OPINION:The reason defaulting is not a viable option is that it would lead to a flight of capital and deeper disaster
AMONG THE many things we have learned from this crisis is that governments and financial markets find it difficult to understand each other.
Governments cannot grasp why the markets lose confidence in the state of public finances so quickly and regain it so slowly, after a long period of fiscal consolidation. The markets, for their part, are mystified by the failure of governments to take simple and timely steps to sort out the problems they face.
To tackle the problems of public finance, one of the measures that many believe should be adopted in some developed countries, particularly in Europe, is to default on or restructure public debt. Not a day passes without a suggestion of that kind being made by market participants, economists and commentators.
Such a measure is considered effective because it allows – according to those who propose it – a rapid reduction in the debt burden, making it more sustainable. It enables a country to avoid implementing an overly restrictive fiscal policy, which may further hamper growth and lead to social tensions. It spares taxpayers from having to pay for mistakes made by investors, especially foreign ones, who have lent too eagerly to the country.
More generally, they argue, the default of a sovereign state allows the financial markets to function better and to incorporate the risk premium appropriately.
Given all these apparent advantages, you may wonder why countries experiencing financial distress, starting with the European states, have so far refused to follow this advice. Why are democratically elected governments so reluctant to default on their debt and follow the path taken in the past decade by countries such as Ivory Coast, Pakistan, Nigeria, Ukraine, Venezuela and Zimbabwe?
One hypothesis is that our democracies are incapable of handling sovereign crises such as the one we face. An alternative view is that the recommendations made by economists are, at best, based on simplistic models that do not allow the complexity of the situation to be grasped and thus lead to mistaken conclusions. In other words, the cure could do more harm than the disease.
An assumption often made is that governments can renegotiate with their creditors the terms and conditions of their debt instruments without this having major repercussions on the rest of the economic and financial system. This assumption is largely based on the experience of developing countries with underdeveloped financial systems and mainly foreign creditors.
What is not well understood is that, in advanced economies, public debt is the cornerstone of the fiscal system and a vital component of the savings held by citizens.
As recent events have shown, the simple fear of a default or of a restructuring of public debt would endanger the soundness of the financial system, triggering capital flight. Without public support, the liabilities of the banking system would ultimately have to be restructured as well, as was done for example in Argentina with the corralito (freezing of bank accounts).
This would lead to a further loss of confidence and make a run on the financial system more likely. Administrative control measures would have to be taken and restrictions imposed. All these actions would have a direct effect on the financial wealth of the country’s households and businesses, producing a collapse of aggregate demand. Taxpayers, instead of having a smaller burden of public debt to bear, would end up with an even heavier one.
Many commentators fail to realise that the main impact of a country’s default is not on foreign creditors, but on its own citizens, especially the most vulnerable. They would suffer most from the consequences of such an action in terms of the value of their financial and real assets.
The economic and social impact of such an event is difficult to predict. The democratic foundations of a country could be seriously threatened. Attentive observers will not fail to notice that sovereign defaults tend to occur in countries where democracy has rather shallow roots.
Europeans have not forgotten the devastating effects that the expropriation of wealth, such as that carried out during the two world wars by way of inflation or defaults, may have on the economic and social fabric. There is awareness that, in the end, it may be less costly to tackle excessive public debt with the traditional remedies – that is, achieving an adequate level of primary surplus – rather than looking for quick fixes. There is also awareness that, without restoring economic growth, the debt burden cannot be reduced over time. This requires major structural reforms aimed at improving the functioning of the labour, capital and goods markets.
That is why, even if belatedly and reluctantly, governments and parliaments in Greece, Ireland and several other European countries have adopted tough recovery programmes and radical reforms. And that is why the other European countries are supporting them. They know that the alternative is much worse for their citizens.
To understand what is happening in Europe, economics textbooks are useful but the history ones even more so. – Copyright The Financial Times Limited 2010
Lorenzo Bini Smaghi is a member of the Executive Board of the European Central Bank