Fintan O’Toole: In the battle over Greece’s debt, German idealism is pitted against Greek realism

‘Those who believe the evidence are heretics. Angela Merkel is the pope; Alex Tsipras is Galileo’

When euro zone leaders meet on Thursday to discuss the latest episode of their crisis, the room will be divided between coldly rational realists and ideologically driven Utopians. The champions on either side will be Greece and Germany. Yes, it will be German idealism against Greek realism.

The Germans hold to a utopian view of how international financial markets work – that the market is a moral universe where everybody keeps their word and all debts are paid. But the overwhelming weight of empirical evidence is that this is a fantasy. Not only are debt write-offs quite common, but they work.

Says who? Well, let’s try Germany’s own leading experts on the question. A study by Carmen Reinhart and Christoph Trebesch, published in October by the University of Munich, looks at negotiated debt deals in the periods after the first World War and between 1979 and 2010.

In these two periods alone, they count 47 “default and restructuring episodes”. These involved both debts owned by countries to private lenders (largely like Ireland now) and debts owed to other governments (like Greece). They ask the €300 billion question: what happens to countries that have debt written off?


Untrustworthy countries

There’s a gut answer to this question and it’s the one that dominates German thinking at the moment: countries that have debt written off are like known criminals that get away with a crime. They will go on with their nasty behaviour and no one will trust them again.

This is why causing pain in Ireland or Portugal or Greece is the moral thing to do – it is being cruel to be kind. If a country does not honour its debts, it will suffer even more deeply in the long term because no one will want to lend to it again.

But the gut answer is demonstrably wrong. The outcome of organised restructuring of debt – in other words, of negotiated default – is almost always good.

In the 1930s, no fewer than 18 advanced economies defaulted on debts they built up during the first World War and in post-war reconstruction. These debts were owed almost exclusively to the US and UK. Just one country, Finland, paid the war debts as scheduled. In 1931, the US introduced a moratorium on the servicing of these war debts and in 1934 all the debtors except Finland defaulted.

In the post-1979 period, meanwhile, 29 middle-income economies negotiated defaults on their debts in various stages over the succeeding decades.

In some cases, these write-offs were enormous. France’s default in the early 1930s, if we were to translate it into what it would mean in relation to Ireland’s current national debt, would be the equivalent of us getting a write-down of around €90 billion.

So what happened, on the whole, to these countries? Did they all go to hell in the same handcart? Were they locked out of international financial markets because nobody could trust them ever again? Mostly not. In fact, in a great majority of cases, they were much better off.

The study looked at what had happened to these economies four years after the final resolution of their debts. For both the 1930s defaults and the post-1979 episodes, the picture is broadly the same: GDP rose in the defaulting countries by between 9 and 16 per cent. Of 47 countries studied, 39 had positive growth, six stayed flat, and just two economies declined.

Higher income, lower debt

The authors conclude that “the economic landscape after a final debt reduction is characterised by higher income levels and growth, lower debt servicing burdens and lower government debt”.

Something even more remarkable emerges from this study. We are told repeatedly that countries that don’t pay all of their debts get terrible ratings from the big agencies and thus get locked out of the international financial markets. This turns out to be nonsense.

Reinhart and Trebesch looked at 30 episodes of agreed default between 1979 and 2010. And here’s the thing: the ratings of the countries that defaulted didn’t fall but rose, by an average of 38 per cent after four years.

This is worth repeating: a structured and decisive default on unpayable debts doesn’t make it harder for a country to borrow money internationally. It makes it easier. Lenders see countries that have dealt with their overhang of debt as a better risk than those that haven’t.

The researchers stress the word “decisive”. The benefits of default come from a sense of finality. This problem has been dealt with; these debts are gone. On the other hand, partial, temporary deals – the kind of ad hoc crisis management we have at the moment – is associated with “longer default spells and protracted slumps”.

In a way, what’s happening in Europe right now is another round in a battle that’s been raging since telescopes were pointed at the skies – the battle between science and religion. The true believers know in their hearts that Hell awaits us if we depart from the path of financial righteousness. Those who believe the evidence are heretics. Angela Merkel is the pope; Alex Tsipras is Galileo.