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There will be more defaults in the eurozone

In last week’s weekly newsletter, I explained why Spain was in big trouble. Today I want to present the full context euro zone-wide and why there will be more sovereign defaults to come in the euro zone.


Summarising Spain

First, the short story on Spain is that Spain had a speculative boom due to low interest rates in the euro zone and the inflow of capital from other euro zone countries associated with those rates. This boom came to an end with the Great Financial Crisis leaving an overindebted Spanish private sector in its wake. Now Spain is suffering from a balance sheet recession in which businesses and households have attempted to increase net savings in order to pay down the debt to levels that are covered by the now depreciated assets which serve as collateral. As long as these assets provide insufficient collateral for the debts that depend on them, the private sector will continue to reduce consumption and investment. Spanish property prices are likely to fall further, meaning that asset price depreciation will continue, making a continued balance sheet recession a near certainty.

Meanwhile we know that the financial sectors of any economy must balance. So this attempt to gain a larger net surplus position by companies and households in Spain must be felt by the external and government sectors in equivalent measure. An increase in the private surplus, therefore, is matched by a combined decrease in the capital account and government balances. The key sticking point here is the government balances because a ballooning of government debt has brought the Spanish economy to the breaking point. And given the likelihood of continued attempts to net save, you can bet more deficits and debt are coming.

Conclusion: The balance sheet recession in Spain will necessarily increase public sector indebtedness until debt falls to a level covered by the still depreciating Spanish asset prices, Spain, which is indebted in a foreign currency i.e. one in which its government is not sovereign because it cannot create it, faces a potential sovereign default as a result.

Austerity is a ‘Morality Play’ that creates Debt Deflation

Now a lot of people get their moralism on when talking about this issue. That is to say, these issues are invariably discussed in terms of the ‘morality’ of debt sin. The indebted are seen as sinners who have overburdened themselves with promises they can’t or are unwilling to keep.

The goal using this ‘sin’ framing then should be to ‘reduce the sin’ i.e. reduce the level of indebtedness as demonstrated by some neutral yardstick like debt to GDP or debt to income. Austerity i.e. cuts in spending or increases in taxes are always going to be seen as the most direct path to reducing deficits for sovereign governments in this context. Liberalising employment markets and selling off state assets to promote competiveness will help maintain growth while also reducing debt further.

Unfortunately, austerity doesn’t work quite that simply because of the private debt. The root cause of the problems in a country like Spain – and this is true in Ireland and Portugal as well (less so in Greece and Italy) – is private debt. If the government cuts spending, it is cutting income available to the private sector. These government budget cuts have no relevance to private sector balance sheets. The private sector remains as indebted as before. So the same impetus to cut still exists for households and businesses to get their debts in line with asset prices. The government cuts will simply reduce the income the private sector has available to reduce its indebtedness and so these public sector cuts must be met with private sector cuts if individuals, families and businesses are to net save and reduce their indebtedness. A debt deflation takes hold.

The key to realise here is that asset prices are variable. They rise and fall according to the income available to purchase the assets. And so when government cuts are met with private sector cuts in order to reduce overindebtedness, the end result is asset price deflation and increased relative indebtedness. A family that bought a property for 350,000 euros might find its 300,000 euro mortgage is backed by a house worth 250,000 euros after the initial drop in asset prices. The family will then feel compelled to save more in order to reduce their indebtedness until the mortgage is down to 250,000 euros or the property value has risen to the mortgage level. However, with more income sucked out of the economy, some people will lose their jobs and not be able to pay their mortgages. They will default and a glut of available properties will hit the market. That family home could fall to 200,000 in value. And now you have a real distressed asset.  This is how debt deflation can take hold and it is precisely what is happening in Greece, Ireland, and Spain and to a lesser degree in Portugal and Italy.

The Political Response is Creditor Friendly

The framing I have presented fits the facts well and most of it is not controversial. But from a policy perspective it is hard to act upon.

In western economies, contracts are considered the bedrock of law and social order. The assumption is that a contract between two willing parties is inviolable because allowing these contracts to be broken without penalty undermines the rule of law and leads to chaos. Therefore, in debt contracts, it is almost always the debtor that is the violator who must be met with sanction. Moreover, creditors are generally wealthy and are therefore powerful politically. In most instances, their rights and interests will take precedence, particularly when it is the debtor who is most likely to violate the contractually agreed-upon terms. Policy will invariably shade heavily toward creditor interests until a deep downturn and depression from creditor-centric policy forces a change.

Steve Waldman gets it right when he opines:

wouldn’t creditors be better off in a booming economy than in a depressed one? In a depression, creditors may not face unexpected inflation, sure. But they also earn next to nothing on their money, sometimes even a bit less than nothing in real terms. “Financial repression! Savers are being squeezed!” In a boom, they would enjoy positive interest rates.

That’s true. But the revealed preference of the polity is not balanced. It is not some cartoonish capitalist-class conspiracy story, where the goal is to maximize the wealth of exploiters. The revealed preference of the polity is to resist losses for incumbent creditors much more than it is to seek gains. In a world of perfect certainty, given a choice between recession and boom, the polity would choose boom. But in the real world, the polity faces great uncertainty. The policies that might engender a boom are not guaranteed to succeed. They carry with them a short-to-medium-term risk of inflation, perhaps even a significant inflation if things don’t go as planned. The polity prefers inaction to bearing this risk.

This preference is not at all difficult to understand. The ailing developed economies are plutocratic democracies. “The people” do have power, but influence is weighted in a manner correlated with wealth. The median influencer in these economies is not a billionaire, but an older citizen of some affluence who has mostly endowed her own future consumption. She would like to be richer, of course. But she is content with her present wealth, and is panicked by the prospect of becoming poorer. For such a person, the depression status quo is unfortunate but tolerable. The risks associated with expansionary policy, on the other hand, are absolutely terrifying.

In the euro zone, there are then four core political issues that must adapt to these circumstances.

  1. Respect for the present institutional arrangements. The ECB is not a lender of last resort to sovereign governments. The lender of last resort is intended to be a central bank lending to individual financial institutions that are clearly regarded as solvent during crises. And this is done at a penalty rate against good collateral. That’s what lender of last resort means. It is a lender of last resort to banks, not governments. That is the institutional arrangement in Europe. And it must be respected. We do know that central banking was actually begun in England to fund the English government. But the central bank is supposed to fund government, not be its lender of last resort. The Federal Reserve, for example, was created in 1913 after the Panic of 1907 to fill that role with banks and not government. So, legitimately, Europe has a sovereign debt problem that cannot be ameliorated by the ECB without changing institutional arrangement.
  2. Desire for fairness i.e. avoiding the moral hazard of bailouts. Many in core countries see the periphery countries as deadbeats looking for an easy ride. remember the morality play of debtors as deadbeats living beyond their means. That is a big factor politically. I posted a story from an Austrian newspaper about Greece receiving 33,000 euros in aid per capita on Twitter two days ago. I have since seen this story pop up on several German-language news sites in Germany, Austria, and Switzerland. The inference is that Greece is getting a free ride. Clearly that story resonates and has made the circuit around German-language news sites as a result. That is why I depicted the framing in my seminal post on "How Belgian debt, Italian anarchy and Greek profligacy lead to economic chaos in Europe". The point is that many Germans, Austrians, and Finns see the Greeks as free riders hell bent on mooching off of the fiscal probity of core Europe. Voters in those countries feel put upon as a result.
  3. Resistance to austerity-induced economic Depression. The austerity plans now in place in Greece and elsewhere in the periphery are not sustainable without debt relief. Austerity is not a good way to solve unsustainable fiscal trajectories because fiscal contraction reduces output and tax revenue, and therefore increases budget deficits. You need a Herculean level of budget cuts and asset sales to overcome this effect. And even then, the lower level of output and the permanently diminished tax base from asset sales will make any debt burden that is constant or increasing in nominal terms that much harder to finance. This is why default was inevitable in Greece and will occur elsewhere as well.
  4. Fear of a default-induced economic depression. The flip side of the austerity-induced depression is the default-induced depression. Europe dithered and dithered on Greece with this fear as the subtext. We now realise that Greece was manageable as I have said all along. It is Italy and Spain that we have to worry about. An Italian or Spanish default would be a credit event as in Greece. This would render many financial institutions insolvent. So, an Italian or Spanish default would be uncontrolled and immediately crystallise losses that must run through the balance sheets of everyone holding their bonds. It would lead to a general bank run in those nations and fan sovereign debt contagion out to countries like Portugal, Ireland, Slovenia, France and well into Eastern Europe. It would be a very bad situation, much worse than Lehman Brothers’ default.

These four political issues are often in conflict and it is this conflict that creates the muddle through in policy. How can policy makers respect institutional arrangements, while still alleviating the burdens of austerity through debt reduction in a way that is fair and manageable? It is a difficult task.

Moving toward a sustainable solution

In my view, there are three choices for the euro zone: monetisation, default and breakup. It seems as if everyone is bearish on the euro zone these days. Anyone who believes we can escape with monetisation and just Greece defaulting is optimistic. Anyone who thinks the euro zone will not break up is still optimistic but somewhere in the middle. The majority of people seem to expect more defaults and a breakup, the question being who defaults and how violent the breakup is.

On that score, I am pretty optimistic compared to most. I believe it is mostly a political question and I think enough political will exists to prevent worst case outcomes. What I see happening is Greece exiting the euro zone and Portugal at a minimum defaulting. I am not ready to make any further downbeat predictions than that. The size of Spain and Italy shield them from some level of policy error because European leaders know a default in either country would probably mean a global depression and market panic. That’s where I am. But again, it’s a political question.

Of course, the Europeans have had an opportunity to deal with the fundamental problems of its financial sector’s undercapitalisation and the sovereign indebtedness at the euro zone’s periphery. They have dithered, choosing superficial and phony approaches like stress tests instead of addressing fundamental issues – and this largely because of the policy conflict outlined at the end of the last section of this post.

Monetisation: As I predicted in 2010, this approach is the easiest and therefore has been the prominent outcome. What brought it to a head was Italy. If Italy were to default, the result would be financial Armageddon and a major worldwide Depression, perhaps one worse than the Great Depression. The Germans know this. The ECB knows this. And so the LTRO was fashioned to use bank lender of last resort liquidity as a pass through to sovereigns. This was a brilliant tactical design that allowed the ECB to respect the existing institutional arrangements while still preventing worst case scenarios.

But of course central bankers always prefer to force elected officials to make the tough political choices that are the essence of fiscal policy. Monetisation is a policy choice that helps the national governments achieve their fiscal aims, a quasi-fiscal role. The periphery has no reason to make reforms or move to fiscal consolidation without the sovereign insolvency stick and so the ECB is using that stick as much as they can reasonably do. The problem with this approach is it will subject the euro zone to crisis again and again because austerity is a debt deflationary policy response as we outlined above.

Default. This second path is more tricky and therefore not likely unless it is forced upon the Europeans as it has been with Greece. Remember, creditors wield the political power that says we must continue to service the debt until it becomes clear that it is unpayable. And that means a considerable amount of economic pain until this point is reached as in Greece.

Ireland, on the other hand, despite having socialised its banks losses like Iceland, is in a fundamentally better position than Greece. Its debt-to-GDP is lower, it’s structural deficit is also lower, and it has good export competitiveness. Ireland is also doing better economically after doing a real cliff dive. It is the banks in Ireland which are insolvent and these losses, having been socialised, are threatening the sovereign with insolvency too. The right thing to do would be to de-couple the bank/sovereign issue by rescinding the senior and junior bank debt guarantees. And politically, this would also be favourable with the Irish people as well. Bottom line: Ireland will probably default, but I think it will default on bank debt. A sovereign default is also possible.

Portugal is the next Greece. It will default. If I had to bet on any next default, it would be Portugal. Portugal still has a large current account deficit after a decade of running them (over 10% of GDP for 10 years). Net foreign debt is more than 100 percent of GDP and government debt to GDP is above 80%. Now, Portugal’s privatisation program is more advanced than Greece’s and Portugal has initiated labor market reforms with the government, and the main trade unions all agreeing. And Portugal has been much more successful in cutting its deficit than Greece. But austerity is still debt deflationary and Portugal’s bond yields are still high. When the present IMF program is over and Portugal has to come to market for debt, it won’t be able to. That is when the default will occur if not before. With Greece as a precedent, Portugal would insist on haircuts for private bondholders.

Italy and Spain each will always face a liquidity-induced insolvency without central bank intervention. The price action in their sovereign debt confirms this. When we hit the 6% threshold, investors sell bonds and yields rise as the liquidity crisis becomes a self-fulfilling spiral: higher yields begetting worsening macro fundamentals leading to higher default risk and therefore even higher yields. In this sense Italy and Spain are really no different than Greece, Ireland and Portugal.

But, as mentioned above, Spain and Italy are too big to fail.  This is where the rubber hits the road on policy. In running through Italian default scenarios in November it was obvious to me that an Italian (or Spanish) default would mean Depression. Their economies are simply too large and interconnected with other world economies to suffer a sovereign default without serious financial market and economic trauma. And I believe European policy makers are smart enough to avoid this. If necessary, Europe will change the institutional arrangements or allow these countries to leave the euro zone. It is that important.

Breakup. I think Greece’s departure from the euro zone is inevitable. I wrote how and why Greece will leave the euro zone and discussed the political economy of a Greek default (and euro zone exit) in February. The question is whether any of the other countries can and will leave, especially if Greece leaves. Because of the importance of Spain and Italy, I continue to predict that Europe will make an unlimited commitment to Spanish and Italian bonds as a lender of last resort through the back door mechanisms it has devised. However, they will need to make changes to institutional arrangements for this to hold because the present policy is unsustainable. Therefore, I also continue to expect Europe to move to change its constitution to include greater fiscal integration, but also to include explicit mechanisms for countries to leave the euro area. It may eventually need to allow the ECB more discretion in the case of credit crises like the one we are witnessing.


At a minimum, I don’t think a breakup would happen straight away because we are in a crisis and a breakup now would also lead to a significant economic Depression. But once the situation is stabilised, thoughts will turn to these issues. If the situation spirals down due to the debt deflationary policy response, then yes we could see more than just Greece depart. But the Europeans will do their utmost to heap as much pain on Greece as they can to make that an unpalatable path.

Conclusion: So the crisis will continue and the potential for a ‘policy mistake’ will increase the longer it does. However, given the conflicting political considerations, Europe has few choices available. For now, it will dither through, reacting as necessary at each step of the crisis until the union breaks up or heals and moves to fiscal integration. Along the way, a re-default by Greece is likely, a Portuguese default will be inevitable, an Irish default possible, and a Spanish or Italian default unthinkable.


Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.