Entering the age of default

By Felix Salmon
July 6, 2010

James Saft today quotes the “six ways to dig oneself out of a debt hole” of Jeffrey Gundlach. Boiled down, they are

  1. Growth
  2. Lower interest rates
  3. A money transfer from an outside benefactor
  4. Higher revenues (taxes) and/or lower spending
  5. Printing money
  6. Default.

He’s too polite to mention the seventh option, which is to lie about how much debt you have and hope the markets don’t notice.

It’s worth bearing this list in mind in light of what David Merkel has to say about sub-sovereign debt:

I have long said that the health of the states is a more valid measure of the health of the nation than looking at national statistics. Why?

  • The states can’t print money, or force ask allow the central bank to buy their debt.
  • In general, the states must run balanced budgets. (Would that we constrained the Federal government to do the same through amending the Constitution. Somebody bring that up after the crisis is over, please?)
  • State statistics are more reliable than Federal statistics, because they serve fewer political goals.

John Dizard seems to be thinking along similar lines, saying that Greece has already started restructuring its debt, on the grounds that the state hospital system is imposing haircuts on its creditors.

It’s only natural to look at sub-national defaults and near-defaults, from entities like Greek hospitals or the state of Illinois, as indicative of a broader fiscal malaise. If nothing else, it’s a sign that the sovereign is either unwilling or unable — or both — to bail out the troubled borrower in question. And as Merkel says, sub-sovereign defaults are “purer” than their sovereign counterparts, since a lot of the tricks available to the sovereign are inaccessible to anybody else.

I don’t think it’s fair to say that problems with Greek hospital debt mean that the sovereign has already defaulted, any more than non-payment from Illinois means that we’re in the middle of a US default. But I do think that default will become more common among sub-sovereign debtors, and as it does so, both creditors and debtors will start considering it seriously among the menu of options available. When nobody’s doing it, default is unthinkable. But once it starts popping up all over the place, it becomes a strategic option. That’s true of homeowners, who are more likely to default when their neighbors are doing it too, and it’s true of sovereigns as well.


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Felix, wouldn’t we be bailing out Illinois already, if they were the first in line for bailouts, instead of fifteen (after Goldman and banks, auto companies, the housing market, the unemployed, etc etc)?

Posted by DanHess | Report as abusive

I know this may seem hopelessly wonkish and naive, but didn’t Ed Prescott show that in a growing economy with a growing population a modest deficit (1-2%) is *more* efficient than a balanced budget? Economics may be too important to leave to the economists, but we shouldn’t ignore them, should we?

Posted by Publius | Report as abusive

1. Imho defaults will rise, simply because the standard method of solving things at central government level, throwing money at problems, and a lot of it, will at least be more difficult and within some countries even umpossible.
2. I donot think that such a default is per definition a sign of an economy in bad shape. Eg state governmennts are governments and those often overspend (at any level).
Central governments have other means to solve the problem, but imho that only means that the danger signs can be places further away.
3. Default gives the problem that you become at least for a few years a pariah with creditors. Massive numbers of defaults will make the markets nervous.
4. Problem is different in the EU compared to the US. US economy usually grows faster but mainly it has a growing population and growing workforce. Which means that EU, with its aging population should have built up some reserves instead they only built up a lot of debt. Plus that there is upward pressure in such a society on debtlevels from off balancesheet guarantees (pensions) that become real money to pay.
5. 1-2% deficit with a growing economy might not be such a bad idea, the problem however is that most governments don’t leave it with that.

Posted by Rikh | Report as abusive

The plight of the states does indeed create a dilemma for monetary propagandists given that the states cannot print money. Ironically, this same issue is what sunk Greece, Spain, and Portugal, who surrendered their printing presses as they joined the EU (just as the states do as members of the US). What political message can be used to conceal the looming fiscal disaster contained within almost every state in the union? Moreover, what of default and its implications as a way to go forward? The political debate in our society is likely to proceed into unknown philosophical spaces as the reality of local and regional economic depression begins to challenge the top-down political regimes of Federalism…

Posted by mckibbinusa | Report as abusive

Is Illinois too big to fail?

Posted by minipaws | Report as abusive

..and what happens when the people stop recognizing the so called “sovereign” as sovereign ? the quaint old “by the consent of the people” thing ? it might suprise how much this is now taking place..thanks to Felix and Jim, and Reuters, for these excellent articles..

Posted by gramps | Report as abusive