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Dec 3rd 2009
From The Economist print edition
What would happen if a member of the euro area could no longer finance its debt?

“FORD to City: Drop Dead.” That famous headline from the Daily News ran after President Gerald Ford refused to bail out New York City in October 1975, when the city was close to bankruptcy. Within weeks Ford relented. Behind the belated rescue lay a fear that default by New York would hurt the credit of other cities and states, and perhaps of America.

Similar worries are now being expressed about the euro zone, in light of the standstill request by Dubai World. That the firm had financial troubles was known, but many investors had assumed its debts were backed by the government of Dubai, and ultimately by Dubai’s oil-rich neighbour, Abu Dhabi. There are similar ambiguities within the euro bloc. If countries with rickety public finances, such as Greece, Ireland and Spain, ever found themselves unable to refinance their debt, would other euro members with deeper pockets rescue them? If not, would default by one euro-zone country threaten the viability of the euro itself?

There are few signs of an imminent funding crisis. Yields on the ten-year government bonds of Greece and Ireland, the two euro-zone countries with the largest budget deficits, are a bit below 5%. That is steep compared with the yield on German bonds, at 3.1%, but hardly indicates a buyers’ strike. When investors were last so nervous about the credit of the euro-zone’s periphery, in March, countries were still able to tap bond markets. Greece, for instance, raised €7.5 billion ($9.4 billion) in a single ten-year bond issue, though it had to offer a coupon of 6%.

The worry is that such appetite for risk may not last forever. The euro-zone countries with the most fragile public finances also have worryingly high unit-wage costs. Poor wage competitiveness makes it harder for them to grow quickly and to generate tax revenue. Currency devaluation is the usual remedy for that ill, but is not an option for countries locked inside the euro.

Though their troubles are similar, each country has faced them differently. Mindful of its large public debt, Italy refrained from using fiscal policy as an active tool to stimulate the economy, and has managed to keep its budget deficit below the euro-area average (see left-hand chart). Ireland has tightened fiscal policy by 4-5% of GDP since the crisis struck. A further tightening is expected when its 2010 budget is announced on December 9th, though uncertainty about the public cost of bailing out its banks remains. Spain is reversing its fiscal stimulus by raising its main value-added tax rate next year. As in Ireland, prices in Spain fell faster in the year to October than in the rest of the euro area, a sign of improving competitiveness (see right-hand chart).

The country that stands out as unrepentant is Greece. It ran persistent deficits even in good times. Its new government said in October that this year’s budget deficit would be more than twice as big as previously advertised. The government says it will cut the deficit to 9.1% of GDP next year. But pressure from euro-zone finance ministers for stronger action is building: they will meet in February to approve a new Greek plan to fix its finances, which must be submitted to the European Commission this month.

Some think any problem will be Greece’s alone. After all, the treaty that created the euro contains a “no bail-out” clause that prohibits one country from assuming the debts of another. That makes Greece’s public finances a matter between it and its creditors. Any promise, tacit or otherwise, of a bail-out by others would only encourage more profligacy (a view that mirrors Ford’s initial stance towards New York). In principle, a default by Greece or by any other euro-zone country would not threaten the euro any more than default by New York City in 1975, or California today, would mean the end of the dollar. Indeed, membership of the euro could help make debt-restructuring more orderly, since it would remove currency risk from the equation.

These arguments seem solid enough, but the tale of New York’s bail-out underlines how reality is never quite as tidy as theory. The city came perilously close to declaring bankruptcy when its pleas for a rescue by the federal government fell on deaf ears. What finally saved the city was anxiety about the fallout, in the form of possible bank insolvencies and borrowing costs for the rest of America, had it been unable to pay its debts.

New York’s federal bail-out was punitive, however. Some debtholders did not get their money back straight away, a technical default. The city had to cut public services, shed jobs, freeze pay, abandon capital projects and raise taxes to make sure it could pay back the federal loans. Such belt-tightening had proved necessary even in the months before the rescue. When it came, the president could claim that “New York has bailed itself out.”
The non-bail-out bail-out

It is easy to imagine a similar kind of hard bail-out, should a euro-zone country ever run short of cash. The terms of any deal would depend on the same balance of fears: on the one hand, the fear that trouble might quickly spread to a big country, such as Italy, or to euro-zone banks; on the other hand, the supplicant’s fear of being cut off from external finance. The process would be messy; some debts might not be paid on time. It would be hard to sell to voters in rescuing countries unless, as in New York’s case, the interest rates on bridging loans were punishingly high.

A tough-love bail-out would still need someone with deep pockets to provide the cash. Given the state of public finances even in more stable countries, such as France, that cannot be taken for granted. Germany is better placed but would be unwilling to act alone. Could a defaulter remain in the euro? It is hard to see how it could leave. A country that had just lost the trust of investors in its fiscal rectitude could scarcely build a credible monetary system from scratch. There is no obvious means to force a miscreant out, since euro membership is designed to be irrevocable. How badly the euro’s standing would be hurt by a default would depend on the state of public finances elsewhere: if America were struggling too, the dollar might not seem an attractive bolthole. If the current struggles with a strong euro are any guide, euro members might even half welcome a tarnished currency.