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Commentary

The Real Default Risks Are in Europe, Not the U.S.

Despite renewed fears of a U.S. sovereign debt default, the most worrying cases are still in the eurozone.

Standard & Poor's sent a warning shot across the U.S. fiscal bow this week by lowering its outlook on the country's sovereign debt. S&P is worried that political gridlock will make it impossible for the U.S. to undertake the fiscal reforms needed to bring the structural deficit under control.

Although the timing was a bit surprising, the content of S&P's warning didn't come as too big of a shock to most market watchers. As Morningstar's Eric Jacobson pointed out, the report didn't tell us anything we didn't know already. The deficit has been in the news for a long time now, and the fact that Washington is gridlocked is not an astounding fact. S&P is absolutely correct that finding a solution to the fiscal situation in the U.S. is going to be incredibly difficult; there are going to be tough choices about health-care spending, tax rates, and social security that could be very unpopular politically.

But a U.S. sovereign debt-rating downgrade isn't something that is keeping me up at night. The political climate might be difficult right now, but a debt deal isn't impossible. The negotiations that led to the aversion of the government shutdown and the fact that politicians on both sides of the aisle seem willing to tackle the issue gives me some hope that an agreement can be struck. It will likely be far from ideal, but it should be enough to maintain the country's AAA rating. The U.S. also has the (admittedly unappealing) option of a so-called polite default. By printing money and letting inflation run, dollar-denominated debts suddenly seem less burdensome.

Now of course anything Congress does to bring the deficit down is going to have a profound impact on investors. It should reduce some uncertainty in the marketplace, but higher prices, taxes, and medical and pension costs will weigh on just about all investments. The deficit, and the potential solutions to it, should be high on a list of things to keep an eye on, but the possibility of a U.S. sovereign default isn't anything to particularly draw concern.

More Risk Across the Pond
However, just because I'm not worried about the U.S. defaulting, doesn't mean I'm not worried about sovereign defaults in general. In fact, I think the debt situation in Europe could very well get worse before it gets better. Take Greece, for example. It has mostly receded from the headlines in recent months, but its crippling debt load is still very much intact. The country has passed enormous austerity measures, but there is only so much cost-cutting can do.

Greece will likely have to grow at an impressive clip, attract an even larger EU bailout compared with the one last year, or have massive inflation to avoid restructuring its debts. And I have trouble believing any of those scenarios will come to pass.

Growth doesn't seem like a great bet. Greece's economy is not terribly competitive compared with others in Europe, and there is little reason this is going to turn around anytime soon. The EU stepping in and making investors whole also seems like a stretch. It took considerable political wrangling to create the stability fund which allowed Greece to stave off short-term default. Crafting an even larger package would be virtually impossible. Parliaments across Europe (most recently Finland) are becoming increasingly skeptical of bailouts, making it difficult to build consensus. It's hard to imagine another huge payout to Greece that doesn't ask for bondholders to share in the pain.

Inflation isn't possible either because Greece doesn't control its currency. The European Central Bank is already tightening monetary policy in order to stem off inflation throughout the eurozone. Jean-Claude Trichet isn't going to allow rampant price increases just to help out Greek debtholders.

So that leaves us with the sovereign default option. Bondholders will be forced to accept less than face value for their debt in order for Greece to put the crisis behind it. This isn't going to be a pretty sight. The restructuring will likely be loud, messy, and add even more uncertainty surrounding around other weaker eurozone members, such as Ireland and Portugal. Greece is a small country, and the default won't be cataclysmic. But it will have a real, and negative, impact on world markets. Investors looking to fret about sovereign debt risk should keep their eyes focused on Europe.

What do you think? Is the U.S. in real danger of defaulting on its obligations? Will the eurozone be able to keep Greece from defaulting?