Monday, April 25, 2011

"The likes of Portugal should default on their debt"

Faced with an increasingly dire financial situation, Portugal has started negotiating a bailout package with the European Union (EU) and the International Monetary Fund (IMF). It follows in the footsteps of Greece and Ireland, two countries where bailouts have proved ineffective. Still, few dare defend the most effective policy option in all three cases: a managed sovereign-debt default.

Such a default would allow the Greek, Irish, and Portuguese governments to push back their accumulated debt obligations, lowering the interest rates they serve, postponing reimbursement, and, if necessary, repaying only part of the capital they owe. Like personal bankruptcy – which allows an over-indebted individual to renegotiate reimbursement terms – a sovereign default allows countries to repay current debts according to future income expectations. A bailout, on the contrary, prioritises lenders by reimbursing them completely and abiding by the initially agreed-upon interest rates and repayment schedules, forcing the government to adjust future income to the weight of accumulated debt.

Bailout proponents continue to sing its praises. By forcing the troubled government to change its economic policy, it supposedly fosters growth and prevents further debt crises. By imposing the majority of the costs on the rescued countries, it purportedly stiffens their fiscal discipline. Finally, by preventing a sovereign default by a member of the eurozone, it allegedly stabilises debt and currency markets.

Upon closer inspection, however, none of these benefits materialise. In Greece and Ireland, bailouts did not stabilise markets, did not encourage economic growth, and did not inspire a change of heart about credit. If anything, these cases suggest that, within the straitjacket of a monetary union, the bailout mix does not work. It requires strict fiscal measures that discourage economic growth and make it impossible to lower the debt-to-GDP ratio. (read more)