Are sovereign debt crises inevitable?

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Thanks to the ongoing debacle in Greece, we’ve become all too aware about the dangers of the rapid build-up of government debt throughout the developed world in the wake of the financial crisis. The potential consequences of that trend are made ever more frightening in a new study by economists Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard University (authors of the book This Time is Different: Eight Centuries of Financial Folly). They conclude that there is a “strong link” between banking crises and sovereign defaults. In fact, they state, banking crises can help predict sovereign debt crises. Their study spans two centuries and 70 countries, in both the developed and developing world, and makes for some nail-biting reading. Here are their main conclusions:

First, private debt surges fueled by both domestic banking credit growth and external borrowing are a recurring antecedent to domestic banking crises…Second, banking crises (domestic ones and those in international financial centers) often precede or accompany sovereign debt crises. Third, public borrowing accelerates markedly and systematically ahead of a sovereign debt crisis (be it outright default or restructuring).

A frequent contributor to those sovereign debt crises, they explain, is “hidden debts” – for example, private debt that unexpectedly becomes public as a result of the crisis. Here’s what they say:

In a crisis, government debt burdens often come pouring of out the woodwork, exposing solvency issues about which the public seemed blissfully unaware.  One important example is the way governments routinely guarantee the debt of quasi-government agencies that may be taking on a great deal of risk, most notably as was the case of the mortgage giants Fannie Mae and Freddie Mac in the United States.  Indeed, in many economies, the range of implicit government guarantees is breathtaking.

Yet even without the effect of large, banking sector rescues, governments still get themselves into debt trouble simply as a result of the economic pain inflicted by a financial crisis. They explain:

Largely owing to collapsing revenues, government debts typically rise about 86 percent in the three years following a systemic financial crisis, setting the stage for rating downgrades and, in the worst scenario, default.

Reinhart and Rogoff conclude:

Banking crisis are importantly preceded by rapidly rising private indebtedness. But banking crises (even those of a purely private origin) directly increase the likelihood of a sovereign default in their own right (according to our findings) and indirectly as public debts surge.

To state the obvious, we’re going through a banking crisis that is playing out along the exact lines laid out by Reinhart and Rogoff. Does that mean a sovereign debt crisis is inevitable? Not necessarily. I asked Dr. Reinhart this question via email, and here’s what she said:

I think the biggest difference now is attempts at international cooperation that were largely absent in the 1930s. For example, Greece in isolation without the European mantle (and I mean over and beyond the lines of credit the Greek government will be able to tap) might have already slipped into default.

However, she adds that there’s a limit to what such cooperative action can achieve. “These efforts will wear thin in the absence of a robust recovery (which does not yet seem to be in the making),” she adds.

We always hear that, in the case of stocks, past performance doesn’t necessarily ensure future performance. Let’s hope that when it comes to debt defaults, 200 years of evidence doesn’t necessarily predict what will happen in the future either. In my opinion, however, it is impossible to look at the data compiled by Reinhart and Rogoff and not become even more concerned about a coming wave of sovereign debt crises that would be a disaster for the budding global recovery.

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