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‘What if’ becomes the default question

By Wolfgang Münchau

Published: January 18 2009 19:26 | Last updated: January 18 2009 19:26

What if one of the member states of the eurozone were to default on its debt? On the occasion of the euro’s 10th birthday, this has become the most frequently asked question about the single currency zone.

The probability of a default is low but clearly rising. The decision by Standard & Poor’s, the ratings agency, to downgrade Greek sovereign debt and to put Spanish and Irish debt on watch seriously rattled investors last week, for good reason. If the financial crisis has taught us one thing, it is to take perceived tail-risks more seriously.

Before I answer the question, it is best to consider what would not happen. For a start, the eurozone would not fall apart. A government about to default would be mad to leave the eurozone. It would mean that, in addition to a debt crisis, the country would also face a currency and banking crisis. Bank customers would simply send their euros to a foreign bank to avoid a forced conversion into a new domestic currency.

So if a default were to happen, it would almost certainly happen within a eurozone that remained intact. If you put your mind to it, it is quite difficult, even in theory, to think of a circumstance in which the eurozone would blow apart. One theoretical possibility would be for the European Central Bank to generate massive inflation, prompting Germany to leave in disgust – not exactly the most likely scenario right now.

So we are stuck with the eurozone for better or for worse. If a default happens, the central banks and governments of the eurozone would be forced to co-ordinate their policies whether they liked it or not. Under its statutes, the euro system, which includes the ECB and the national central banks, is not allowed to monetise (that is, buy) new sovereign debt or to grant overdraft facilities. But the ECB is allowed to buy debt in the secondary markets, which is a way of monetising debt. All it would take is a decision by the ECB’s governing council.

What about a direct fiscal bail-out by other member states? I suspect that the non-defaulting governments would be reluctant initially. Many of them had difficulty selling austerity-type policies to their domestic electorates and they might not achieve the parliamentary majorities needed for a bail-out. Some would no doubt argue that a bail-out would carry the risk of moral hazard.

But governments would soon discover that simply saying No was not going to work either. Back in the real world, governments would have to take into account the risk of contagion. For example, a sovereign default by a small country could wreak havoc on the markets for credit default swaps and might even destroy financial institutions in other eurozone countries.

A default could also trigger a panic rise in bond yields elsewhere, which could turn the threat of contagion into a self-fulfilling prophecy.

If confronted with this more realistic situation, governments would, I suspect, react similarly to the way they responded in the aftermath of the collapse of Lehman Brothers, the US investment bank. Complacency would be followed by anger and by grandstanding lectures on the virtues of fiscal discipline (I can see a speech coming by the German finance minister).

This would be followed by an emergency meeting one weekend in Brussels in which the European Union, perhaps together with the International Monetary Fund, would agree a package of credits to stabilise the defaulter.

The recipient would, in turn, have to accept an austerity programme, perhaps even the temporary loss of fiscal sovereignty, to ensure that the loan was repaid and to reduce moral hazard. In other words, the Europeans would bail out one of their own, but it would not be fun for anyone, especially not for the defaulter.

In the long run, a conditional bail-out combined with persistently positive bond spreads could even be a healthy development for the eurozone. Putting roughly the same value on Greek and German debt – which is what financial markets did for most of the last 10 years – never made sense.

If that situation had been allowed to persist, it would have produced serious difficulties for the eurozone further down the road. When the euro was launched in 1999, many commentators, including me, predicted that the markets would exert sufficient pressure on member states to run responsible fiscal policies. It took 10 years for that prediction to prove correct (which means, of course, that it was not such a great prediction).

A far more serious threat would be a cascading series of defaults that would eventually include one or more of the eurozone’s large countries. That would be a momentous challenge for the system but the policy response would be no different, only faster.

In extremis, you could conceive of a scenario under which the bail-out had to be so large that it would bring down the entire system. This could then provide the non-defaulters with an economic incentive to leave.

But dream on. If Germany, for example, had such an incentive to leave, it would almost certainly forgo that perceived economic benefit and stay for political reasons. If you assume the worst-case scenario of a default by five or six countries, a full fiscal union would be more probable than a break-up.

Most likely, we will see neither, but we may see conditional bail-outs.

Send your comments to munchau@eurointelligence.com

More columns at www.ft.com/wolfgangmunchau

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