The Euro Debt Crisis: Debt Default - dummies

By Julian Knight

It’s begins with D and it’s the word that bankers, business people, and politicians dread hearing — it’s default. Like an individual, country’s can go bankrupt too. They can turn around to their creditors and say that they will not be paying back their debts. And what can the creditors do? Repossess and auction off a country? Not really.

But it doesn’t happen that often — and certainly not in Europe. Here’s why.

  • Once a default has occurred, it’s less likely that investors will want to buy any new government debt issues in the future

  • It’s not just foreign banks and governments that invest in debt, it’s also the country’s own pension funds and financial institutions. A government that defaults on its debt inevitably impoverishes its own banks and people.

Argentina was the last large country to default on its debt, in 2002. This default led to a collapse of the banking system and wiped out of millions of peoples’ life savings. The economy of the South American country is only now getting itself back on its feet.

Greece’s partial debt default

In 2011, investors in the Greek government were told that they would only be paid back a proportion — as little as 60 percent — of the money that they had invested in Greece’s debt. So if they held one million Euro of Greek debt, they were set to only get back 600,000 Euro. This is called taking a haircut. The fear is that investors with Italian, Spanish, Portuguese, Irish, and even perhaps French government debt may soon be asked to take a haircut. This isn’t as bad as a full blown debt default, where the government reneges on its debt.

Larger countries cause larger problems if they default

The bigger a nation’s debt, the more damaging a default or a haircut will be to investors, and the more likely it is to damage the world’s banking system or spark a recession. For example, Greece is a small country, and a partial Greek default can be managed. But if a bigger country like Italy, Spain, or France were to follow suit, the potential for damaging repercussions would be much greater.