Europe’s Monetary Cordon Sanitaire

WASHINGTON, DC – German Finance Minister Wolfgang Schäuble likes to criticize other governments, including that of the United States, for their “irresponsible” policies. Ironically, it is the German government’s loose talk that has brought Europe to the brink of another debt crisis.

The Germans, responding to the understandable public backlash against taxpayer-financed bailouts for banks and indebted countries, are sensibly calling for mechanisms to permit “wider burden sharing” – meaning losses for creditors. Yet their new proposals, which bizarrely imply that defaults can happen only after mid-2013, defy the basic economics of debt defaults.

The Germans should recall the last episode of widespread sovereign default – Latin America in the 1970’s. That experience showed that countries default when the costs are lower than the benefits. Recent German statements have pushed key European countries decisively closer to that point.

The costs of default depend on how messy things become when payments stop. What are the legal difficulties? How long does default last before the country can reach an agreement with its creditors? How much more must it pay for access to debt markets later?