Domino theory
Feb 18th 2010 WASHINGTON, DC
From The Economist print edition
Assessing the risk that Greece’s woes herald something far worse
Satoshi Kambayashi
HOW far is it from Athens to America and which countries lie on the way? That may sound like an esoteric geography question, but it is being asked by investors as Greece’s debt crisis creates global jitters about the safety of sovereign debt. So far Portugal, Ireland and Spain, the other high-deficit countries on the periphery of the euro zone, are thought to be next in line. In most big rich economies, yields have been stable and well below their long-term average (see chart).
But nerves are fraying elsewhere. The cost of insuring against sovereign default has risen in 47 of the 50 countries for which these instruments exist. Dubai’s sovereign credit-default-swap spreads soared to their highest level in a year this week, amid concern about the terms of a debt restructuring by a state-owned conglomerate. There is increasingly shrill commentary arguing that Greece is the start of a far bigger problem. “A Greek crisis is coming to America”, blared the headline on a recent Financial Times article by Niall Ferguson, a financial historian.
The stakes are high. A sudden loss of confidence in all sovereign debt, and especially in American Treasuries, the world’s benchmark “risk-free” asset, would have calamitous consequences in a still-fragile recovery. Equally, an exaggerated fear of sovereign risk could prompt governments into premature fiscal austerity, which might itself push the world economy back into recession.
Neither the shrill nor the sanguine arguments can be dismissed out of hand. Fiscal pessimists point both to past experience and to the arithmetic of public debt for evidence that sovereign-debt crises could spread far beyond Greece. The lesson of history, as documented in a magisterial study of financial crises by Carmen Reinhart and Ken Rogoff, is that public debt tends to soar after financial crises, rising by an average of 86% in real terms. Sovereign defaults have often followed.
The arithmetic argument for pessimism is equally compelling. Virtually no rich country has a “sustainable” debt position, in the narrow sense that none is running a tight enough budget or is growing quickly enough to stop its debt burden from rising. The worst offenders on this count are the euro area’s peripheral economies, as well as Britain and America.
Greece stands out for the size of its debt stock, the scale of its budget deficit and the grimness of its growth prospects given high domestic costs and an inability to devalue. Worries about where growth will come from are the main reason why fears have, so far, focused on the other weak members of the euro zone (although Spain attracted decent demand for a 15-year bond sale on February 17th).
America and Britain, having their own currencies, are in a different position. But they are not immune to concerns about growth and debt dynamics. On February 18th Britain reported a deficit for January, a month of surplus since records began in 1993. Pessimists also fret about the sheer scale of America’s public borrowing and, especially, China’s role in funding it. News that foreign demand for Treasuries fell sharply in December and that Beijing was a big seller has fanned their concerns.
Nonsense, says the sanguine camp, whose members include Paul Krugman, a prominent New York Times columnist. In their view, those who fear a sudden rise in sovereign risk, particularly for America, misunderstand the reasons for the build-up of sovereign debt and underestimate the role of Treasuries as a safe haven. Sovereign-bond yields are low because private demand for capital is weak. And it is likely to stay that way as Anglo-Saxon households rebuild their savings and firms hold back from investing.
On this view, America and Britain are better compared to Japan than to Greece. Japan’s public debt—almost 200% of GDP on a gross basis—has risen steadily in the two decades since its asset bubble burst. It is far higher than in any Anglo-Saxon economies. Despite several downgrades, Japan has not had a debt crisis.
It is true that Japan, as a big creditor nation, can tap into ample savings at home, whereas America relies more on foreign investors. But the breadth of the financial crisis across the rich world, and hence the surfeit of savings relative to investment, means this distinction can be overdone. What is more, investors still flee to, not from, American assets when they worry about risk. The dollar has risen by 4.8% against the euro since the start of the year. Existing investors in American debt, such as China, have no incentive to drive down its value with a fire sale of their holdings.
If Greece’s plight shows that investor sentiment can change quickly and Japan’s history shows that it need not, where do other sovereigns stand? So far low yields have vindicated the sanguine view for all but those on the very edge of the euro zone. But there are three reasons to believe that could change.
The first lies in the strength of emerging markets. A gradual reorientation of their economies towards domestic spending will slowly reduce the global supply of savings, even if rich-country growth remains weak. Other things being equal, that ought to push up the cost of capital. At the same time rapid growth means most emerging economies’ sovereign-debt ratios, already much lower than those in the rich world, will fall. True, rich countries can point to a far superior payment record. Over the past 50 years sovereign defaults have been confined to the emerging world. But the definition of what is a “safe” borrower could shift, benefiting Brazil, say, and hurting America and Britain.
Second, the debt problems in big rich economies go well beyond the temporary effects of the crisis. It is thanks to an ageing population and soaring health and pension costs that America’s debt ratio will still be rising in a decade. Investors have long shrugged off this structural deterioration. Insouciance seems less likely when the starting point is much higher debt.
Third, the rise in interest rates that should naturally accompany an economic recovery and increased investment demand might itself spawn a higher risk premium on sovereign debt, especially in America. The average maturity on federal debt is less than five years, so higher yields translate relatively quickly into bigger interest payments, worsening the fiscal position. Richard Berner of Morgan Stanley expects ten-year bond yields to reach 5.5% by December, up from 3.7% now.
None of these possibilities suggests that America or Britain is at risk of a debt crisis, in the sense that bond yields soar as investors suddenly flee. But they do suggest that a bigger rise in yields than expected and a subsequent worsening of their debt position is possible. That demands a credible medium-term plan to cut deficits. Otherwise Greece’s problems could be the start of something much bigger.
Copyright © 2010 The Economist Newspaper and The Economist Group. All rights reserved.
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