A defective default: keys to understanding the sovereign debt crisis – part 1

Abstract

The sovereign debt crisis affecting several eurozone countries is a threat to Europe's financial stability and has had significant international repercussions. The fear of a default within the eurozone has spread from Greece to other states. The various summits that have taken place on the subject have provided only partial and insufficient responses to the problems confronted. For several months now, it has appeared that one of the main impediments to resolving the crisis has been the massive exposure of the financial sector to the debt of eurozone states. A fall in the value of this debt, owing to investor distrust, may lead to banks requiring financial injections to protect their capital positions. As a result, additional funds might well be required from eurozone states. Such support might come from the states directly or come from them indirectly via the European Financial Stability Facility: a double hit for eurozone members. The crisis has made clear the fundamental imbalances in the economies of European states that have, for many years, financed modest economic growth through a steady increase in public and private indebtedness. The eurozone's problems have also demonstrated that the risk of sovereign default is real and not merely theoretical. Because of a general failure, pre-crisis, to contemplate the possibility of a default in the eurozone, a satisfactory legal framework for sovereign debt on sovereign default has not been constructed, a consensus on accounting standards for assessing the value of risky debts has not emerged, and adequate rating methodologies which can be relied upon in unprecedented circumstances have not been devised. These three technical aspects of the sovereign debt matrix (the legal framework, assessment for accounting purposes and credit rating) have not been at the forefront of public attention. They are, however, critical to the effective management of the crisis. This article explores constraints on the policy options available for dealing with the eurozone crisis, explains the reasons behind certain policies which have already been adopted to tackle the crisis, and proposes a number of possible reforms which could help resolve the crisis.