Belfast Telegraph

Bad debts are are not just a eurozone issue

By Stephen King

It could be seen as a dress rehearsal for the real thing. Europe's financial crisis may have done untold damage to the euro's reputation but the fundamental problems within the eurozone also exist on a much grander scale.

Europe's government debt crisis could quite easily turn into a global crisis.

When the euro was first created, both borrowers and lenders were far too cavalier. The Greeks, Spanish and Portuguese borrowed too much, while the Germans and French lent too much. They all failed to see the risks ahead.

Those countries which used to succumb to regular doses of inflation or revaluation were suddenly deemed safe. Yet their safety was untested in one crucial area: what would happen if their fiscal positions deteriorated alarmingly, perhaps as a result of a deep recession?

Would they be able to deliver the necessary austerity to bring the books back to balance? Or, instead, would they have to default in the face of civil unrest?

Lenders didn't worry about the possibility of default, partly because their historical knowledge was rather scanty. During the interwar period, another time of economic and financial turbulence, defaults were a fairly regular occurrence – largely because, like now, government debts had become excessive. Lenders also didn't seem to recognise that unanticipated inflation and devaluation are themselves forms of default.

If a government prints money and pushes inflation higher, and if interest rates don't rise quite so quickly, creditors lose out. Adjusted for inflation, their returns from having lent to the government are now lower than they hoped for. Alternatively, if a government prints money and pushes the exchange rate lower, foreign creditors who lent to the debtor nation in its own currency will now be worse off in their own currencies. On both counts, the printing press is an instrument of default by stealth.

Individual countries within the eurozone are no longer able to increase their print runs at will, because they are all part of a single currency. They cannot default by stealth. So if there cannot be default by stealth, why not simply default? As investors have belatedly begun to recognise this option, they've become more than a touch panicky. They thought their money was safe in the single currency because they believed the single currency would prevent the stealthy defaults that had so damaged investors in the past.

They forgot, however, that all defaults, whether stealthy or otherwise, typically happen because governments cannot pay the bills. But is this really only a eurozone problem? Hardly. Countries throughout the Western world are awash with too much government debt.

The UK, which has a higher ratio of government debt to GDP than Spain, has already attempted a stealthy default following the 2008 collapse in sterling and the subsequent rise in inflation.

It seems, however, that the printing press, on its own, has not been able to do the trick. Activity in the UK remains weak and the new Government is about to deliver to the nation the same kind of austerity medicine already seen in Greece and the Iberian peninsula.

Among the biggest offenders, however, is the US, where the government is still mulling over the possibility of a further fiscal stimulus later in the year.

The US almost certainly will not default, at least not in the commonly accepted way. Instead, it will default by stealth.

Typically, American politicians demand a Chinese currency adjustment because they believe China is following a mercantilist trade policy. What they conveniently forget to mention is that China is also one of America's biggest creditors.

The Germans lent to the Greeks on generous terms earlier in the decade and the Chinese are doing much the same with the Americans now. And the Americans, like some Greeks, may one day wonder whether a default might be a rather neat trick.

The only difference is that an American default would take the form of a big decline in the dollar. Governments cannot borrow indefinitely, because their foreign creditors will eventually lose faith. They will do so because, in a choice between protecting the interests of the domestic taxpayer and looking after the foreign creditor, it's the domestic taxpayer who votes.

Belfast Telegraph