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Time: Can Sovereign Defaults Tank the Global Economy?

Author: Michael Schuman
July 19, 2011

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Investors are running for the hills these days, shaken to the core by fears that sovereign defaults will roil global markets and derail the shaky recovery. They have a lot to worry about. European leaders will gather for an emergency meeting on Thursday to try to finally hammer out an agreement on a second bailout of tottering Greece – a package very likely to include some sort of de facto default. Contagion threatens to drag other euro zone economies into a similar state. Yields on Spanish and Italian bonds reached fresh euro-era highs on Monday. Meanwhile, across the pond, talks to raise the debt ceiling in the U.S. are stalled by mind-numbing partisan politics in Washington. With so much uncertainty, it's no surprise that gold hit another all-time high.

Still, are the fears justified? How dangerous are sovereign defaults to the world economy?

The main way a sovereign default could hurt global growth is through its impact on the financial sector. Banks holding the defaulter's bonds swallow losses and, in severe cases, might need to recapitalize to fill in the holes left in their balance sheets. That means they become conservative and make fewer loans. Then there's the direct impact on growth from the country that defaults. Invariably, defaults lead to massive contractions in output, as governments get cut off from global financial markets and are forced to implement budget reforms and austerity programs. After Argentina defaulted in 2001, its economy tanked by nearly 11%. Then there is the contagion effect. Investors burned by one country become nervous and flee anything else that could get them into further trouble, potentially causing a series of sovereign defaults that then send shock after shock through the global economy. The IMF painted just such a scenario when warning about risks to the global recovery in June. Olivier Blanchard, director of the IMF's research department, said:

In the best of cases, improving competitiveness and returning to fiscal health in some of these (European) countries will be a long and painful process. It will require strong policies, namely fiscal consolidation, structural reforms, and policies which protect the most vulnerable...It's clear that these countries cannot get out of the hole alone. The stakes are very high; failure to commit and implement policies or failure to deliver on financing, hold the risk of triggering disorderly financial and sovereign defaults. Contagion through various channels to the rest of Europe then holds the risk of derailing the European recovery and perhaps even the world recovery.

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