But what happens if several nations go bankrupt in a very short span of time? Will people realize that the safety of sovereign debt is nothing more than a theory? It is definitely stronger than the theory that housing prices can only go up, but at the end of the day it is still just a theory. In finance, contagions start with doubt and grow until the doubt itself becomes contagious.
Financial systems are first and foremost acts of faith. Money’s value is based on what people believe that value to be (and by money I mean any thing people are willing to exchange for something else). For the longest time the financial system was based on gold and the faith that other people will always want even though it had very little intrinsic value.
That is why gold sells for a lot more than its one practical use – a really, really excellent electrical conductor – could possibly justify. Food, on the other hand, has actual value beyond what other people say it is worth. If the filet mignon market crashes you may not have riches but you do have dinner.
This is also why the U.S., Germany, and Japan can borrow money cheaply while Greece can barely borrow money at all.
Right now there is no faith that Greece will be able to pay its debts in a year, which is why Greek one year bonds are trading over 270 percent. (As far as I’ve been able to find out, the volume for this bond was 0 on Wednesday. Yet its yield at the end of the day was 20 points higher than it opened. I knew bond prices were based on emotion, apparently they are also based on whim.) The reason Greece is hopeless because its government owes 142 percent of its GDP.
But Japan’s government owes 194 percent of its GDP. The U.S. and Germany owe 85 and 83 percent, just a smidge more than France and 20 points more than Spain, which everyone knows is dead in the water. So, a rational and dispassionate view of the situation would suggest that the allegedly secure sovereign bonds have no real basis for their safety other than our collective faith.
When the euro does finally fall off the cliff it’s going to take down not just the nations that are on everyone’s watch list but a bunch of others, too. I expect much of eastern Europe to default. Hungary is practically dead already. So we will likely see a lot of other nations go belly up all at the same time. However, some of them won’t be nations on the “periphery.” Some will be nations whose defaults should make people seriously question their faith in sovereign debt.
There is nothing inherently wrong with having sovereign debt as the central tenet of our monetary system. It’s not like there’s something better to replace it with. The problem is many people think the reliability of sovereign debt is a certainty and not a hope. What happens when the believers find they have put their faith in something that is very fallible?