European debt crisis: the short vs. the long run

(Julkaistu 16.4.2011)

On the 7th of April, Portugal announced that it also needs a
financial rescue package from the European Union (and the IMF). In many
instances politicians across Europe have insisted that using billions of
euro of other European nations money is required for averting a full
blown financial crisis in the eurozone. Such an crisis is also argued to
lead to diminished economic growth, widespread unemployment, and falls
in the tax income of European countries. If we look at the arguments
usually given to foster  these views more closely, it quickly becomes
clear that the results of possible debt restructuring are not all so
clear as has generally been presented. The discussion also completely
lacks any kind of analysis on what will the economic consequences of
these ‘rescue packages’ be in the short vs. the long run.

The argument given by politicians (and probably handful of economists
too) to support the ‘bail-out’ usually goes as follows. If a nation of
the eurozone is allowed to default, this will lead to restructuring of
its debt which will lead to big losses for creditors, which in many
instances are the banks in the EU area. As banks suffer big losses, this
will lead to financial crisis, where credit, once again, becomes
restricted leading to a European wide or even global recession. In
addition, as the defaulting nation cannot borrow from the international
financial markets anymore, it is forced to make some drastic cuts on its
budget. This will lead to massive unemployment and to a recession. As
country hits an economic downturn, the demand for commodities also
falls, leading to fewer exports from countries in the EU. This will
enhance the recession in the EU area, as many European countries are net
exporters. Thus, the default of an Eurozone country (or EU country for
that matter) will cause European-wide financial crisis and recession.

The story presented above has two serious deficits. First, it is not
at all clear that the selected policy option (emergency loans) will
enhance the growth of now nearly defaulting nations of the eurozone in
the longer run. Second, it makes a flawed argument that the financial
crisis could not be stopped by other means.

When a country defaults, it usually makes a unilateral announcement
that it cannot or just will not pay back its debt. In that instance, its
capability to borrow from international financial markets basically
disappears. This will lead to a situation where the country is forced to
stabilize its budget as it cannot borrow from abroad anymore (although
in practice IMF will provide emergency and restructuring loans, but
these usually include severe restrictions on public sector spending).
Thus, severe cutbacks in public spending will take place, which will
lead to layoffs in the public sector and cuts in social benefits, etc.
(although Finland never defaulted, similar measures were basically taken
in the depression of 1991-1993). Although this will create
unemployment, cutbacks will also force public sector to increase its
productivity, e.g. reducing unnecessary bureacracy. As countries in the
eurozone cannot devalue their currency, the wage rates will have to
adjust. This will lead to deflation (obviously), but it will also
increase the competitiveness of products made in a defaulting country.

Country will also start negotiating with the debtors on how and to
what value its debt will be restructured. This is crucial for the
recovery. The financial crisis in Argentina (1999-2002) dragged on as
the government delayed its announcement on default, restructuring, and
the exit from the currency peg with dollar. After the announcement it
took three years on Argentina to renegotiate its debt, but they
eventually managed to renegotiate its debt to about 3/5 of where it
stand when it defaulted in 2002. However, if the reconstructuring can be
done within a reasonable time period, country can start to concentrate
on growth enhancing policies. Argentina contracted for three and a half
years (1999-2002), but has grown ever since defaulting! This is the
crucial difference between the options of defaulting on debt and relying
on bailout loans. In most cases, bailout only increases the share of
foreign debt which leads to increases in interest payments. Even if
bailout money would be used just to refinance old (and possible more
expensive) debt, which is not the case with Greece or Portugal, the
share of debt to GDP would remain the  same and the problems of accruing
more debt from the international financial markets would remain
basically the same. Thus, bailouts only solve problems in the short run and they do absolutely nothing
to solve the actual problem in the longer run and may actually make the
debt crisis worse by increasing the debt burden of a country. Heavy
debt burden diminishes growth as a big fraction of the income earned by
the country (=GDP) goes to interest payments.

This leads us to the most crucial questions in the euro area debt
crisis. They are, how large will the losses to creditors be and will
this lead to European financial crisis? According to the Economist, the
foreign banks exposure to the public sector debt of the three nearly
defaulting countries, Greece, Ireland and Portugal, is about 1/2 of the
size of the announced bail-out funds [1].
So, that is not a problem. European countries, including Germany and
France, could easily compensate the losses to their banks even if the
three countries would not repay any of their debt (which will not
happen). However, the total exposure (including loans to banks,
companies, households, etc.) of foreign banks on the “defaulting three”
is about two to three times the size of the announced bailout funds. So,
the total exposure is very high. But, it is likely that most of the
companies, for example, will not default. According to Bloomberg,
Argentina had 43 companies missing their interest payments on debt from
1990 to 2009 with the total cost of 14.5 billion dollars (the GDP of
Argentina in 2010 was about 340 billion from which the private sector’s
share was about 280 billion) [2].
And this is with four years of GDP contraction, sovereign debt default,
and with massive outflow of foreign capital and rioting and looting.
So, in Argentina at least, the defaults in the corporate sector have
been miniscule with respect to the default on the external debt of no
less than 130 billion. There would also be some domestic bank defaults,
but the exposure of foreign banks to these and to public sector debt
could be covered with the announced bail-out funds.

Thus, the euro area has two choices. We can foster emergency and
other loans to bail-out countries and keep them solvent but in an
economic hardship, or we can let the countries default and take the
fall, but at the same time make it possible for the countries to grow
again in the long(er) run. And let us not forget that defaulting is a
natural event occurring in the market mechanism.




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