Is a Sovereign Credit Event a Disaster?by Edwin M. Truman | July 20th, 2011 | 03:45 pm
On both sides of the Atlantic, policymakers face sovereign credit events. If those events materialize, will the result be a disaster? Yes and no. Yes if the credit event occurs in the context of a failure by policymakers to address convincingly the underlying short-term and medium-term economic, financial, and political issues. No if the credit event occurs in the context of a convincing program to address those issues.
Who has to be convinced? Market participants and the general public more broadly will be the final arbiters—not the accountants and credit rating agencies (CRAs). At present, markets are far from convinced that policymakers will come close to doing the right thing, and the general public is confused about the implications of a sovereign credit event.
In the United States, a failure to raise the limit on the debt limit by August 2 would produce a credit event in the form of a default by the federal government on some or all of its obligations. As reported by the Pew Research Center the People and the Press on July 18, 2011, however, the US general public is divided 40-39 percent on whether such an event would lead an economic crisis and associated major economic problems.
Jean-Claude Trichet, president of the European Central Bank (ECB), said on July 18: “A credit event, selective default or default must be avoided . . . [because] who would consider a default of any sovereign country, in the context of a European and global crisis of public finances, a good solution?” His former ECB colleague Otmar Issing on the same day told the Frankfurter Algemeine Zeitung that a debt restructuring in Greece would be the “worst possible accident” for the economic and monetary union (EMU) in Europe because it would cause Greece to stop its economic reform efforts and undermine similar efforts elsewhere in the euro area. On the other hand, George Soros was quoted as telling the British Broadcasting Company that the European Union (EU) is in denial about the “basic bankruptcy” of Greece, and many other economists and political commentators agree with him.
Why all the confusion? First, it is useful to remember the technical definition of a credit event. The International Swaps and Derivatives Association (ISDA), in its master agreement, lists six credit events: bankruptcy, obligation acceleration, obligation default, failure to pay, repudiation or moratorium, and restructuring. The last occurs when the terms governing the obligation have become less favorable to the holders than they would otherwise have been. Some of these events require judgments, which is where the accountants and the CRAs come in.
Second, context matters. If a credit event occurs in the context of a complete failure by policymakers to address the underlying short-term or longer-term problems, the credit event will be consequential for the relevant economy and financial system regardless of what the accountants and CRAs say. If a credit event occurs in the context of a convincing effort to address the underlying problem or problems, it will be less consequential and may even be positive because the resulting obligations should bear a lower risk of default in the wake of the event.
Let’s look at the US and European cases.
The United States faces a medium-term sovereign debt problem in the context of a weak economy and profound disagreement over how the country got in this position and how to get out of it. Nevertheless, the United States faces a relatively well-defined two-by-two choice: how to distribute the improvement in the US fiscal position between the short term and the longer term (timing) and how to distribute the improvement between expenditure reductions and revenue increases (modality). This is one important difference between the US and the European situations. If before or after August 2, with or without a technical credit event, US policymakers succeed in substantially addressing the US medium-term fiscal problem, then regardless of what the accountants or CRAs say the United States will be better off. On the other hand, if policymakers kick the can down the road with or without triggering a technical credit event, the US credit standing and the health and stability of the US economy and financial system will be increasingly at risk. The political integrity of the United States would not be at risk, however. This is a second important difference between the US and the European situations.
Europe defined as either the European Union or the euro area faces a much more complex set of problems. Four issues are most prominent: (1) The Greek economic and financial reform program and the prospect that Greek sovereign debt is, or soon will be, unsustainable. (2) Ring-fencing is needed to limit the impacts of what is done for and with Greece on the economic reform, financial reform, and debt sustainability on other members of the euro area and European Union, starting with Ireland and Portugal, but including Italy, Spain, and even countries like the United Kingdom, Sweden, and Hungary, which are outside of the euro area. (3) Steps are necessary to ensure the stability of major European financial institutions so that they can support the recovery of the European economy. (4) The euro area must be stabilized and the European project, which has evolved over more than 50 years, should move forward. Only a comprehensive program will do the job. The economic and financing aspects of the program involve more than filling in the cells in a two-by-two matrix, and the program has an important political dimension.
If within the next few days, or weeks at most, European policymakers end their shell games of the past 18 months and commit to a comprehensive program to support economic and financial reform in each of the members of the European Union individually and to support the European financial institutions and the European project, the European Union and the euro area will be stronger whether or not a credit event is technically part of the mix. European leaders must squarely address the challenges that face them rather than focusing on how the accountants and CRAs score their actions. In other words, Jean-Claude Trichet’s focus on the technicalities fails to advance the substance.
If within the next few weeks, or months at most, Greek citizens and policymakers abandon all hope of a better future, then who knows where the rot will stop. Whether or not a credit event is part of the scenario will be the least of the problems facing Europe. In other words, Otmar Issing appears to be reading the incentives incorrectly. The central issue for the European project is not to avoid the possible moral hazard for Greece induced by a sovereign restructuring of its debt; the central issue is the risk to the European project derived from a lack of policy determination in Greece and elsewhere induced by a lack of collective outside support for those difficult choices. If accompanied by other needed actions in Greece and in Europe, a restructuring of Greek sovereign debt, by definition a credit event, would stabilize the euro and advance the European project.
Both the United States and Europe face the near-term prospect of credit events. Depending on the context, those events, if they occur, may have serious consequences or be non-events. The challenges facing European policymakers are more existential in nature. However, if policymakers in either case mishandle the substance, the potential adverse effects will extend beyond the United States or Europe to the health and stability of the global economic and financial system.