Debating the “Default Option”
This post was written by John McHale
As linked to by Philip below, Ashoka Mody reignites debate on the default option. His views must be taken seriously given his vast experience on economic crises. But it is important to put his proposals in context. They are largely aimed at European policy makers. A large private/official-sector debt write off, followed by a commitment to provide necessary funding support as countries moved in a phased way to the low debt/balanced budget model common for states in the US, could well be a route out of the current crisis.
The problem is that this option is not on offer. In these circumstances, the more a default option is kept on the table as a possible future choice, the harder it will be to regain creditworthiness. Who would want to buy Irish bonds now if they stand a significant prospect of facing write-downs on their investments in the future? To the extent that expectations of default remain high, the concern is that it would be less than the orderly/supported model described by Ashoka. The evidence from past defaults is that they come with large output costs. The fear of the crisis entering a new virulent phase would undermine confidence and growth in the present, making it harder to stabilise the vicious feedback loops between the banking, fiscal and real sectors.
An implication is that it is important to move decisively in one direction or the other. Either get on with the type of solution proposed in the article or take the default option off the table to the maximum extent possible. With the first option not actually available, the Irish government have moved in the second direction – with reasonably good results in terms of the restoration of creditworthiness. This option can only work with a strengthened institutional structure for EMU – Patrick Honohan’s euro 2.0. A core component must be a strengthened lender of last resort for sovereigns backed by fiscal rules that limit risk and moral hazard. The ECB’s OMT programme – however rationalised by the ECB itself – is an important step in this direction, but more needs to be done.