# What happens if a country defaults?



## Igcuimhne81 (14 Jul 2010)

Just a general question and not related in anyway to what is happening in the world economy at this moment. But what effect would a default have on a country like Ireland?

What would happen to our membership in the euro?
What would happen to deposits held?
What effect would there be on inflation/deflation?

Thanks


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## Chris (15 Jul 2010)

Igcuimhne81 said:


> Just a general question and not related in anyway to what is happening in the world economy at this moment. But what effect would a default have on a country like Ireland?


This all depends on how the defult happens. Ideally Ireland would talk to bond holders and explain the situation and come to an agreement. This is what private citizens are being advised to do when they have trouble with debts, and is the right advice for a state as well.
If, on the other hand, things turned out Greek, head in the sand style then the default would be very chaotic.
This recent article sheds some light on what could happen in Greece and draws comparisons to Argentina's default: 



Igcuimhne81 said:


> What would happen to our membership in the euro?


I have heard conflicting reports on whether it is possible for a member to be kicked out of the euro. I haven't looked at the legal documents signed by member states, as I have made provisions for an Irish default regardless of what happens currency wise. 
Many articles have been written about this subject, here is just one:
http://www.foreignpolicy.com/articles/2010/03/23/could_greece_get_kicked_out_of_the_european_union




Igcuimhne81 said:


> What would happen to deposits held?


If Ireland were to default it would certainly not be able to live up to any deposit guarantees. This would make it very difficult for Irish banks to get funds on the money markets and would likely result in bankruptcies, with risks to deposits.



Igcuimhne81 said:


> What effect would there be on inflation/deflation?



I assume you mean the overall price level of goods. Inflation is always a monetary phenomenon, i.e. it is the increase of the money supply through credit expansion and printing of new money. Higher prices are merely the consequence/symptom of inflation.
At the moment, with the euro, the newly printed money has been largely offset by credit contraction (through debt defaults). The newly created money is being used by banks to fix their balance sheets, but as soon as they start lending out the excess reserves held, we will see huge increases in prices.
If Ireland default and stay in the euro, then we would probably initially see more credit contraction as banks go out of business. These would be replaced by new or foreign banks and credit would quickly start flowing again.
If Ireland defaults and leaves the euro, I see a whole different picture. The replacement currency would be hugely devalued and the money supply would be inflated to "stimulate" the economy. This would result in higher prices of all consumer and capital goods.
Basically, I see no way that we will avoid much higher prices, as politicians have proven that they will do anything to stop the corrective actions of a recession.


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## RMCF (19 Jul 2010)

Some of this is the 'nuclear' scenario, and makes for worrying reading.

As someone with their life savings in deposit in Ireland, the thought of having it wiped out is very scary. Surely this would not be allowed to happen across the country, the place would descend into anarchy and chaos.


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## Chris (19 Jul 2010)

RMCF said:


> Some of this is the 'nuclear' scenario, and makes for worrying reading.
> 
> As someone with their life savings in deposit in Ireland, the thought of having it wiped out is very scary. Surely this would not be allowed to happen across the country, the place would descend into anarchy and chaos.



Yes indeed, it is a worst case scenario, but today's downgrade reflects that it is not an impossibility. I don't think it is a case of would it be allowed to happen; if it does happen, especially in an unorganised way, then I believe nothing could be done to stop it.
As for anarchy and chaos, this government's cozy cartel with expenses and wages is so rediculuous that in any other country there would already have been mass protests.


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## Duke of Marmalade (19 Jul 2010)

Chris said:


> ...At the moment, with the euro, the newly printed money has been largely offset by credit contraction (through debt defaults). The newly created money is being used by banks to fix their balance sheets, but as soon as they start lending out the excess reserves held, we will see huge increases in prices.


Lots of interesting stuff Chris, but I'm not sure I agree entirely with this analysis. 

Here's my very simple model of what happened. Banks lent stacks to developers (both directly and through giving mortgages to homebuyers), developers gave stacks to farmers for their land. That's when the money supply was created. If farmers started to spend their windfalls on goods and services then big inflation would follow. The land turns out to be worthless. Developers can't pay back their loans. Government buys loans from banks so that they are still able to back the farmers' and everybody else's deposits. This support does not increase money supply but does prevent the existing money supply (deposits) becoming meaningless, so of itself it is not inflationary but counter deflationary. 

Because of the massive asset deflation we have seriously deflationary wealth effects. The farmers can still go on their spending spree, but developers can no longer support the construction industry and homeowners in negative equity substantially reduce their consumer demand. And nobody wants to lend or borrow. All in all I don't see any hyperinflationary effects.


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## Chris (19 Jul 2010)

Duke of Marmalade said:


> Lots of interesting stuff Chris, but I'm not sure I agree entirely with this analysis.
> 
> Here's my very simple model of what happened. Banks lent stacks to developers (both directly and through giving mortgages to homebuyers), developers gave stacks to farmers for their land. That's when the money supply was created. If farmers started to spend their windfalls on goods and services then big inflation would follow. The land turns out to be worthless. Developers can't pay back their loans. Government buys loans from banks so that they are still able to back the farmers' and everybody else's deposits. This support does not increase money supply but does prevent the existing money supply (deposits) becoming meaningless, so of itself it is not inflationary but counter deflationary.
> 
> Because of the massive asset deflation we have seriously deflationary wealth effects. The farmers can still go on their spending spree, but developers can no longer support the construction industry and homeowners in negative equity substantially reduce their consumer demand. And nobody wants to lend or borrow. All in all I don't see any hyperinflationary effects.



Hi Duke, your analysis is correct and I also do not see hyperinflation as the most likely outcome, but high, double digit price increases are quite likely. The monetary inflation of the last decade which lead to the housing bubble resulted in price inflation to be mainly seen in real estate and to a lesser (but still high) amount in consumer products. This bubble has now burst and there was a severe credit deflation resulting in especially real estate prices plummeting. 

However, what I was referring to is the money printing that has happened, and is going to happen, since the bubble burst, i.e. 'Quantitative Easing'; especially the €750b announced to rescue countries on the brink of default, but also the unlimited over-night funds available to banks from the ECB. Also bear in mind  the fact that the ECB will directly buy debt from member states in increasing amounts; they are saying that they are draining this newly created money off, but do you trust them to get it right?

I'm not sure what the exact excess reserves are with the ECB, but the Fed, according to its own estimates, records excess reserves of over $1tr. Fractional reserve banking with a minimum reserve of 10% will mean that this would result in up to an additional $10tr in the Money stock, which is double what it is now. Again, the Fed says it will drain it when necessary, but I do not believe that they can or even want to.

At the moment banks have a very sweat deal: borrow from the ECB at 1% or from the Fed at pretty much 0%, then use that money to buy German or US bonds that yield just under 3% (bond prices have rocketed since 'Quantitave Easing' was introduced). Guaranteed, central bank backed profits that are slowly repairing the balance sheets. Eventually they will start lending out this money as the temptation will be too high and I, for one, am not banking (no pun intended) on central banks to be able or willing to do anything about it. Everyone from SMEs to Joe Public are crying out for more credit to be made available. Do you think that when this eventually happens, central bankers and politicians will scream for it to be stopped or even slowed down? No, they will go with whatever is the popular demand, and then blame evil speculators and greedy entrepreneurs for any increases in prices. Hyperinflation, while not strictly defined is still rather unlikely, but high price inflation is pretty much inevitable.


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## Duke of Marmalade (19 Jul 2010)

Okay _Chris_, it will need careful management by the ECB as well as the will.  The banks have the liquid reserves to fuel wild money creation but they haven't the capital reserves to grow the asset side of the balance sheet and anyway the economy doesn't want credit even at these rdiiculously cheap levels.

I remember in the inflationary 70s all the focus was on money supply and the authorities used most ad hoc devices like corsets and the like to try and control it.

My view is that the authorities can control inflation if they want to.  In the 70s they were half hearted because the inflation helped to soften the blow of the oil crisis.

There is a danger that in a desire to dilute the real value of sovereign debt they will relax on inflation.  Thank heavens for Germany and I see the Euro starting to do quite well again.


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## Chris (19 Jul 2010)

Duke of Marmalade said:


> Okay _Chris_, it will need careful management by the ECB as well as the will.  The banks have the liquid reserves to fuel wild money creation but they haven't the capital reserves to grow the asset side of the balance sheet and anyway the economy doesn't want credit even at these rdiiculously cheap levels.


It requires a level of management that only a free market can provide. I have to disagree on the economy not wanting credit, I believe the economy is completely hooked on credit, which is why there is talk of governments 'forcing' the banks to lend out to SMEs, or providing billions in funds directly. SMEs are desparate for credit, large corporations are finding it relatively easy to get funding in comparison.



Duke of Marmalade said:


> I remember in the inflationary 70s all the focus was on money supply and the authorities used most ad hoc devices like corsets and the like to try and control it.
> 
> My view is that the authorities can control inflation if they want to.  In the 70s they were half hearted because the inflation helped to soften the blow of the oil crisis.


Inflation is a monetary phenomenon created by central banks and governements. Higher prices are merely a consequence of inflation. For central banks to claim that they are in the business of keeping inflation low, is like a vodka distiller saying their sole purpose in business is to keep alcoholism low. This might actually be a good topic for a new thread.



Duke of Marmalade said:


> There is a danger that in a desire to dilute the real value of sovereign debt they will relax on inflation.  Thank heavens for Germany and I see the Euro starting to do quite well again.



Yes indeed, there is a great danger of governments deciding to inflate away the debt, which is almost certain to happen in the US. I also thought Germany would be the one country to stand in the way of that happening in the euro zone, but all the talk from Merkel and the main opposition SPD lead me to believe that they will not stop the monetization of debt in the euro zone.


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## Duke of Marmalade (19 Jul 2010)

Chris said:


> For central banks to claim that they are in the business of keeping inflation low, is like a vodka distiller saying their sole purpose in business is to keep alcoholism low.


 
An intriguing anology but as with all analogies open to critique. I prefer that the CB is like a painter deciding on how many prints she should make of her work. Too few and its not worth the effort, too many and her work is devalued.


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## Chris (20 Jul 2010)

Duke of Marmalade said:


> Too few and its not worth the effort, too many and her work is devalued.



But why have some incompetent politicians, or their appointees, try to guess what amount is best, when a gold standard is perfectly capable of doing this. As already mentioned, it's a bit off topic to go into what inflation actually is and who it benefits, but I'll put together new post at some stage.


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