Why European debt defaults are necessary

By Felix Salmon
November 30, 2010
saying that the eurozone needs "solidarity", and that Germany in particular needs to get with the all-for-one-and-one-for-all program, after getting itself into this mess by encouraging far too many countries to join the euro in the first place.

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Jim O’Neill of Goldman Sachs is now going around saying that the eurozone needs “solidarity,” and that Germany in particular needs to get with the all-for-one-and-one-for-all program, after getting itself into this mess by encouraging far too many countries to join the euro in the first place. At the same time, the survival of the euro, he says, “requires Germany to be not so noisy and aggressive about how other countries should run their economies.”

You can see the problem here: if enacted, it would mean that the European periphery can run up massive debts, safe in the knowledge that Germany will pay them off. Willem Buiter calls this by its proper name—permanent fiscal transfer—and says that it’s “most unlikely” even in Ireland, let alone in (say) Greece.

Even Buiter—who now works for Citigroup, remember, which has a long and painful institutional memory when it comes to sovereign lending—is talking about the fact that some kind of default (he calls it “restructuring”) will be necessary, certainly in Greece and Ireland, before markets have any confidence that the problems in those countries are resolved.

Certainly the current pain in Greece—retail sales down 10% year-on-year—feels very similar to the deflationary nightmare that Argentina lived through pre-default. The post-default chaos was worse, but the fact is that default was needed, in Argentina, to get the country back onto a growth path. And Argentina’s debt levels were much lower than those in the European periphery.

Europe is going through a debt crisis, and a debt crisis can only be permanently resolved by reducing—rather than simply rolling over—the debt in question. Sovereign debt crises are special cases, and in some rare cases—Brazil in 2002, say—they can be resolved through fiscal policy and economic growth rather than through default. But Greece 2010 is not Brazil 2002. It has vastly more debt, for starters, it doesn’t have a free-floating currency, it doesn’t have oil and other natural resources like soybeans and iron ore which bring in enormous income during a commodity bubble, and more generally it doesn’t have the ability to grow quickly for a sustained period of time.

The EU in general and the European Financial Stability Facility in particular have bought Europe’s periphery some breathing room. They need to take the next couple of years to work out an equitable and workable debt restructuring in these countries. Without one, they will be mired in deflationary recession, exacerbated by massive fiscal cutbacks, for years to come.

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