Why debt default makes sense for sovereigns like Ireland

It is very easy to see why the global banking community and foreign finance ministers want Ireland to restructure its debt mountain. But for the Irish people left to pay this huge bill over decades the logic is not so sure, and ultimately in a democratic country it will be their political decision whether to pay or not.

Indeed, the perilous democratic position of the Irish Government negotiating the deal leaves open this very possibility. Did not Russia and Argentina most recently default on their debts? It did not bring the global banking system down, for all the howling at the time, and banks were back lending to Russia within three years.

Russian boom

The Russian economic boom of the 2000s followed soon after the default of 1998. It might be the same for Ireland with its low-tax, export-orientated economy. Being saddled with enormous debt for the next generation or two is a far less certain way to recovery.

Besides in any banking system there are supposed to be bad debts that actually fail. Not all lending decisions are a passport to steady profits for the banks over a lifetime. Lending entails risk, and that risk is built into the interest rate charged. When loans go bad they fail and the banks lose money.

Two years ago the global banking system almost collapsed and governments around the world stepped in with massive amounts of money to keep the system going. It worked but did nothing to remove the bad debts that caused the crisis, in fact there was even more borrowing.

The danger was always that this stored up even bigger problems for the future. Well we are now in that future. We avoided disorderly chaos in the banking system two years ago but still have to unwind the actual bad debts.

That means creditors actually have to lose money, stop over paying their staff with big bonuses and fire large numbers of people. The banking sector has to contract and reorganize into a smaller, better regulated sector that will not make the same stupid lending mistakes again, or at least not for another generation or two.

Financial crisis part 2

Is this the next phase of the global financial crisis? It has to be and that also explains why the Fed pushed on with its $600 billion QE2 program. The Fed knows what happens next and it is getting prepared.

But this is uncharted territory. It will not be possible to save all the banks again. There will be winners and losers and those banks with the worst bad debts will be losers. Those individuals and corporates with big debts will also go bust and lose everything.

However, in this process asset prices will correct downwards to a level at which economic activity can resume, and this is actually a far more solid basis for an economic recovery than artificially propping up everybody with low interest rates. And interest rates will inevitably go up much higher in this phase of the crisis, before they can start to come down again.