European Sovereign Debt: Default Now or Default Later?

by: The PolyCapitalist

If you're following the ongoing European sovereign debt and banking crisis, expect to hear increasing discussion of whether eurozone countries should "default now or default later?"

Eurozone Up Against The Ropes (Again)

After a summer respite from concerns about the solvency of European banks, several countries are once again rattling markets and the euro currency. Most recently news that Ireland appears to be insolvent has taken center stage. But not to be forgotten is Greece, the epicenter of the financial earthquake which rocked Europe this spring.

In an article titled Beware of Greeks Bearing Bonds, author Michael Lewis makes a rather provocative claim: even if Greece could somehow soldier through years of IMF/EU prescribed economic austerity to muster the financial wherewithal to pay foreign creditors back, it's not in the Greek character to do so. In the article's accompanying Q&A Lewis states "paying off the debt implies the sort of resolve and collective purpose that they (the Greeks) lack."

Is Default Inevitable?

There is a premise behind the question of whether to "default now" or "default later" which is that default is not just probable, but inevitable.

While debate exists on how many eurozone countries will ultimately default, the consensus outside perhaps Germany and the IMF PR department is that at least Greece will need to "restructure" its debt (aka default) at some point. So if in fact default for one or more eurozone countries is inevitable, would it be better to default now or default later?

Default Later?

The big justification for "default later" is the ever ubiquitous systemic risk concern. Here's the argument: if Greece were to default now while the global economy is still fragile it could be worse than defaulting down the road when the financial system has had time to repair. The key assumptions underpinning this argument are a) the financial system will in fact grow stronger over time and b) default can be successfully delayed.

In the case of Greece, the argument to default later is especially strong among those concerned that default will result in Greece leaving the euro currency. With respect to the two above assumptions, b) will hold so long as the "shock and awe" team (Eurozone countries, ECB, IMF, and Fed) continue to prop up Greece's finances.

Assumption a), however, is more of a question mark. For example, the IMF/EU austerity program prescribed for Greece will result in increased indebtedness. According to IMF projections, Greece's debt would rise to about 150% of GDP in 2013 despite large government cuts. Increasing Greece's debt levels can hardly provide confidence that the system is getting stronger. I expand later below on other reasons for why assumption a) may not hold up.

Default Now?

The argument for "default now" includes the opposite of the above "default later" assumptions, and a third reason: not allowing markets to clear.

Simply put, the market clearing process is hindered when government policy and intervention prevents an insolvent country like Greece from going bust. This in turn inhibits the establishment of true market prices in the form of higher yields on Greek debt.

Why could market clearing be important in the case of Greece? Two reasons. First, there is tremendous market uncertainty about default fallout for European financial institutions which hold Greek sovereign debt. And while the market may be expecting Greece to default, what's unknown is the size of a Greek default. Will Greek bondholders receive $0.80 on the dollar? $0.50? Even less? The final figure has major implications.

Current default uncertainty is hindering European credit markets as banks are uncomfortable lending to each other, which is forcing the ECB to play an outsized role. And with government taking the place of the market, the growth of new loans and private sector economic activity is stunted.

A second reason market clearing is important is that the support provided to Greece potentially threatens both the solvency of larger European nations and confidence in the euro currency. The concern over the ECB's role is reflected in the decline in the value of the euro we've seen this year vis-a-vis the U.S. dollar, Swiss franc, etc. Extending credit and monetary support to delay default increases systemic risk, thereby preventing the system from growing stronger over time.

Default Later is a Political, Not Economical, Decision

Since the economic arguments don't hold up it's clear the decision to delay Greece's debt restructuring is political. Current European administrations are loathe to play the blame game over who's fault the sovereign debt crisis is near elections.

There is also the issue of the "pot calling the kettle black". Greece is hardly the only eurozone member to run repeated deficits in excess of Brussels 3% rule. In short, it's not hard to see why Europe's politicians would prefer to put the inevitable off for another day.

Like the political decision to delay default, the euro has been referred to as a "political currency". Historically politics and a sound currency haven't mixed well.

Disclosure: No Positions