event ever come to pass! (For this to work there would also have to be political costs to getting rid of a finance minister that refused to default, or broader political costs to the government as a whole.) One drawback of putting a “default nut” in charge of finance is that default might be or excessively delayed or avoided altogether when it is the right course. However, given how the perception of a soft restructuring down the road can trap a country outside the markets, this risk of an excessive ex post default aversion could well be a price worth paying.
The candidates for minister for finance should be falling over one another to signal to Mr. Kenny and Mr. Gilmore that default is anathema to their very being.
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:
I draw on arguments from some recent blog posts on the default question in a piece for today’s Irish Independent.