Is Default the Default Option?

Sovereign default is a political choice. There is no specific tipping point where a country’s debt becomes economically unsustainable, and default inevitable.

Market perception of default risk, as measured by the interest rate charged, is determined by a country’s track record in servicing its debts as well as by the size of its debt, the size of its economy, and the rate at which both are growing.

Unlike people, countries never repay their debts; they just roll them over.  In this way, a country can theoretically support a very large national debt, so long as the bond market is willing to lend at a manageable interest rate.

Japan, for instance, has a debt-to-GDP ratio over 200%, far above all but the worst case scenarios envisaged for Ireland. Yet Japan is not perceived to be at imminent risk of default, and can borrow money over 10 years at an interest rate of about 1%, compared to Ireland’s 13%.

Ireland, the UK , and the US will all record budget deficits of about 10% this year, yet the UK and the US can still borrow at rates of about 3%.

Ireland’s problem is not the size of its deficit, but the catastrophic error made in socialising the losses of a bust banking system coupled with market fears that more such losses lie waiting to be found.

The challenge is compounded by not being able to print money or to borrow in our own currency, as are Japan, the UK and the US. However, none of this makes default inevitable.

The state has very significant theoretical scope to raise taxes to service its debts. Even in the late 1980s, as every penny raised in income tax went to cover interest payments, Ireland did not seriously contemplate default.

Sovereign default may be a choice, but it is no easy option.

Recognising that it carries very significant costs and risks, a government will only choose default when it becomes the least worst option – when the political cost of servicing the debt becomes unsustainable. That Greece and its eurozone partners are only now actively considering default, after months of civil unrest is testament to this high threshold.

The endgame in Greece will help determine Ireland’s range of options. A Greek default not only makes a default in Ireland politically possible, it increases its probability, a momentum that may be difficult to stop if it takes hold in the market. Recent developments in Italy further underlines the interconnected nature of the eurozone’s crisis, and the need for decisive action.

In the event of default, all creditors take a hit. Banks, both Irish and European, would need more capital. Pension funds would be burned. Governments would lose money lent directly to the defaulter and would be called on to bail out the ECB and the IMF.

Countries that default do not remain locked out of the bond market indefintely Indeed,  after an initial period of dislocation, it is quite possible that forward-looking lenders would become more willing to lend if default enhanced long-term fiscal sustainability.

In the event of an Irish default, we would not likely return to a scenario where Ireland could borrow money cheaper than Germany, but neither would we be faced with the double digit rates in the current market.

At this point in time, the political calculus would suggest that an Irish default default is neither feasible nor desirable. Unilateral, pre-emptive default is not a credible policy option, but neither is the prevailing optimistic orthodoxy.

While there may be no ‘golden mean’,  a credible, pan-European path must be found if the tyranny of the bond market is to be mitigated, and disorderly default averted.

Recent events in Europe, and in the markets, suggest that endgame may be upon us. Meanwhile, a continent holds its breath.

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