The source of denial

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.

Some commentators followed a different tack, arguing that since every debtor is matched by a creditor, losses are offset by gains and so debt does not really matter. But when the debt is secured against an asset, lenders and borrowers can both lose. Suppose that Acme Finance lent $10m to Wile E. Coyote for the building of a roadrunner-meat processing plant. When the plant was built, Acme Finance might feel its loan was secured by an asset. But the coyote's repeated failure to catch roadrunners would leave the plant running idle. Eventually Mr Coyote would go bankrupt and Acme would be forced to write off the bulk of the loan.

As a result, you need to be suspicious of arguments that net debt ratios are more significant than gross measures. Net measures offset the value of assets owned by the debtor against the amount owed. But have those assets been accurately valued? Or is their value dependent on the easy availability of credit, as was true of American houses in the early 2000s?

The European sovereign-debt crisis has produced its own sequence of denials and recantations. Peripheral governments said at first that the banking crisis would not require a dose of fiscal austerity, blaming the rise in their bond yields on speculators and ratings agencies. When yields stayed high, despite austerity programmes, they denied that they would need to seek international financial aid. Once that aid was received, countries felt obliged to rule out the possibility of partial default, the stage that Greece has reached now. But Greece has a solvency, not a liquidity, problem and it is a matter of when, not if, creditors take a hit.

The lesson of this long process of obfuscation and retreat is to place no faith in official statements of reassurance. Debtors will usually claim (and may even believe) they can service their debts, just as alcoholics deny they have a drinking problem. In any case, an early admission of a solvency problem would be akin to informing your spouse of your intention to commit adultery: it would precipitate a crisis rather than avert it.

On April 18th Standard & Poor's put America's AAA credit rating on negative watch. Mary Miller, an assistant treasury secretary, sought to reassure the markets. “We believe S&P's negative outlook underestimates the ability of America's leaders to come together to address the difficult fiscal challenges facing the nation,” she responded. But she would say that, wouldn't she?

America is not Greece. It has a much greater chance of growing out of its debt and it has the “exorbitant privilege” of issuing debt in the world's reserve currency. At least its politicians now recognise that something must be done about the deficit, even if they disagree about the solution. But grand plans, like denials, need to be taken with a bucket of salt. Actions will be the best sign that the denial phase is over, not more words.

Economist.com/blogs/buttonwood