"Fitch Warns Default in Euro Zone Is Possible" warned a headline yesterday.
A sovereign default within the euro zone is possible, Fitch Ratings said on Tuesday. Brian Coulton, managing director and head of Europe, Middle East and Africa sovereigns at Fitch Ratings, said it was possible to have a sovereign default within the euro currency bloc, but that would not necessarily mean the break up of the euro zone.
So the next question to ask is how bad is this and historically is this economic situation unique or a common occurrence?
Reinhart and Rogoff attempt to answer that question in their just published NBER working paper.
From Financial Crash to Debt Crisis by Carmen M. Reinhart, Kenneth S. Rogoff NBER Working Paper No. 15795* Issued in March 2010 NBER Program(s): IFM
Newly developed long historical time series on public debt, along with modern data on external debts, allow a deeper analysis of the cycles underlying serial debt and banking crises. The evidence confirms a strong link between banking crises and sovereign default across the economic history of great many countries, advanced and emerging alike. The focus of the analysis is on three related hypotheses tested with both "world" aggregate levels and on an individual country basis. First, private debt surges are a recurring antecedent to banking crises; governments quite contribute to this stage of the borrowing boom. Second, banking crises (both domestic ones and those emanating from international financial centers) often precede or accompany sovereign debt crises. Indeed, we find they help predict them. Third, public borrowing accelerates markedly ahead of a sovereign debt crisis; governments often have "hidden debts" that far exceed the better documented levels of external debt. These hidden debts encompass domestic public debts (which prior to our data were largely undocumented).
An Economist blog adds this commentary
The economics profession has an unfortunate tendency to view recent experience in the narrow window provided by standard datasets. It is particularly distressing that so many cross-country analyses of financial crisis are based on debt and default data going back only to 1980, when the underlying cycles can be half centuries and more, not just thirty years.
For this latest paper, Ms Reinhart and Mr Rogoff content themselves to look back at just the last two centuries' worth of crises, using a dataset that covers seventy countries. Here's one picture of what that looks like:
What you see here are levels of public debt, the share of countries facing default or debt restructuring, and the share of countries with inflation over 20%. I quite like this chart. What you see is a clear correlation between debt loads and defaults and restructurings. It would be an extraordinary aberration if a raft of debt defaults and work-outs didn't ultimately accompany the latest peak in levels of public debt.
The inflation picture is also interesting. We see four clear peaks in the share of countries with inflation rates over 20%. The first two are associated with the First and Second World War (recall that after the Second World War, America cut its debt load in half through inflation). The third corresponds to the late 1970s, when oil price increases and runaway wage-price spirals fueled inflation. And then there is a fourth in the early 1990s, associated with emerging market debt crises (Brazil experienced a hyperinflationary episode during this period, for instance).
It's a fascinating image. The authors are right: debt cycles do appear to be somewhat rare and about a half-century in duration. And the struggle to work out recurring debt tends to play out in consistent ways, with increases in default and the occasional bout of rapid inflation.
After banking crisis there is a much higher likelihood of a country default, because government debt is used to bailout banks and others. According to Rienhart and Rogoff, Debt to GDP becomes a problem at 90% to 100%. The
Walter Derzko, Smart Economy, Toronto
Author of the soon-to-be published book-
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