April 20, 2011
Greece denied that it was planning to restructure its debt this week (see Economics focus), even as traders in the credit-default-swaps market made bigger bets that it would. A pattern of denial in the face of mounting evidence has been a recurring feature of the debt crisis.
Back in 2005 and 2006 received wisdom denied that the rapid growth of subprime mortgages was a problem. American house prices were extremely unlikely to fall at the national level. In any case, the debt had been widely spread among investors thanks to the derivatives market.
Once the subprime woes became obvious optimists still argued that their economic impact would be limited. The banks downplayed the extent of their exposure to subprime lending. As the scale of their exposure was revealed they switched tack to argue that they had a liquidity, rather than a solvency, problem.
When the banks duly had to be bailed out and debt was transferred from the private to the public sector, a further layer of denials was needed. The finances of governments are not like those of individual households, it was said. Governments have the power to tax and to print money, and have recovered from high debt-to-GDP ratios in the past.
That rationale was undermined by the work of Carmen Reinhart and Kenneth Rogoff, who showed how countries had defaulted on their debts on many occasions in the past. Countries do have a much bigger credit limit than individuals but there is still a cap on their borrowing capacity. The economy must generate enough taxes to service the debt or must have safeguards in place to stop any attempt to inflate the debt away from spiralling into hyperinflation.
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