By Kathleen Brooks, Director of Research UK,Forex.com
Is default really such a dirty word?
If banks lend people more money than they should, they face the risk of the borrower defaulting on their debts.
So why shouldn’t countries simply not pay?
Default might not be a bad thing, if you are an Irish taxpayer. As the EU authorities debate a long-term solution to Europe's sovereign debt crisis, it might want to consider the benefits of the "D" word and not just rule it out completely for fear it could turn investors off all eurozone assets.
Ireland wasn't fiscally profligate, its banks were. Lax regulatory regimes and a toxic chumminess amongst bank executives and property developers were at the root of Ireland's problems.
Along comes a housing bust, a state guarantee for all bank debt and the next thing you know the sovereign rating is getting cut and the country is cap-in-hand to the IMF and EU bailout fund.
Not their fault
The devastating result is that the Irish public has to pay increasing levels of tax for years to honour its former government's guarantee and take money out of their own pockets to pay the bondholders who chose to invest money in some of world's riskiest banks.
When you lay the argument out like this it seems thoroughly unfair.
Sharing the burden for the banks' mistakes between the Irish taxpayer and the people who lent the banks money in the first place makes sense for two reasons.
Firstly, it would reduce the debt in Ireland's economy and help foster growth over the coming years and, secondly, a default mechanism should help to prevent risk-free lending from distorting financial markets in future.
Not just Ireland that could benefit
This second point could also benefit Greece. Even though the Greek bailout was caused by government spending spiralling out of control, bond holders (who lent the money to them) turned a blind eye.
While the previous government failed to detail the true extent of the budget deficit, an investor could have done some simple research and found that Greece never adhered to the eurozone's fiscal rule that countries should spend no more than 3% more than their GDP in the 15 years leading up to its bailout.
So investors who bought Greek debt did so knowing that the country was flaunting EU fiscal rules. Yet Greece could still borrow money like it grew on trees.
While authorities in Athens need to urgently impose fiscal discipline and change a mind set of government hand-outs and tax evasion that is pervasive in Greek society, bond holders also need to be taught a lesson.
Irresponsible lenders should pay too
Essentially that lesson is that lending to a country is not risk free. As European Union authorities are debating the "grand bargain" and a long-term solution to the sovereign debt crisis this month, they would be wise to seriously consider haircuts (paying less back) and defaults as an option.
The markets might not be as against the idea as some may think. If you know that you could be subject to losses on your debt investment then you can price the risks accordingly.
While it is true that the cost of borrowing will be higher than it was during the boom, it may end up being lower than it is currently, especially for Greece, Ireland et al.
The more formal the process to allow a default the less scary it will be. And these changes could go some way to improving the health of the financial markets too, as they might make investors do more research and price risk according to hard facts, not based on implicit guarantees from the EU that no investor will be subject to a loss.
Investors are in limbo right now. They aren't willing to buy peripheral bonds, not because of the threat of default, but because of the uncertainty about how the sovereign crisis will reach a conclusion.
Reducing the debt burdens of these nations will go some way to doing this. Default might not be such a bad idea after all. More from Forex.com
So why shouldn’t countries simply not pay?
Default might not be a bad thing, if you are an Irish taxpayer. As the EU authorities debate a long-term solution to Europe's sovereign debt crisis, it might want to consider the benefits of the "D" word and not just rule it out completely for fear it could turn investors off all eurozone assets.
Ireland wasn't fiscally profligate, its banks were. Lax regulatory regimes and a toxic chumminess amongst bank executives and property developers were at the root of Ireland's problems.
Along comes a housing bust, a state guarantee for all bank debt and the next thing you know the sovereign rating is getting cut and the country is cap-in-hand to the IMF and EU bailout fund.
Not their fault
The devastating result is that the Irish public has to pay increasing levels of tax for years to honour its former government's guarantee and take money out of their own pockets to pay the bondholders who chose to invest money in some of world's riskiest banks.
When you lay the argument out like this it seems thoroughly unfair.
Sharing the burden for the banks' mistakes between the Irish taxpayer and the people who lent the banks money in the first place makes sense for two reasons.
Firstly, it would reduce the debt in Ireland's economy and help foster growth over the coming years and, secondly, a default mechanism should help to prevent risk-free lending from distorting financial markets in future.
Not just Ireland that could benefit
This second point could also benefit Greece. Even though the Greek bailout was caused by government spending spiralling out of control, bond holders (who lent the money to them) turned a blind eye.
While the previous government failed to detail the true extent of the budget deficit, an investor could have done some simple research and found that Greece never adhered to the eurozone's fiscal rule that countries should spend no more than 3% more than their GDP in the 15 years leading up to its bailout.
So investors who bought Greek debt did so knowing that the country was flaunting EU fiscal rules. Yet Greece could still borrow money like it grew on trees.
While authorities in Athens need to urgently impose fiscal discipline and change a mind set of government hand-outs and tax evasion that is pervasive in Greek society, bond holders also need to be taught a lesson.
Irresponsible lenders should pay too
Essentially that lesson is that lending to a country is not risk free. As European Union authorities are debating the "grand bargain" and a long-term solution to the sovereign debt crisis this month, they would be wise to seriously consider haircuts (paying less back) and defaults as an option.
The markets might not be as against the idea as some may think. If you know that you could be subject to losses on your debt investment then you can price the risks accordingly.
While it is true that the cost of borrowing will be higher than it was during the boom, it may end up being lower than it is currently, especially for Greece, Ireland et al.
The more formal the process to allow a default the less scary it will be. And these changes could go some way to improving the health of the financial markets too, as they might make investors do more research and price risk according to hard facts, not based on implicit guarantees from the EU that no investor will be subject to a loss.
Investors are in limbo right now. They aren't willing to buy peripheral bonds, not because of the threat of default, but because of the uncertainty about how the sovereign crisis will reach a conclusion.
Reducing the debt burdens of these nations will go some way to doing this. Default might not be such a bad idea after all. More from Forex.com
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