“It is not whether [governments will] default, but how, and vis-à-vis whom,” said Arnaud Mares, a research analyst at Morgan Stanley in London.

Many governments currently have structural problems and are insolvent by some definitions. Their “default” is a matter of time and holders of government debt will likely suffer losses, said Mares.

Negative Equity

Even before the Great Recession, many governments already had negative equity -- and governments with negative equity are insolvent, said Mares.

Mares calculates government equity as the power to tax versus social liability. Social liability is broadly defined as what the government has promised the public to spend on things like health care, defense, pension, etc. 

Great Recession Exacerbates Situation

Great Recession spending, in the form of stimulus, bailouts, etc., caused the equity of some governments to be negative by large magnitudes.  

And unless there are dramatic policy shifts, pre-recession deficits will continue and the equity will remain negative. In addition, the financial crisis caused “a permanent loss of output,” which decreases the accompanying tax revenues thereby exacerbating the deficit problem.

Furthermore, the aging population in the developed countries will add more social liabilities in the form of health care and pension costs, said Mares.

It's Different This Time

Some take comfort in the fact that many countries had higher levels of debt post-WWII. However, the fiscal situation of governments today is profoundly different from 60 years ago.

After the second world war, the former Allied countries accumulated high debt because of war expenses. But after the war, they no longer had to run those temporary high budget deficits. Their situations were sustainable, no one defaulted, and they paid down their debt over time.

Coming out of the Great Recession, many indebted countries will continue their trajectory of running high deficits, even if they cease to apply stimulus measures. The cause of their high debt is structural, not temporary, and their situations are unsustainable. Hence the inevitable default.

Default Vis-à-vis Whom?

Governments have obligations to other stakeholders besides their debt holders, i.e. they have other parties to default on. The U.S. government, for example, can default on federal employee pensions, Social Security and Medicare.

Which stakeholders governments default on ultimately depends upon the political influence each of these stakeholders wield. As the population ages in developed countries, it is difficult to imagine bondholders winning the battle against pensioners who also depend on government health care benefits.

“Default” Vis-à-vis Debt Holders

In the scenario of defaulting on debt holders, Mares isn't predicting an outright legal default for developed countries, i.e. not paying the principal and coupons on their bonds. However, he thinks governments may “default” through “financial oppression.”

Or to put it another way, governments will cause their bond-holders to suffer financial losses; they just won't do it through defaulting in the legal sense.

One method of “financial oppression” is using regulatory incentives to coerce institutions to buy government debt at unattractive prices. In fact, before financial deregulation in the 1980s, the U.S. government used to mandate financial institutions hold certain levels of government debt.

Another method is to repay the debt with devalued money. In fact, Joachim Fels, Chief Global Fixed Income Economist at Morgan Stanley, said “sovereign risk boils down to inflation risk.” And while modern history has few examples of U.S. or European countries defaulting in the legal sense, there are cases of “defaulting” through currency debasement.

As examples, Mares cited the U.S. in 1934 and post-WWII, the U.K. post-WWII, and France after both world wars.

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