Ir­ish debt de­fault would be far from Ar­maged­don

Earth would be a bet­ter place if these bankers were forced to take a re­me­dial course in Chris­tian the­ol­ogy.

The Pak Banker - - Editorial5 - Kevin Hassett

The world's eco­nomic pol­icy mak­ers have talked up a zero-tol­er­ance at­ti­tude to­ward sov­er­eign-debt de­faults. For ev­ery trou­bled na­tional bor­rower, there seem to be a dozen cen­tral bankers ready to hand out cash, al­ways to avoid Ar­maged­don. Earth would be a bet­ter place if these bankers were forced to take a re­me­dial course in Chris­tian the­ol­ogy. Then they would stop ob­sess­ing over Ar­maged­don, at least un­til a Mes­siah ap­pears.

Debtors have failed to make good on their obli­ga­tions through­out his­tory, and we're still here. De­faults by fi­nan­cial in­sti­tu­tions are, of course, too nu­mer­ous to count, but gov­ern­ments crash as well. We have a long record to see just how they play out.

Ac­cord­ing to "This Time Is Dif­fer­ent: Eight Cen­turies of Fi­nan­cial Folly," the 2009 book by Carmen M. Rein­hart and Ken­neth Ro­goff, there were 238 ex­ter­nal debt de­faults or reschedul­ings from 1800 to 2008. Spain tops the list with 13 oc­cur­rences in its his­tory, though none since the 19th cen­tury.

To­day we are sup­posed to be­lieve that if one small coun­try such as Ire­land goes down, the rest of us will too. Yes, the world is more in­ter­con­nected now than 200 years ago. That doesn't make ev­ery cough a sure sign of pneu­mo­nia.

At the risk of un­der­state­ment, throw­ing money at a coun­try tee­ter­ing at the brink of de­fault isn't how things used to be done.

In 1902, Euro­pean na­tions re­sponded to a Venezue­lan govern­ment debt de­fault with mil­i­tary force. Ger­man, Ital­ian and Bri­tish gun­boats block­aded ports, seized cus­toms houses and bom­barded a Venezue­lan fort. Venezuela caved, agree­ing to re­struc­ture and pay its debts.

These days, when Euro­pean lead­ers see Greece and Ire­land on the brink of de­fault, they don't send gun­boats --they send money. The word "re­struc­ture" is taboo. Some­where along the line it be­came un­ac­cept­able to take 80 cents on the dol­lar from a debtor nation, but ac­cept­able to give that same nation 20 cents to keep its pay­ments on sched­ule.

The prob­lem is, once you do that, ev­ery­one wants 20 cents.

The the­ory of bailouts is in­tri­cately re­lated to the fear of Ar­maged­don. If in­vestors see Greece go down, the story goes, they might panic and stop lend­ing to other na­tions, even ones that should be con­sid­ered healthy. In this view, de­fault spreads like in­fluenza in 1918.

The the­ory doesn't stop with na­tional gov­ern­ments. If Cal­i­for­nia de­faults on its debts, then the credit cri­sis might sweep up all the other states. If Bear Stearns Cos. fails, then so will ev­ery­one else.

We seem to have be­come a world in which we as­sume a panic is around ev­ery corner. When mar­kets are ir­ra­tional, it's im­pos­si­ble to say what might set them off, and fear of dis­as­ter be­comes a pow­er­ful ex­cuse for pol­icy mak­ers to do what­ever they choose.

Econ­o­mist Vin­cent Rein­hart re­views the legacy of the 2008 Bear Stearns bailout in an ar­ti­cle to be pub­lished in the Jour­nal of Eco­nomic Per­spec­tives. As he points out, the U.S. govern­ment, in its wis­dom, wiped out eq­uity hold­ers but saved bond­hold­ers, and in­vestors be­gan to ex­pect this pol­icy.

Rein­hart writes, "This ex­pec­ta­tion made it profitable to iden­tify the next fi­nan­cial firm to be re­solved and then to sell its stock short and use the pro­ceeds to pur­chase its un­se­cured debt. If the can­di­date firm was iden­ti­fied cor­rectly, the debt would ap­pre­ci­ate in value and its stock col­lapse."

The Bear Stearns bailout, then, only de­layed the in­evitable re­al­iza­tion of losses from the col­lapse of the real es­tate mar­ket. It abet­ted the fic­tion that govern­ment can save us. Only when Lehman Broth­ers Hold­ings Inc. was al­lowed to go down did mar­kets re­al­ize that the losses were just too big. The process would have been more or­derly if the re­struc­tur­ing be­gan at once.

It's just as bad for coun­tries. Cen­tral bank in­ter­ven­tions be­come an ex­cuse to avoid tough choices. While no one would rec­om­mend that we re­turn to the gun­boat days, the old-fash­ioned hard-nosed ap­proach had a big ef­fect on con­ta­gion.

Econ­o­mists Kris Mich­ener and Marc Wei­den­mier stud­ied what they call su­per­sanc­tions -the use of mil­i­tary or po­lit­i­cal pres­sure to force re­pay­ment of sov­er­eign debts, a com­monly used en­force­ment mech­a­nism from 1870 to 1913.

They found that fol­low­ing su­per­sanc­tions, "on av­er­age, ex ante de­fault prob­a­bil­i­ties on new debt is­sues fell by more than 60 per­cent, yield spreads de­clined ap­prox­i­mately 800 ba­sis points, and de­fault­ing coun­tries ex­pe­ri­enced al­most a 100 per­cent re­duc­tion of time spent in de­fault."

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