“Unnecessary, undesirable, and unlikely”; this is how an IMF Staff Position Note of last September characterized the prospect of default in a developed economy. Almost everybody would agree that a sovereign default is always undesirable, but the markets seem to assume that for at least one country classified as developed, namely Greece, default has now become highly likely. Markets have marked down Greek government debt to such an extent because they can see that political resistance against open-ended financial support in the stronger EMU member countries like Germany, coupled with adjustment fatigue in Greece, have led to a situation in which a default becomes “however undesirable, ultimately unavoidable”.
How could this unfortunate dilemma have arisen? This would be the first default of a developed country since the Second World War. It was a combination of borrowing in the national currency and control over the printing press that has allowed OECD governments to avoid outright defaults in the last 60 years. Emerging market countries by contrast suffered from what economists called the ‘original sin’, i.e. by and large they could not fund themselves in their own currency, certainly not with foreign investors. This meant that when they ran of dollars they had no choice but to default. The countries that have adopted the euro have put themselves into the position of emerging market issuers: they issue their debt in a currency that they cannot control and thus subject themselves to a similar default risk as emerging markets.
Emerging markets suffer chronically from elevated macroeconomic instability. In the good years of expanding global liquidity, they attract large capital inflows at low real interest rates and enjoy a credit-funded boom. In the bad years, when creditors suddenly retract, they find themselves deprived of fiscal and monetary policy options to smooth the decline in output and subject to high sovereign country risk premia, which choke the economy.
Greece and other peripheral euro area member countries seem to be in a similar situation today. What can be done about this? The obvious answer seems to be that the euro area needs to create a “European Monetary Fund” with similar tasks as the “International Monetary Fund” has at the global level, namely to alleviate the stress created by volatile international capital flows. Europe has now created an IMF-like structure in the form of the European Financial Stability Facility (EFSF) to provide financing for governments that have been shut out of the market.
That the EFSF has aroused even more controversy than the operations of the IMF is understandable given the huge difference in economic weight between the IMF and the EFSF rescue operations. The IMF has never disbursed more than $40 billion (?33 billion) in any one year, which never accounted for more than 0.1% of global GDP. In the eurozone, the Greek programme alone weighs about 10 times as much, since the direct contribution of the euro area members (about ?80 billion) amounts to about 1% of their collective GDP. The programmes for Ireland and Portugal combined will add about the same as much. It is thus understandable that the resistance in the creditor countries against continuing large financial support or “bail-outs” is also much stronger. It is thus unavoidable that political resistance will sooner - or a popular revolt in the creditor countries will later - bring an end to the rescue operations, thus leading to a default by the country (or countries) most in need of support.
A further difference between an emerging country and the euro area sovereign debt crisis is that the problems of even the largest emerging markets could never endanger global financial stability, but a default of Greece is widely perceived as putting the financial system of the entire euro area at risk.
This leaves creditor countries in a quandary: their citizens revolt against further bail-outs but their bankers tell them that a default by Greece would constitute a second Lehman with huge costs.
The obvious way out would be to strengthen the financial system of the euro area so that it its stability would no longer be endangered by a default in the periphery. However, this takes time and money and a strong political will. Given the interconnectedness of financial markets in a common currency area, weakness in any one corner spills over into the entire system, which cannot be stabilized until all of its major components have been dealt with.
But Europe lacks a common body that has the fiscal resources to stabilize the system as a whole. The required fiscal resources exist at the national level, but their use is generally guided by purely national considerations and interests. In other words, Europe faces a fundamental collective action problem. Europe will not be able to address this crisis until this problem is resolved and the financial system as a whole has been strengthened to the point that a default can be contemplated without a meltdown of the European banking system.
Daniel Gros is Director of The Centre for European Policy Studies