Europe’s self-image is taking a beating: ratings downgrades to the sovereign debt of Spain, Greece and Portugal; Ireland on the “watch” list; and, at least according to the British tabloids, the UK on the brink of bankruptcy, replaying its 1976 humiliation, when the International Monetary Fund came to the rescue. In the gloomier precincts of public opinion, the dominos are all in place: after the housing market and the financial sector swan-dived into despair, governments, especially in Europe, are next in line to leap into the abyss.
The trouble is, this view applies a very mistaken lens to today’s events. The ground rules for the sovereign debt of emerging market countries do not work for developed economies, as we will explain.
Most emerging market debt is issued in a major currency like the US dollar or the euro. If an emerging country lacks the foreign currency to repay or to service its debt, it faces the risk of defaulting and the likelihood of a steep devaluation in its currency.
But developed nations usually issue sovereign debt in their own currency. Thus, they can, if necessary, “monetize” the debt: they can print the money they need to manage it. Of course, if they print too much money, they also face currency devaluation. But default is not a danger.
Back to the UK, currently all its debt is in British pounds. Now, the UK enjoys one of the lowest government debt-to-GDP-ratios of all developed countries, 47.5% in 2008, compared with over 60% for the US and over 180% for Japan. This alone should soothe default fears. The cookie jar is not empty.
Granted, the foreign liabilities of the banking sector and its ongoing bailout add to the UK’s total liabilities. But the banking sector’s 4.5 trillion dollars in foreign liabilities is matched by its 4.6 trillion dollars in foreign assets. And these assets would also go to the UK government in a worst-case full nationalization of the banking sector. More cookies in the jar.
True, the pound may well depreciate, which would help reinflate the depressed UK economy, but default simply isn’t going to happen.
The members of the European Monetary Union issue debt in euro. And here is a critical difference: individual EMU countries have no control over the European Central Bank. Thus, they cannot monetize their debt and inflate themselves out of trouble. Moreover, EMU and EU institutions are prohibited by law from supporting a defaulting member country. But no law prevents one or more EMU members from aiding another country.
And there a good reasons to help: If an EMU country defaults on its debt, intra-government bond spreads would likely widen sharply. This would raise the financing costs for other EMU high-debt countries, pushing them towards insolvency and, in a true domino-effect, undermine the stability of the whole Union.
Therefore we see Europe’s default fears as overdone. While the default of an EMU member country cannot be ruled out, it is unlikely, and other scenarios will first be tested before it happens.
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