Saving Portugal and Spain: Solutions (1)

After all the negative messages from this series, it is time to finally start working on the possible solutions. In this first post I will address the more financial solutions. Some have been discussed by European leaders, others should be.

The first solution is to lend a lot of money to these countries to help them cope with their deficit and debt payments. This policy can work to stem the problem of loss of trust on the side of the bondholders. It is quite simple to see why: if you know that you will get your money back one way or another, it is very safe to lend your money (in this case buy bonds). But in here there is the immediate problem: to give this trust to bond holders, one needs to be able to lend enough so that whatever happens, the country can pay its debt obligations. That means that you need to have very big reserves ready for lending (a job well suited for a central bank, which has virtually infinite reserves). But even if you're willing to do this you need to be sure that the treasure country is inherently sound (or force it to make policies to ensure this). If this is not the case you need to lend until the end of days and you're effectively subsidizing. In the Euro zone this is far from reality, and politicians more liked to pretend it was true rather than knowing it. This is why the policy has been branded: extend (the loans) and pretend (everything is OK) by some bloggers.

If the countries are in more than just a liquidity issues and I believe they are then it is time for more drastic measures. One of the proposed measures (and already kinda enforced on Greece) is the orderly default on its debts. An orderly default is simply the country agreeing with the owners of its bonds not to pay them in full or on time or both. In contrast a disorderly default is a country unilaterally giving the finger to its bondholders and not paying its bonds at all. The disadvantages of a default, either kind, is the loss of trust on the side of the bondholders and a disastrous rating from the rating agencies. Furthermore, since often a significant portion of the owners of sovereign bonds are domestic actors (banks, pensionfunds, etc.) the effects for the economy are likely to be bad as well. The main advantage is that the country is relieved of its debt burden and it can move forward, and if a country defaults orderly many of the bond holders will eventually return (be it that you borrow at higher rates). If a default is disorderly the country will be shunned from the financial markets and that is in this age very very bad. Therefore an orderly default is always better than a disorderly one.

However if the underlying economy is not sound, a default will not solve most problems (and could be even worse than a large debt burden). In fact the only way to move out of the mess is to get the economy running again. This can be by external factors such as, increased trade. But this is unlikely to happen since most of the world is still struck by the financial and euro-crisis. Structural reforms like cuts usually take too much time as I mentioned in a previous post. Therefore the only way forward is to invest in the country. Since this is usually impossible by the state, it needs to either borrow money using bonds with such a long maturity that it can use the money to grow or with foreign investment. If the money is well spend it could be the only way out of a debt and economic crisis that Portugal and Spain are now in.