Investors are running for the hills these days, shaken to the core by fears that sovereign defaults will roil global markets and derail the shaky recovery. They have a lot to worry about. European leaders will gather for an emergency meeting on Thursday to try to finally hammer out an agreement on a second bailout of tottering Greece – a package very likely to include some sort of de facto default. Contagion threatens to drag other euro zone economies into a similar state. Yields on Spanish and Italian bonds reached fresh euro-era highs on Monday. Meanwhile, across the pond, talks to raise the debt ceiling in the U.S. are stalled by mind-numbing partisan politics in Washington. With so much uncertainty, it’s no surprise that gold hit another all-time high.
Still, are the fears justified? How dangerous are sovereign defaults to the world economy?
The main way a sovereign default could hurt global growth is through its impact on the financial sector. Banks holding the defaulter’s bonds swallow losses and, in severe cases, might need to recapitalize to fill in the holes left in their balance sheets. That means they become conservative and make fewer loans. Then there’s the direct impact on growth from the country that defaults. Invariably, defaults lead to massive contractions in output, as governments get cut off from global financial markets and are forced to implement budget reforms and austerity programs. After Argentina defaulted in 2001, its economy tanked by nearly 11%. Then there is the contagion effect. Investors burned by one country become nervous and flee anything else that could get them into further trouble, potentially causing a series of sovereign defaults that then send shock after shock through the global economy. The IMF painted just such a scenario when warning about risks to the global recovery in June. Olivier Blanchard, director of the IMF’s research department, said:
In the best of cases, improving competitiveness and returning to fiscal health in some of these (European) countries will be a long and painful process. It will require strong policies, namely fiscal consolidation, structural reforms, and policies which protect the most vulnerable…It’s clear that these countries cannot get out of the hole alone. The stakes are very high; failure to commit and implement policies or failure to deliver on financing, hold the risk of triggering disorderly financial and sovereign defaults. Contagion through various channels to the rest of Europe then holds the risk of derailing the European recovery and perhaps even the world recovery.
At the same time, the euro debt crisis has been simmering for 18 months, and these fears have remained just that – fears. Sure, markets have been in turmoil, but the overall economic chaos caused by Europe’s debt woes has, despite the dire warnings, been relatively limited. The euro crisis might be one factor behind the slow recovery of the global economy, but I doubt anyone would say it is the primary factor. The dampening effects of continued high employment and housing market busts in the U.S. and other advanced economies, we could argue, are bigger than Europe’s debt problems.
The fact is that the world economy regularly absorbs the shock of sovereign defaults. Despite the common belief that states are “safer” investments than, say, corporations, governments stiff their creditors with startling regularity. In fact, sovereign defaults go as far back as the origins of the sovereign state itself. The first recorded case took place (ironically) in Greece in the 4th century BCE, when metropolises failed to pay back loans granted by a temple. In modern times, we’ve witnessed several spectacular crashes, including Argentina and Russia (1998). Such defaults are always destabilizing events, but the global economy seems to weather them without massive upheaval. The dotcom bust did far more damage to global growth than Argentina’s bust.
Nor do defaults seem to inflict that much pain on the wayward countries themselves. The Economist recently noted that in many (but not all) cases, economies fell sharply after the immediate default, but then rebounded quite strongly thereafter. In other words, the overall economic impact of a default seems to be sharp but short. The Argentina case is especially interesting (as explained in this Financial Times piece) since its post-default economic record has been surprisingly robust.
Will the same be true this time around? In the medium term, the prospects for the Greeks look bleak, and a default would clearly rattle the European banking system, with possible ripple effects spreading out to the U.S. from there. But still, Greece is a small economy (about $300 billion), and in the end the impact of a Greek default might not be as severe as, for example, the 2008 collapse of Lehman Brothers. And the same is true of Ireland and Portugal. The three economies combined account for a mere 6% of the GDP of the euro zone. It is telling that the IMF raised its growth forecast for the euro area at the same moment Blanchard made the above comment, to 2% in 2011. As Greece, Ireland, Portugal and Spain struggle, economies like Germany are powering ahead, apparently unfazed. The failings of the PIIGS aren’t even undermining European growth, let alone global growth.
On the other hand, though, the current sovereign debt crises are taking us into somewhat uncharted territory. The recent history of sovereign defaults has been confined to emerging markets. Now the problem is taking place in the center of the developed world. And because of Europe’s monetary union, the tiny economies of Greece, Ireland and Portugal and linked to the very big economies of Italy and Spain. The major risk here is that a couple minor defaults in Greece and other peripheral European economies so sours investor sentiment that the problem expands to larger economies that can create much more dangerous global shockwaves. Then we’re looking at something truly terrifying, with unknown consequences for the global economy. (And if the U.S. can’t find a way of lifting its debt ceiling, we could see a default of biblical proportions that would fundamentally change the global economy, due to the unique role the U.S. plays in the world. Though I still believe that outcome is extremely unlikely.)
Perhaps the bigger risk to growth will come from how other governments react to the sovereign debt crises on the European periphery. Panicked budget cutting and austerity measures implemented in economies not under the same pressure (i.e. the U.S.) could have much more severe consequences for the global economy than any actual sovereign default in a country like Greece. The problem we’re facing today is that the debt crises burning away in Europe are occurring at a time when the global economy is already so weak from other factors, making us much more vulnerable to shocks.
So in the end, we might be overestimating the overall impact of a sovereign default or two, especially if they remain limited to smaller economies. Yet with the global recovery so anemic, it might be better if we don’t find out.