Imminent Eurozone Default: How Likely?

By Simon Johnson
The big question of the week in Europe is deceptively simple – will any countries that share the euro as their currency default on their government or bank debts in the foreseeable future?  The answer to this question determines how you regard bonds from countries such as Portugal, Spain, Italy, and Belgium.
Answering this question is not as simple as it seems, however, because it involves taking a view on three intricate issues: What exactly is the eurozone policy now on bailouts, can big eurozone countries really be bailed out if needed, and what happens to the politics of these countries and of the eurozone has a whole as pressure from the financial markets mounts?
The prevailing consensus – and definite official spin – is that over the weekend European leaders backed away from the German proposal to impose losses on creditors as a condition of future bailouts, i.e., from 2013.  The markets, in this view, should and likely will calm now; there is no immediate prospect of any kind of sovereign default or (more politely) “reprofiling” on debt, including the obligations of big banks.
But a close reading of the Eurogroup ministers’ statement from Sunday suggests quite a different interpretation.  It’s a straightforward text, just 2 ½ pages long, but it has potentially momentous consequences – as it envisages dividing future eurozone crises into two kinds.
“For countries considered solvent, on the basis of the debt sustainability analysis conducted by the [European] Commission and the IMF, in liaison with the ECB [European Central Bank], the private sector creditors would be encouraged to maintain their exposure according to international rules and fully in line with the IMF practices. In the unexpected event that a country would appear to be insolvent, the Member State has to negotiate a comprehensive restructuring plan with its private sector creditors, in line with IMF practices with a view to restoring debt sustainability. If debt sustainability can be reached through these measures, the ESM [European Stability Mechanism] may provide liquidity assistance.” (from the middle of p.2; emphasis added)
Translation: if it is decided your country is “insolvent”, rather than illiquid, then you have to restructure your debts.  But who exactly will decide?  Look at the preceding one line paragraph in that document (again on the middle of p.2) for the bombshell.
“On this basis, the Eurogroup Ministers will take a unanimous decision on providing assistance.”
In other words, any one member of the eurozone can veto a country being determined merely illiquid – thus cutting them off from cheap and endless credit (from the ECB or ESM or any window to be named later).  So now Germany effectively has a veto – as do other fiscally austere countries including Estonia (from January 1st when it becomes the 17th member of the eurozone.) 
Most likely we will witness the creation of an Austere Coalition (actually a modified Hanseatic League) of Germany, Austria, Finland, Estonia, and a few of the smaller countries.  Ending moral hazard – the prospect of soft bail out money forever – is an admirable goal.  But getting there under current conditions is going to be rocky because that new regime implies countries need to have less total debt and a longer maturity on their debt than they do now.  Transitional arrangements have not been put in place – other than the ad hoc sequential bailouts that we now see unfolding.
As for the resources needed to “bail out” countries now facing market pressure, the IMF and EU combined definitely have enough money in hand to help with Portugal and Spain – if this becomes necessary.  But they do not have enough funding currently to deal with Italy, Belgium and other larger countries (if there is a sequence of crises in the year ahead).
The IMF can, in principle, raise further resources beyond what it already has in hand; its membership (and effective owners) includes almost all countries in the world. IMF resources are shrouded in jargon; here is a relatively clear recent statement – bottom line: the IMF has no more than $1 trillion, but in terms of usable cash, the experts start to look pale as you discuss committing more than $500bn. 
But in the US this would involve a very awkward conversation with the Republican House of Representatives, among others.  Who else around the world has a stock of hard “convertible” currency sufficiently large to make a difference?  The call list for the IMF’s Managing Director is short: China, Abu Dhabi, Saudi Arabia and perhaps Singapore, Russia, and a few others.  This is not an easy scenario for anyone.
The IMF could also create its own money – known as Special Drawing Rights.  Again, check with your elected representative and the head of your central bank to see how they feel about this.  No one wants a global central bank that would operate without the prospect of proper political oversight.
The 27-member European Union could come up with further resources for itself.  But this would involve more taxes for the fiscally sound parts of the eurozone, including Germany.  And at some point soon the German taxpayer may decide enough is enough – which is exactly where the terms around the ESM come into play.
The euro is also a “reserve currency”, meaning that other countries like to use it for their precautionary savings.  Again, in principle the European Central Bank could create enough new money to enable all indebted governments to discharge their debts in full.  No one wants to contemplate the inflationary consequences of that.
In short, the larger European countries are “too big to bail”.
But do they really need a bailout or are we just looking at a “run on sovereign debt” or pure financial panic in Western Europe?
There are definitely elements of a panic at work but keep in mind one important point – such runs can become self-fulfilling, i.e., they create the exact conditions that started people worrying in the first place.
In fall 1997 in Indonesia, for example, financial markets began to worry about the collapse of the Suharto regime.  Initially, this seemed farfetched – after all Suharto had been in power for more than 30 years.  But the rapid depreciation of the rupiah put great pressure on the Indonesian corporate sector, which had borrowed heavily in dollars, and this contributed to undermining Suharto politically.  After many twists and turns, Suharto fell.  (As always, I recommend Paul Blustein’s book, The Chastening: Inside the Crisis That Rocked the Global Financial System and Humbled the IMF; Blustein is the Michael Lewis of international finance.)
The market proved itself right in the sense that dramatically lower asset prices reduced perceived legitimacy of the regime and generated a great deal of political uncertainty.  This uncertainty justified the fall in asset prices.
Could something similar happen in Europe today?
Just as for Asia in September 1997, such a sequence of events does not seem very likely, but there is no question that European domestic and regional political institutions are undergoing a severe stress test.
Whose coalitions will collapse?  Where will governments prove unable to stay the course on fiscal policy?  And, at the end of the day, whom do the Germans trust enough to provide with unlimited financial backing?
Governance in Asia did not change in 1997 – there were long-standing issues with the way companies operated (chaebol in Korea, family firms in Thailand) and with the relationship between the state and business (Suharto’s family in Indonesia).  During the boom, investors did not particularly worry about what this implied.
But when downturn comes – in Asia’s case with a rapid depreciation of currencies; in Europe’s case it is a crisis of confidence in “investment grade” debt – governance becomes a salient question for everyone who can move money.
The biggest issue today is not how Europe could be governed in some future ideal world, but rather how it is governed – and how any misgovernance will play out and be perceived as the pressures now really begin to mount.
An edited version of this post appeared this morning on the NYT.com’s Economix blog; it is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.