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Sovereign debt: a right royal mess?

5 February 2010
by Patrick Love

If you liked the subprime crisis, you’ll love sovereign debt. Subprimes had us asking if some “banks”, as we used to call them, were too big to be allowed to fail. Sovereign debt has us wondering about countries.

And not just wondering. On Thursday, financial markets the world over tanked, and the euro fell to its lowest level against the dollar since last June.

Initially, Greece had been the main target for speculators. The budget deficit is 12.7%, compared to the 3% target, and government debt is approaching 113% of GDP (one of the worst ratios in the world). The country’s credit rating had already been cut from A- to BBB+ in December amid fears over the country’s solvency (a rating below BBB is a junk bond). This means that the government has to pay higher interest rates to finance its debts, adding to the deficit spiral.

Greece isn’t alone. Portugal, Ireland and Spain all have deficits around 10% of GDP and are also attracting unwelcome attention, and fuelling fears that sovereign debt could interact with a number of other factors to inflict serious damage on a fragile recovery.

There’s nothing new about sovereign debt crises, but they used to be for developing and middle-income countries. The last big one was in 1982 when Mexico announced it couldn’t service its foreign debt. Other Latin American countries did likewise, followed by countries in Southeast Asia, Africa and Eastern Europe.

Referring to 1982 is like going back to the Big Bang on a financial market timescale, but in a paper for Princeton Studies in International Finance in 1997, Michael Bowe and James W. Dean ask a number of questions that remain pertinent today.

Why did market forces not deter creditors from lending and debtors from borrowing so very much more than could be repaid? Once the crisis was under way, why were market forces unable to resolve it on their own? Was government intervention rational and justifiable?

We’ll take up some of these themes in From Crisis to Recovery, and talk as well about how the esoteric world of financial markets interacts with the real economy. Apart from anything else, you may owe the banks $1600 more than you realised.

Yesterday’s collapse wasn’t due to sovereign debt worries alone. It was triggered by mixed US jobs figures, as well as fears about a collapse in commodity prices.

What lies ahead? The OECD’s economic indicators published today give some idea, but along with the talk of a double dip recession, there’s the grim prospect of a bungee jump recovery, with the world economy bouncing up and down before sorting itself out.

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