Iceland on the Thames Can Countries Really Go Bankrupt?

By SPIEGEL Staff

Part 2: The Euro Safety Net


Prior to their adoption of the euro, countries like Italy, Greece or Spain simply devalued their currencies in troublesome times and lowered their interest rates to increase the export opportunities for their economies. As members of the euro zone today, however, this option is no longer available because of stringent budget rules in place to ensure the common currency's stability.

The potential collapse of the euro zone has been a hot topic in financial market circles recently. One problem is that the euro treaty doesn't have provisions aimed at allowing highly indebted countries to voluntarily exit the common currency. Even if it did, though -- any countries to leave the euro zone would simply exacerbate their problems. Their credit ratings would plummet further, loans would get more expensive. And old debts would have to be repayed in euros. If their own currency devaluated, that would get even more expensive. Germany's EU commissioner, Günter Verheugen, considers the debate over exiting the euro to be "purely cheap propaganda against the euro from speculators in the Anglo-American capital markets."

European currencies are having a difficult time.
DER SPIEGEL

European currencies are having a difficult time.

But what would actually happen if a euro zone member state went bankrupt? During the next 24 months, for example, Greece will have to come up with €48 billion in order to service old debts, while at the same time plugging holes in its budgets.

If a country like Greece became insolvent, it would be initially be spared of the worst consequences of bankruptcy because of its membership in the euro zone. The euro would lose some of its value, certainly, but the Greek economy doesn't play huge role in Europe and the depreciation would be limited.

The consequences for Greece would also be limited. Because the currency would remain relatively strong, there would be no crisis in the retail sector, there wouldn't be any consumer hoarding and no black market -- in other words, it wouldn't create an economic crisis any greater than the one that would already exist. Nor would it lead to an increase in unexmployment.

Under the protective shield of the European Union, life in a bankrupt state would be relatively comfortable. The more important question, though, is how the EU would react.

Worst-Case Scenario

One scenario is that it could declare Greece to be an exceptional case and provide bridge loans in order to prevent the bankruptcy. But it would have disastrous consequences. After all, why would weak countries make any effort to balance their budgets if they knew the EU would bail them out in the worst-case scenario.

If the EU remained firm against Greece, that would certainly be fair to the member states who have practiced balanced budget discipline in the past. But that would also be politically untenable because it would drive investors away from any country that showed even the slightest signs of not being able to service its debt. They would have to continue raising the interest rates on bonds, and eventually the Greek virus would spread further, driving other countries into bankruptcy.

In this highly theoretical scenario, the euro would, indeed, collapse. The currency could survive the bankruptcy of one member state, but it couldn't sustain a series of them.

Euro-skeptics have long warned that tension inside the euro zone could destroy the currency one day. They now feel their convictions have been affirmed -- even if the aforementioned scenarios remain far from reality.

Iceland is as good as bankrupt: Will other European countries follow?
DPA

Iceland is as good as bankrupt: Will other European countries follow?

Germany itself has little trouble getting money. But even here, in light of the multibillion euro shortfalls in the national budget, investors are slowly starting to get nervous about German bonds. Many uncertain investors are starting to ask "what the future looks like for countries with AAA ratings," says Moody's analyst Alexander Kockerbeck. Experts at the US ratings company are already feeding worst-case scenarios into their computers. In one, they input test data for 2010 and 2011 assuming the economy would shrink by 3 percent each year. In that model, the national deficit rose quickly from today's close to 70 percent to 80 percent of GDP.

"The interest burden would be around 7 percent of government revenues," Kockerbeck said, saying Germany could still manage to preserve its high credit rating. But if that figure got up to 10 percent, the country might lose the best rating, causing its financing costs to soar.

Competing ratings agency Standard & Poors, which last week cut Spain's rating, holds a similar view. Analyst Kair Stukenbrock last week confirmed Germany's AAA rating. He also said he currently "assumes that the German economy and government budget can weather the current financial crisis without losing its credit worthiness."

Strangled by Interest Payments

In normal times, assuming a country has a solid credit rating and a good economy, borrowing is routine. Germany routinely floats short- and long-term bonds that pay interest. They can have a duration from anywhere between one day and 30 years. But some other countries, including Spain and France, even issue 50-year bonds. They are mostly sold through auctions -- and the higher the price, the cheaper it is for countries to borrow, but that also reduces profits for investors.

Repaying that debt is far more complicated. In the simplest case, the country just pays back the debt. It's extremely rare, of course, for a country to do that. In most cases countries renew their debt rather than repay it -- and by doing so they create new debt. Already today, the German government must pay €43 billion a year in interest. It's the second-biggest chunk in the federal budget after social expenditures.

But that could quickly change. If, for example, interest rates were to rise to their 1995 levels, the country would be faced with an additional €20 billion in payments, and that's without factoring in any new debt. Of course, given the nature of the current crisis, the debt burden will rise. Nobody knows how high, nor how the country can eliminate that debt before it starts to get strangled by interest payments.

One way to pay down debt, of course, is massive spending cuts and austere savings probrams. That, though, is difficult. Much more attractive is the inflation route. The state can just print money and pay its bills. Or the central bank prints money and pumps it into the economy. The currency becomes devalued, but the state doesn't care because that makes it easier to pay off its debts.

Riot policemen walk during clashes with demonstrators during a protest in Riga on Jan. 13.
AFP

Riot policemen walk during clashes with demonstrators during a protest in Riga on Jan. 13.

No matter how a country elects to pay down its debt, it's the taxpayers who are left to foot the bill in the end. Indeed, the only time it is possible to repay the deficit by government savings is during boom phases, periods when the government can increase taxes, or if it can reduce its expenditures.

The people also pay the price of inflation because as the currency get devaluated, prices increase.

Up until now, the process has been subtle. Since the end of the 1990s, the major central banks in the US and Europe have trippled the volume of money in circulation. In recent months, the volume of money in circulation in the US and Europe has increased by almost half.

Universal Phenomenon

Central banks are trying to use the flood of liquidity to prevent a collapse of the global financial system and, as a result, of economies. At the same time, they may also be laying the path for the next crisis. Money is already insanely cheap: the US Federal Reserve has sunk its key interest rates to almost zero, and the European Central Bank is already down to 2 percent. It is extremely likely that interest rates will be lowered even further.

But if the bailout packages take effect and the economy starts to rebound, then central banks will again raise interest rates -- otherwise we would be threatened with a massive wave of inflation and the next, even worse crisis, would be inescapable. But the move may also lead many highly indebted countries to go bankrupt.

In a study for the International Monetary Fund, US economists Carmen Reinhart and Kenneth Rogoff researched financial crises of the last 800 years and concluded that state bankruptcies were a "universal phenomenon." Many countries have, in fact, gone bankrupt more than once.

Between 1500 and 1800, France became insolvent eight times. Spain went bankrupt seven times during the 19th century. Insolvency is a common phenomenon in every period of history, they concluded, and it would be erroneous to think that state bankruptcies are a "distinctive feature of the modern financial world."

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