Default not the end of the world

The world's economic policy makers have talked up a zero-tolerance attitude towards sovereign-debt defaults. For every troubled national borrower, there seem to be a dozen central bankers ready to hand out cash, always to avoid Armageddon.

Debtors have failed to make good on their obligations throughout history, and we're still here. Defaults by financial institutions are, of course, too numerous to count, but governments crash as well. We have a long record to see just how they play out.

According to This Time Is Different: Eight Centuries of Financial Folly, the 2009 book by Carmen M. Reinhart and Kenneth Rogoff, there were 238 external debt defaults or reschedulings from 1800 to 2008. Spain tops the list with 13 occurrences in its history, though none since the 19th century.

Today we are supposed to believe that if one small country such as Ireland goes down, the rest of us will too. Yes, the world is more interconnected now than 200 years ago. That doesn't make every cough a sure sign of pneumonia.

At the risk of understatement, throwing money at a country teetering at the brink of default isn't how things used to be done.

In 1902, European nations responded to a Venezuelan government debt default with military force. German, Italian and British gunboats blockaded ports, seized customs houses and bombarded a Venezuelan fort.Venezuela caved, agreeing to restructure and pay its debts.

On the brink

These days, when European leaders see Greece and Ireland on the brink of default, they don't send gunboats — they send money. The word "restructure" is taboo.

The theory of bailouts is intricately related to the fear of Armageddon. If investors see Greece go down, the story goes, they might panic and stop lending to other nations, even ones that should be considered healthy. In this view, default spreads like influenza in 1918.

The theory doesn't stop with national governments. If California defaults on its debts, then the credit crisis might sweep up all the other states. If Bear Stearns Cos. fails, then so will everyone else.

We seem to have become a world in which we assume a panic is around every corner. When markets are irrational, it's impossible to say what might set them off, and fear of disaster becomes a powerful excuse for policy makers to do whatever they choose.

Economist Vincent Reinhart reviews the legacy of the 2008 Bear Stearns bailout in an article to be published in the Journal of Economic Perspectives. As he points out, the US government, in its wisdom, wiped out equity holders but saved bondholders, and investors began to expect this policy.

Reinhart writes, "This expectation made it profitable to identify the next financial firm to be resolved and then to sell its stock short and use the proceeds to purchase its unsecured debt. If the candidate firm was identified correctly, the debt would appreciate in value and its stock collapse."

The Bear Stearns bailout, then, only delayed the inevitable realisation of losses from the collapse of the real estate market. It abetted the fiction that government can save us. Only when Lehman Brothers Holdings Inc. was allowed to go down did markets realise that the losses were just too big. The process would have been more orderly if the restructuring began at once.

It's just as bad for countries. Central bank interventions become an excuse to avoid tough choices.

While no one would recommend that we return to the gunboat days, the old-fashioned hard-nosed approach had a big effect on contagion.

Economists Kris Michener and Marc Weidenmier studied what they call supersanctions — the use of military or political pressure to force repayment of sovereign debts, a commonly used enforcement mechanism from 1870 to 1913. They found that following supersanctions, "on average, ex-ante default probabilities on new debt issues fell by more than 60 per cent, yield spreads declined approximately 800 basis points, and defaulting countries experienced almost a 100 per cent reduction of time spent in default."

In other words, a Tony Soprano approach towards a defaulting nation can inspire some major improvements. The world economy has survived sovereign debt defaults in the past, not by bailing out the miscreants, but by paying close attention to their own balance sheets. If you don't want a Greek default to lead to a crisis in your country, balance your own budget ahead of time.

And stop whining about Armageddon.