The following contribution is authored by Simon Johnson, a former chief economist of the International Monetary Fund (IMF) and Peter Boone, chairman of Effective Intervention at the London School of Economics' Centre for Economic Performance.
"German Finance Minister Wolfgang Schäuble likes to criticise other governments, including that of the United States, for their 'irresponsible' policies. Ironically, it is the German government's loose talk that has brought Europe to the brink of another debt crisis.
The Germans, responding to the understandable public backlash against taxpayer-financed bailouts for banks and indebted countries, are sensibly calling for mechanisms to permit 'wider burden sharing'– meaning losses for creditors. Yet their new proposals, which bizarrely imply that defaults can happen only after mid-2013, defy the basic economics of debt defaults.
The Germans should recall the last episode of widespread sovereign default – Latin America in the 1970s. That experience showed that countries default when the costs are lower than the benefits. Recent German statements have pushed key European countries decisively closer to that point.
The costs of default depend on how messy things become when payments stop. What are the legal difficulties? How long does default last before the country can reach an agreement with its creditors? How much more must it pay for access to debt markets later?
The benefits of default are the savings on future payments by the government – especially payments to non-residents, who cannot vote. This obviously depends in part on the amount of debt outstanding, the interest rate, and the country's growth prospects if it continues to pay.
Countries that are near the point where 'can't pay' becomes 'won't pay' have high interest rates relative to benchmark 'safe' debt issued by other governments, because even small shocks can shift the balance for decision-makers towards default. But these interest-rate spreads make the benefits of non-payment greater, so the same shocks can send a country quickly into default."
To read the op-ed in full, please click here.
(Published in partnership with Project Syndicate.)
