That leaves the other two outcomes. First, once Spanish debt levels become worryingly large Germany and Spain can reverse the policies that led to the large trade imbalances. In that case Germany will begin to run a current account deficit and Spain a current account surplus. In this way German capital flows to Spain can be reversed as Spain pays down those claims with its own current account surplus. Neither side loses.
Second, Spain can take steps to erode the value of those claims in real terms. It can do this by devaluing its currency, by inflating away the value of its external debt, by defaulting on its debt and repaying only a fraction of its original value, by expropriating German assets, or by a combination of these steps.
Why must those claims be eroded? Because Spain does not have unlimited borrowing capacity (and presumably does not want to give away an unlimited amount of domestic assets). If Spain’s current account deficit is large enough, in other words, its debt must grow at an unsustainable pace and so it must eventually default (this, by the way, is a variation on the famous Triffin Dilemma). The only way to avoid default is to erode the real value of the debt, and ultimately these are variations on the same thing – Germany will get back in real terms less than it gave.
via mpettis.com
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