When the euro was first created, both borrowers and lenders were far too cavalier. The Greeks, Spanish and Portuguese borrowed too much, while the Germans and French lent too much. They all failed to see the risks ahead. When the euro was first created in 1999, investors in low-yielding northern Europe flocked to high-yielding southern Europe in the belief that membership of the euro would make all government bonds equally safe. Yield differentials disappeared overnight.
This, however, was a fundamental error. Membership of the euro got rid of some risks, but not all. Those countries which used to succumb to regular doses of inflation or revaluation were suddenly deemed safe. Yet their safety was untested in one crucial area: what would happen if their fiscal positions deteriorated alarmingly, perhaps as a result of a deep recession? Would they be able to deliver the necessary austerity to bring the books back to balance? Or, instead, would they have to default in the face of civil unrest?
Lenders didn't worry about the possibility of default, partly because their historical knowledge was rather scanty. During the interwar period, another time of economic and financial turbulence, defaults were a fairly regular occurrence – largely because, like now, government debts had become excessive. Lenders also didn't seem to recognise that unanticipated inflation and devaluation are themselves forms of default. That we don't typically describe them in these terms is merely a linguistic quirk.
If a government prints money and pushes inflation higher, and if interest rates don't rise quite so quickly, creditors lose out. Adjusted for inflation, their returns from having lent to the government are now lower than they hoped for.
Alternatively, if a government prints money and pushes the exchange rate lower, foreign creditors who lent to the debtor nation in its own currency will now be worse off in their own currencies. On both counts, the printing press is an instrument of default by stealth.
Individual countries within the eurozone are no longer able to increase their print runs at will, because they are all part of a single currency. They cannot default by stealth. So if it turns out that they lack the political ability to force through the austerity necessary to deliver fiscal harmony, it's no wonder they might be tempted to think about using the fiscal equivalent of the nuclear option. If there cannot be default by stealth, why not simply default, particularly if the creditors are partly to blame for having lent on such generous terms in the first place?
As investors have belatedly begun to recognise this option, they've become more than a touch panicky. They thought their money was safe in the single currency because they believed the single currency would prevent the stealthy defaults that had so damaged investors in the past.
They forgot, however, that all defaults, whether stealthy or otherwise, typically happen because governments cannot pay the bills. And because European political leaders never really chose to confront this issue, hoping simply that countries would behave themselves fiscally, they have been unable to offer any significant assurances that creditors' money is really safe in the light of a massive deterioration in the fiscal numbers.
But is this really only a eurozone problem? Hardly. Countries throughout the Western world are awash with too much government debt. They're adopting a variety of different strategies to cope. The UK, which has a higher ratio of government debt to GDP than Spain, has already attempted a stealthy default following the 2008 collapse in sterling and the subsequent rise in inflation.
It seems, however, that the printing press, on its own, has not been able to do the trick. Activity in the UK remains weak and the new Government is about to deliver to the nation the same kind of austerity medicine already seen in Greece and the Iberian peninsula in a bid to avoid a downgrade by the ratings agencies. Whether the public will swallow these bitter austerity pills is another matter altogether.
Among the biggest offenders, however, is the US, where the government is still mulling over the possibility of a further fiscal stimulus later in the year, conveniently timed for November's mid-term elections. It has a deficit that, at a likely 10 per cent of GDP, is well above the eurozone average of 6.6 per cent, and a ratio of government debt to GDP that is rapidly heading towards 100 per cent. Yet investors are still happy to lend to the US. Unlike with Greece, Portugal or Spain, no one thinks America will default.
It almost certainly won't, at least not in the commonly accepted way. Instead, it will default by stealth. When the US demands a stronger Chinese renminbi, it is also demanding a weaker dollar.
Typically, American politicians demand a Chinese currency adjustment because they believe China is following a mercantilist trade policy. What they conveniently forget to mention is that China is also one of America's biggest creditors. The Germans lent to the Greeks on generous terms earlier in the decade and the Chinese are doing much the same with the Americans now. And the Americans, like some Greeks, may one day wonder whether a default might be a rather neat trick. The only difference is that an American default would take the form of a big decline in the dollar, lowering the renminbi value of China's vast holdings of US Treasuries.
As I argue in Losing Control: The Emerging Threats to Western Prosperity, the US has adopted the same approach as Catholic priests a few hundred years ago, selling the modern-day equivalent of indulgences to those with faith. This time, however, it's not so much faith in the hereafter but faith in the ability of future US taxpayers to repay their debts.
But why should Americans worry too much about their Chinese creditors? They surely won't. As this reality slowly dawns, the creditors will ask the same questions of the US that the Germans are now asking of Greece. At that point, the financial mess in the eurozone will seem like child's play.
Those who want governments to continue borrowing have overlooked one vital development over the last few decades. With the notable exception of Japan, governments nowadays increasingly do not borrow from their own citizens. Instead, they borrow from international investors: a third of British government debt, about one half of US government debt and three-quarters of Greek government debt is held by foreigners.
As deficits get bigger and debts continue to expand, foreign investors have good reason to feel very nervous. They have little voice in the domestic political process. They fear they're in danger of being ignored. Should their fears of default, stealthy or otherwise, continue to blossom, we will have reached the limits of Keynesian policies. Governments cannot borrow indefinitely, because their foreign creditors will eventually lose faith. They will do so because, in a choice between protecting the interests of the domestic taxpayer and looking after the foreign creditor, it's the domestic taxpayer who votes.
Stephen King is managing director of economics at HSBC stephen.king@hsbcib.com
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