When is a default not a default?

Concerns of ‘crowding out' (a reduction in private consumption or investment owing to increasing government borrowing) and higher bond yields have been voiced for some time; and yet, in some cases, bond yields have fallen to new lows. Japanese 10-year government bonds, for example, now yield 1.11%, despite Japan having the greatest need for refinancing among the countries shown in the chart above. There are many reasons for this: shortterm cash rates are still very low (and likely to stay that way), other riskier markets (such as equities) have been performing poorly, and fears about a double dip have risen. Meanwhile, in the background, core inflation is still falling. Furthermore, many governments are switching away from fiscal stimulus and towards austerity, but there remains a mountain to climb.

One message that we reiterate frequently is that, once debt problems fall into the hands of governments, there are many more options open to cope with those problems than are available to the private sector. Governments have the ability to raise taxes and cut spending, and they may resort to more drastic measures. It is hard for a private company with a debt problem to ask its customers to pay more for an inferior service, because those customers would be likely simply to go elsewhere. Governments, on the other hand, can do just that, as the chances of a population moving en masse to another country are remote.

With a comparative lack of options, a company faced with debts that it is unable to service may be more inclined to resort to defaulting on those debts. This option is open to countries, too, but countries have the advantage of being able to adopt alternative measures, which amount, technically, to a form of default on a promise. A voluntary restructuring of debt, for example, by which a government extends the term of its debt (to a point at which it is better equipped to meet its repayment obligations), can be a method of working through a short-term funding crisis.

Greece appears a likely candidate for such restructuring later this year. It is hard to see how the Greek authorities will be able to instigate dramatic fiscal tightening and maintain positive economic growth while simultaneously paying interest rates of over 10% on their debt: something has to give. Greek bonds already trade at levels that reflect the high probability of debt restructuring, and they are now largely held by the banks and the authorities who will be providing support to the Greek government. A voluntary solution that extends the maturity of the debt (probably involving a ‘haircut', through which the value of the bonds resulting from the restructuring is less than the face value before the restructuring) and keeps Greece solvent is the most likely outcome. This is a form of default, but it is one that should serve to prevent the European sovereign debt-related ‘house of cards' from tumbling down.

Another form of default which governments are prone to pursue involves defaulting on a promise. Raising the national age of retirement is one of the most logical solutions to the long-term liabilities facing governments. For Greek citizens to receive support from their fellow eurozone member countries, the citizens of those other countries should, ideally, enjoy equivalent benefits. Why, for example, should one citizen of the eurozone, who has to work until he is 65, pay for another to retire at 60?

If raising the retirement age is too obvious a form of default on a promise, governments may try something more subtle, for example lowering the real value of the payments they make. The UK government's move to link pension payments to CPI rather than RPI amounts to an effective 0.70% reduction in annual pension payments.

All of the above measures (and more) will prove necessary as Western governments face the challenge of reducing debt burdens for future generations. These tweaks and adjustments are still preferable to actual default (failing entirely to meet debt-repayment obligations), which would raise the long-term costs of future debt, and they are also better than trying to ‘inflate' one's way out of a debt problem. Governments may try, in time, to inflate their way out of trouble but, at the moment, given the disinflationary forces evident in the global economy, this would be very hard to achieve.