Europe's debt crisis intensified over the course of last year, but Credit Suisse analysts believe that Europe is gradually moving toward a resolution. As the Research Institute's publication shows, abandoning the euro would definitely not be a solution, but would rather create chaos in the economy and international financial markets. In many countries, introducing new currencies (or reviving old ones) would result in significant dislocations in household, corporate and bank balance sheets, helping precipitate sudden defaults, uncontrollable flows of funds, and ultimately a new financial crisis.

Collective Action Clauses Strengthen the Disciplinary Role of the Financial Markets
According to the Credit Suisse analysts, the solution for Europe lies in a combination of a stronger stability fund and a cut in the interest rates it charges, a commitment by governments to a quasi-permanent target of cyclically-adjusted primary surpluses, and, where necessary and appropriate, well-controlled debt restructuring. An agreement in principle by the EU governments to include collective action clauses in bonds to be issued by governments and banks as of 2013 is welcomed, as this would strengthen the disciplinary role of the financial markets. The study points out, however, that this will not solve the core problem, which is the indebtedness that exists at present. The analysts emphasize that flexible central bank intervention in the bond market can contribute to short-term stabilization but is not a lasting solution.

Scenarios for the Evolution of Debt in Industrialized Countries
The Research Institute study also contains detailed data, simulations and scenarios for the longer-term evolution of debt ratios in the most important industrialized countries. Among other things, it points out that the debt trajectory in the US is in some sense of greater concern than developments in the euro zone. Although the possibility of a US default in the medium term can be more or less ruled out (because the US issues debt in its own currency), a crisis-like situation could well ensue. If, for example there were to be a sudden rise in inflation in addition to persistently high public deficits, a combination of sharply declining bond prices and a significant drop of the dollar would not be improbable. The repercussions for the world economy and the international stock markets would undoubtedly be negative. The bank's analysts express their hope that the debt problem in the US will be tackled before such a scenario can occur. The latest decisions by the US Congress, taken after the report went to press, however, give some grounds for doubt.

Possible Measures to Resolve the Debt Problem
The study also describes specific measures that could contribute to a long-term solution of the debt problem. On the basis of detailed country comparisons, the analysts describe the degree to which various reforms in social security and health spending could improve the debt situation. The basic conclusion is that targeted measures designed to stabilize pension systems would probably be somewhat easier to achieve than reductions in healthcare spending. In all cases, reforms will be more effective if they improve the level of employment among aging populations. According to the authors, an important step toward a solution would be to create incentives to postpone retirement by means of carefully structured measures to make the age of retirement more flexible.

International economic policy could also contribute to solving the debt issue. The authors note that one of the factors leading to the high level of public (and private) debt in many industrialized countries was high savings surpluses in emerging countries. If spending and saving in the industrialized and emerging countries were to balance out, it would make it harder for debt to build up. The tendency of emerging countries to keep their currencies artificially undervalued is impeding this process of adjustment, and the problem is exacerbated by competition among the emerging countries themselves. Based on a detailed analysis of bilateral and multilateral trade, the study was able to identify groups of countries where the negative effects of this competition would be offset by the introduction of a common exchange rate mechanism (an agreement between individual countries to preserve exchange rate stability and thereby secure flows of trade between countries governed by the mechanism).

Historical Insights as a Basis for the Development of a Risk Indicator
Finally, readers with an interest in history will find a fascinating chapter in the study on the history of default and its causes. It shows how debt crises have been triggered by either severe economic shocks (such as the 2008 financial crisis) or political developments. Defaults have typically been accompanied by a loss of political authority, and in the case of major powers with the erosion of their dominant influence. Given this political and economic mechanism, it does not seem likely that today's biggest debtor countries will have to contend with imminent default anytime soon. However, the emergence of more severe and crisis-like tensions on the financial markets cannot be ruled out. Credit analysts have developed a country risk indicator, also presented in the study, based among other things on historical patterns in the emergence of debt crises.

The reforms the analysts consider most promising, and core and risk scenarios for the economy and financial markets, are summarized in a "Debt Manifesto" and a Q&A section of the report.


"Country Indebtedness – An Update," published January 27, 2011, was prepared under the aegis of the Credit Suisse Research Institute and in close collaboration with analysts from Investment Banking and Private Banking.