If youve been following recent news events in the US and eurozone youll be aware that we seem to be either in the middle of, or on the verge of, a major sovereign debt crisis. From the possibility of a default from some troubled eurozone country like Ireland or Greece to the amateur theatrics played out in Washington last week and now the down grading of the US credit rating. In both these cases, America in particular, it has been the ineptitude of clueless (and largely spineless) politicians that is the real cause for concern, rather than events in the treasury department, the chances of an actual default in the short term were always slim (as Steph Flanders at the Beeb points out). But as I pointed out here, events have now shown how US politicians are arguably powerless to truly do anything about the debt crisis as nobody in America, neither Democrat nor Republican, wants to see big cuts in public spending, nor taxes going up (and the Republicans are probably the worst offenders, see my comments on that here) so its unlikely the matter will get solved before the US goes over the cliff. And the eurozone debt crisis involves similar political problems (as I discuss here).
But what exactly happens when a country defaults on its debts? What if a government goes bankrupt? While smaller nations run by foreign puppet dictators have gone bankrupt from time to time (often deliberately so, read Confessions of an economic hitman), never have we had to worry about a major western country going this way. We’ve certainly never faced the prospect of several major economies defaulting more or less at once and until a few weeks ago the mere thought that the US could one day default was seen as unthinkable (well to the economists, I’ve been saying its probable for many years now). Thus there is in essence no procedure for how to handle this situation. I mean if a country refuses to pay off it debts, its not as if the Chinese can slap a repossession order on the White House or that Goldman Sachs can send some guys around to beat up the Greek President with a tyre iron tho it seems the Greek people and a small dog are doing a fairly good job of that anyway!
Listen to the economists and theyll tell you that if, say, Greece were to default on its debts (some of it owed to them of course!) that a Black hole would open in the Aegean and swallow the country whole I mean shortly after the financial crisis in Iceland which did indeed default on its debts didnt the whole Island blow up and sink back into the Atlantic? As we will see, this fearmongering takes things to something of an extreme and can be discounted. But certainly there are some potentially nasty consequences if a country defaults on its debts which we need to be concerned about. In this article I will explore these issues, in particular the possible impacts for the man on the street and future energy use.
I should note from the start that Im not an economists, thought given the mess theyve made of the global economy I think that makes my two cents on all this more reliable!
When is a default not a default?
Firstly it would be fitting to define what we mean by a default on ones debts. Granted with you or me its pretty clear cut (I ring up the loan company, call them scum and post them the shredded remains of the contract), but with governments it comes in varying degrees.
For example the policies of the US right now, Quantitative Easing, low interest rates with high inflation (relative to current economic conditions) and a failure to properly defend the value of the dollar could be considered a default as it were by default (if youll pardon the pun). Or as its called in the industry a “soft” default.
Consider that prior to the US credit downgrade on Friday, US treasury bonds were averaging a 10 year yield of just 3%, but US inflation rate is officially 3.6% (unofficially around 6%) and the US dollar has depreciated in value against foreign currencies since the start of the financial crisis, about 5-12% per annum depending on which currency we compare it to, even against the Euro its down about 7% over the last year despite the euros many woes. Add it all up and anyone holding US treasury bonds is loosing money on those investments with every day that they hold on to them.
So in essence I would argue that the US is already in a state of default, and that AA+ rating is still not worth the paper its printed on. Indeed given that several Eurozone countries, such as Greece have technically not yet defaulted on their debts (though some default is probably now inevitable) but have had credit ratings reduced to junk status, yet the US is arguably in default and its rated AA+. What gives? This should show you how bias the rating agencies are against the Eurozone and favourable towards the US and UK. The fact that many of these same rating agencies are based in London and New York (so the rating agency staff have savings and a mortgage in US/UK bank accounts) and have strong financial ties to companies heavily invested in the US, many of whom were taking bets against the euro for some time, is all purely coincidental (and if you believe that here’s some magic beans for you to buy!).
While in the short term treasury bonds will still be purchased, largely because the dollar is still seen as a safe haven and there are strong political reasons for China, Middle East oil producers and the Japanese to support the dollar, these conditions are temporary. If the US doesnt get a hold of its problems, or if the political winds change (China and America fall out over something), or the Eurozone crisis blows over and the euro gets viewed as a better safe haven or the Chinese begin to use theyre currency as a global reserve currency (a beeb article about that here) then Washington, New York (and the rating agencies) will be in big trouble.
A more serious default situation could occur where for example a debtor promises to honour its debt obligations, but not pay any interest on them (youll get your money back, but it would be worth a lot when were finished and youll make zero profit) or more serious again, it opts to give investors a so-called haircut as happened to investors in Irish banks back during the Irish banking crisis. As part of the initial negotiations to the IMF the Irish proposed a similar policy towards international lenders (who after all have to share some of the blame for lending recklessly to Irish banks) but this was blocked by the US treasury department (main street bailing out Wall street yet again, see Morgan Kellys, aka “Dr Doom’s”, very informative article which mentions this here).
The worst case scenario, a nation simply refuses to pay anything back (the head of central bank comes out, breaks open the state piggy bank to reveal nothing but a few penny sweets and gum rappers), a so-called “hard” default, in which case investors stand to loose pretty much everything. So depending on these scenarios what happens next? And what is the impact for the average Joe?
Firstly its worth remembering that the bulk of national debts are held by other nations, typically lender nations such as China, Japan, German, Austria, Scandinavia, the Gulf States, etc. So in theory the consequences of a default are largely political. Lets face facts most governments squander cash sufficiently well by themselves that they are hardly in a position to complain if another government does the job for them, and furthermore the lender shares some of the blame for lending money recklessly in the first place. Usually such lending was undertaken for poltical reasons, and the politicians in the lender state need to take some of the rap for ignoring economic advice.
So the likely outcome in many cases is the only end result is a lot of awkward moments at international group hugging fests (G-8, G-33, UN, etc.). For example Ireland is being put under pressure by some to raise its rate of corporation tax. One can see the Chinese getting a bit more bullish if the US defaults on them. Indeed they are already fuming. But its not as if they can declare war or something then again, wars have been started over a lot less than a few trillion dollars!
The danger is that if the lender nations get burned they will be more reluctant to lend in future and charge higher interest rates. That could have negative consequences well discuss later. Also some lender nations, and I specifically mention Japan, could be in financial trouble if certain debts are not repaid (as Japan has financial problems of its own making right now due to 8 years of economic stagnation and the recent Tsunami). Thus a default of say, Italy, could trigger a default of France or a default of America could cause Japan to default. This could lead to a contagion of debt spreading from country to country leading to a chain reaction of sovereign defaults.
Ben Bernanke and the Masters of the Universe
But quite a lot of sovereign debt is held by financial institutions (pension funds, hedge funds, private equity firms, banks, drug dealers, money laundering operations, ponzi schemes, etc.). What do the banks do if a country defaults on them?
Well in theory what they do is go whistle dixie! Capitalism is a game of win some, lose some. Deals do go bad, money is lost, but the returns on the deals that succeed outweigh these losses and result in a net profit. That’s the rules of the game. These financial institutions should be hedging theyre bets to account for the possibly of a sovereign default. And quite honestly, you start charging Greece 20% interest on its loans (as was the case at one point in the recent crisis) and you dont anticipate the risk that they might default on that loan, you need youre head examined! Even the goon squad of a back alley loan shark can figure that one out. Whats that you say? Its all the rating agencys fault as they rated sovereign debts AAA ..same as they did to the sub-prime mortgages and Enron and LTCM, Worldcom, Bear Sterns, Lehman Brothers, Fannie/Freddie ,etc. Fool me once, shame on you, fool me twice, shame on me, fool me 234 times WTF is going on here! The warning signs of this crisis have been around for years if not decades, so theyve no excuses. And if they are unable to determine a risk that a five year old child could identify, then I fail to see how these bankers are deserving of their generous salaries.
But I digress! So capitalist theory would say the only outcome from such sovereign defaults would be that a few of the masters of the universe in these firms see their Christmas bonus replaced with a little pink slip.
Unfortunately, as the financial crisis of a few years ago showed, the money markets dont exactly work according to the rules of capitalism. Many of the spivs and speculators in New York and London got greedy in the boom years. Drunk on the high returns during the 2000s asset bubble they forgot about the lose some part of capitalism and did nothing to hedge theyre bets to consider the possibly of large numbers of deals going bad, as ultimately happened in 2008. Consequently now, as then, if a series of sovereign defaults were to begin this could trigger another banking crisis and a credit crunch. The only difference being that there will be no taxpayer bailout, as it would be the financial woes of governments which would be the trigger for the crisis. And with it clear the taxpayer got conned (again see Morgan Kelly’s article) by the last bailout I doubt the public would support another package of them, even if states could afford too.
Given that the links between the bond market trading floor and ones local high street branch (where Billy keeps his pocket money and Grandma has her little nest egg) have not been fully broken (they should have been, but they werent), there is a danger of this market contagion spreading right through the entire financial system right down to Main street itself. Now, this is the worst case scenario I stress, but it is indeed a risk. What happens then?
The Day After
So what happens after the above financial tsunami hits? A good example would be to look at Iceland yes its still there! And contrary to what the Wall street Journal would have you believe trolls did not descend from the hills and eat all the children. Here the countrys banks all but collapsed with the government refusing to bail them out and defaulting on any debt obligations related to said banks. Actually, the economy now seems to have turned a corner and things are slowly improving. At the end of the day, people still need to eat, sleep and drink and someone needs to supply goods and services. So rumours of Icelands economic death are greatly exaggerated.
Certainly everything is not rosy in the Icelandic garden, people are having trouble getting credit, there are issues with inflation, high unemployment and many are living under the risk of foreclosure. Indeed, its interesting to note that despite the Icelandic default its credit rating is higher than some eurozone countries who, like I said, have yet to actually default on their debts, go figure! But to say as that without banks, all economic activity will simply cease to function if the balloon goes up (as is the mantra youll hear from the right wing press) is simply not the case. And of course a total collapse of the entire global banking sector is a pretty unlikely, even in a worst case (sovereign debt crisis) scenario. Certain lending institutions, credit unions and building societies for example, are forbidden from investing in the sorts of funds at risk and should ultimately weather the economic storm. And not all financial institutions are vulnerable. For example, the Barclays banking group weathered the 2007 crisis better than most as it seems its board never fully bought into the whole Sub-Prime ponzi scheme (or so my spies tell me!).
But certainly there will be some negative consequences of a major sovereign debt crisis. Firstly, governments that are now addicted to debt will find they need to stop borrowing (cos nobody will lend to them!), balance the budget and make some effort to pay off creditors. This will mean some quite steep austerity measures being taken, with large scale redundancies in the public sector and steep tax rises. The Irish 2009 budget should be a wake up call for such countrys, America in particular. It will likely have to cut down (and possibly sell off) much of its surplus military hardware (and if that sounds fanciful note that much of the Yugoslav navy is currently still up for grabs, if youre looking for a bargain!) and military bases. Downtown property (some Federal buildings) and maybe even some national parks might be sold off, as well as its gold, sliver, oil and helium reserves. Its possible that the various DoE and NASA sciences centres (JPL, Livermore, ORNL) will be sold off to the private sector, merged or simply closed down. A good idea of the economic impact of this can be gauged from the recent shutdown of the US space shuttle program in Florida (see here). I would note that I’m not necessarily advocating these policies, merely describing a likely outcome of the crisis. So with many hundreds of thousands of unemployed civil servants, some of them with PhDs and impeccable qualifications, getting a job is going to be much harder. And with so much ex-government hardware and assets in the bargain bazaar, the world economy could well turn into a massive bear market with relatively low prices for certain commodities.
High inflation or even hyperinflation is also a risk. Thats good news and bad news. If you owe money it means the amount you owe in relative terms will decline. Several people who lived through the post-communist era in eastern Europe have told me how they were able to buy theyre houses quite cheaply when the mortgage they were paying on it got pretty much wiped out by high inflation. Unfortunately if you have savings or a pension plan, that will likely get wiped out too, so this is only good news if you dont plan on retiring .ever! And of course if the price of basics like food and fuel is rising quicker than wages (which might even be falling) then making ends meet becomes harder, doubly so if you dont have a job.
But its important to note that such issue would likely be temporary. As I noted there are parallels between the current crisis and similar problems that occurred in Eastern Europe and Russia post communism. In both cases reckless implementation of turbo capitalism (so called shock therapy) were to blame. But Russia and Eastern Europe did turn the corner and are now largely over this crisis, indeed most Eastern Europe economies are easily outperforming Western ones.
The Credit crunch to end all credit crunches
But it is the effect on the availability of credit that will be the real casualty of any sovereign debt crisis. The pendulum will swing from its current extreme (cheap NINJA loans easily available to anyone or any country who wants it) to the opposite extreme (see Merchant of Venice). Creditors, be it the Chinese or prudent savers (or indeed me with my little nest egg), will be increasingly unwilling to lend money and will demand higher rates of interest and strict financial guarantees in support of such lending.
Regardless of how financially prudent you think you are, we all need to rely on credit from time to time. Whether youre the Peoples Republic of China or Bridge Farm in the Cotswolds, on the 28th of every month you need to come up with the cash to pay your employees (and suppliers). And its not as if you can pay them with bits of the three gorges dam or Chelsie the cow! Given that there will inevitably be periods, where more is going out than is coming in, the ability to borrow money to meet such temporary short falls is essential. So if lenders all go as tight as a Scottish highland duck with constipation then that creates some major problems, as the necessary business of borrowing becomes harder and more expensive and this leads to a slow down in economic activity.
This potential credit problem could have grave implications in the longer term, particularly as far as our future energy options. Take the issue of renewables roll out. One of the down sides of renewables is that they come with relatively high capital costs at the beginning (thought lower costs later on as you dont need to worry about fuel, or stopping radiation leaking out and decommissioning or site clearance costs are relatively low). Also in order to fully utilise renewables we need to badly refurbish our energy disruption network. This would likely involve converting much of the natural gas grid to run on hydrogen or install a network of HVDC power lines (or as I suspect a bit of both) as well as all the other kit (cars, boilers, chemical works) that consume this energy. All of these assets come with a high initial capital cost, the idea being that you borrow a large block of capital and then gradually pay it off later using the revenue raised from selling energy over the 30-50 year life of the hardware, likely yielding a modest profit as well.
However, if the global credit markets freeze up, then raising the sort of capital needed to get these projects off the ground will be problematic at best and impossible at worst. And should anyone nuclear energy fans reading the above be feeling smug, I think youll find that the initial capital costs of nuclear are actually higher than renewables and nuclear is heavily dependant on state funding (as this report by Citigroup makes plain). Indeed its probable that one of the first causalities of a sovereign debt crisis could be many nations nuclear industry as governments look to cut costs and make savings. Already we are seeing signs of this process, with the sacred white elephant of Thorp possibly about to be sacrificed in the UK and the Canadian decision to sell off its CANDU nuclear reactor building company. So in short nuclear energy could now be facing a slow death by a thousand cuts over the next few decades.
Fossil fuels? Leaving aside all the environmental arguments and the issue of impending peak oil, the really large and critical resources of fossil fuels, such as the Tar Sands of Canada or Marcellus Shale deposits of the US would require a not inconsiderable expenditure of capital to fully exploit, and again were talking hundreds of billions of dollars here. Where is that money going to come from? Mention peak oil to the Saudis and theyll go into a rant about how theyve plenty of oil left, its just a matter of capital resources, if the world could find its way to lend them a few trillion they could easily double output or so they say! Either way, even fossil fuels will struggle to make ends meet in such a credit environment.
In short we really could not have picked a worst time to have a global credit crisis! Its possible some sort of new credit system to support these projects could be found, e.g. large numbers of people, companies and nations essentially buy shares in renewable projects. They are paid back not with money but with electricity or hydrogen sold to them at a heavily discounted rate. Another option is to look at the idea of so-called Islamic finance options where no interest is charged, which may prove in future to be a superior credit control mechanism to the interest based systems favoured at present.
We are in this mess because certain governments and corporations convinced themselves that they can defy the laws of economic gravity. Unfortunately the laws of economic gravity are as absolute as those discovered by Newton. It just takes a tad longer for them to assert themselves. So the solution is for us all to recognise this reality and take action accordingly.
Many governments are spending well beyond there means. As I point out here, the US drastically needs to cut its level of public spending. And top of my list for the budget axe would be the US military budget, farm subsidies and various corporate welfare and political pork barrel programs. By way of example, take the US carrier fleet, they have 11 of them, more than the rest of the worlds fleet combined! Do they really need all those carriers? Consider than new Carrier killing ballistic missiles (available to Russia, China and possibly Iran) have all but rendered carriers obsolete and of only very limited tactical use in an actual war. So why spend tens of billions of dollars on a vast fleet of them? Similarly, many southern European countries need to reassess whether their pension provisions to state workers are overly generous. Now leaving aside the various socialist arguments in favour of such policies, the bottom line is can these governments now afford it? I think not.
Also drastic spending cuts alone are not the only solution, indeed by depressing the economy they can actually make things worse. And it is essential that certain public services get preserved due to the hardship the withdrawal of such services would produce and the fact that the it will simply result in much higher costs being borne by the taxpayer (e.g. a recent survey found the NHS was actually one of the most cost efficient health services in the world, America was towards the bottom, so privatising health care would likely just increase the cost of health care to citizens not decrease them). I discuss this issue in an article here regarding the British railways.
No, if we want decent public services then taxes need to go up as well. The mantra of those on left is that we should tax the rich as they have most of the wealth. While true, and indeed its inevitable that as the rich hold much more disposable income and they will have to take a fairly heavy hit. Much of their wealth isnt exactly in the form thats easy to pay taxes with. Its a tad inconvenient trying to pay your taxes with jars of caviar and the keys to ones Porsche. Also, chances are a lot of the money that they have that could be used to pay higher taxes will just disappear into offshore bank accounts. The antics of the Irish government trying to get the money off of bankrupt property developers under NAMA (National Asset Management Agency, Irelands bad bank) should give you an idea of the problems were discussing (see here and here). So while yes the rich have to accept that their taxes will rise more than the rest of us, we need to be practical and accept we cant magically solve the whole problem just by taxing the rich.
Perhaps a bit of a more egalitarian approach would be new forms of taxation. A carbon tax would be an idea. This would be useful in discouraging fossil fuel use and levelling the playing field for renewables as well as encouraging energy efficiency, thought the devil is in the details. Another idea is a so-called Tobin tax on international investment transactions. This would not only generate significant revenues but it would discourage the sorts of crazy market speculation that led to this crisis in the first place. There are a number of measures we could take to claw back money held in off-shore tax havens, ranging from high trade taxes with such nations, currency exchange taxes (or a point blank refusal to honour or handle the currency of such nations) to more radical solutions (see Comedian Mark Thomas plans to invade Jersey). In the US theyll probably need to look at higher rates of petrol duty and VAT, bringing both up towards European levels to meet Americas near European levels of public spending.
The issue of the gold standard is often brought up by libertarians, and indeed the mantra from them is to put all youre money into gold right now. While they may have a point here, I would urge caution. Investing in gold is not a risk free decision. Gold is a commodity and its price rises and falls like that of any commodity depending on supply and demand issues. If you invest in gold and the price of gold falls in future (and personally I think its over valued right now due to market speculation) youll risk loosing rather a lot. And also by betting on gold youre betting on high inflation rates in the future. While certainly a risk, its far from a certainty. In the eurozone for example the Germans and French are going to fight tooth and nail to avoid that happening. Indeed theyd sooner see Ireland, Greece and Italy default on or restructure some debts rather than see inflation wipe out the savings of millions of registered voters. And gold is a tad inconvenient form in which to hold ones wealth, as I noted earlier you cant exactly buy two fish suppers with a gold nugget!
As far as the gold standard goes, while I can see arguments in its favour as a temporary confidence building measure post any debt crisis (bring it in now would likely have the opposite effect) I wont see it as a long term option. There are various strong arguments for and against the gold standard and Id side with the against position. There is a reason why governments abandoned the gold standard that are as applicable now as back then. But like I said, it could be a temporary measure taken after any crisis just to help turn things around and get the credit markets up and running.
Ultimately thought we need to reassess the issue of lending. When I was a lad, and that wasnt that long ago, you went into a bank for a loan and met the manager. If the first words out of his mouth were who the hell are you? he certainly wasnt going to give you a mortgage. Hed only do that if you were a known customer of the bank whod proved you could regularly pay your bills and meet your financial obligations. He certainly wont repackage your debt, mix it up with those of lots of other people and try and sell them off in the bond market, largely because nobody with any sense would buy the debts of a random stranger! So we need to reassess the rules of lending and credit. As Ive noted earlier this may even go as far as overturning the idea of interest on loans. And its particularly governments and large corporations where this applies. While this will restrict the flow of capital somewhat, in the case of governments thats not necessarily a bad thing as we dont want them lapsing into the lazy habit of trying to borrow their way out of short term problems.
Unfortunately, the reality is that well meaning as all the measures Ive discussed above might be, the chances of them being adopted until after weve slid into some sort of crisis are now slim to nil. As Ive pointed out in other articles before, the problems of the eurozone and the dollar are largely a result of short term politics that are difficult to overcome. People are unwilling to accept tax cuts, the mantra of the tea party is essentially big government get off our backs .except the bit that gives me a job, cheap subsidised products (cars, Big Mac’s, cheap flights, self-assembly furniture, etc.) and freeways to drive on. Many parts of the US that are the heartland of the tea party are also the US states most dependant on Federal spending and indeed receive much more money from Uncle Sam that its citizens pay out in taxes. Similarly, if any government, especially in the US, tries to put up taxes they find theyve committed political suicide as the citizens, often those on the right who benefit most from taxes, are dead set against paying them. We all need to accept the public services are both necessary and cost money and someone, that being us tax payers, needs to pay for them.
In short, my view is that some sort of sovereign debt crisis over then next decade or so is now inevitable. But contrary to what the economists will have you believe the consequences of that will not be that the world will stop turning and well all be sent flying off into space. Much of what the corporate news media has been reporting recently regarding the current crisis is about as accurate an assessment as the Day after Tomorrow is regarding climate change. Again, many of these experts are the same people who will loose big when the gravy train comes off the tracks.
Yes things will get bad. How bad? Its difficult to say as it depends on the speed at which we all wake up to the crisis, but they certainly wont be catastrophic, and it will be the very wealthy at the top who will ultimately take the major hit. And it will also present us with the opportunity to roll back certain policies, try out new ones and build a more sustainable global economy. There is light at the end of the tunnel, its just a question of how long the tunnel is and do we really have to go into it in the first place.