Defaulting on public debt as a way to progress

Today I consider the idea that governments which have surrendered their sovereignty either by giving up their currency issuing monopoly, and/or fixing their exchange rate to the another currency, and/or incurring sovereign debt in a foreign currency might find defaulting on sovereign debt to be their best strategy in the current recession. I consider this in the context that any government that has surrendered their sovereignty is incapable of pursuing policies across the business cycle that serve the best interests of their population. While re-establishing their currency sovereignty may not require debt default, in many cases, default will necessarily be an integral part of the move back to full fiscal sovereignty. This is especially the case for nations that have borrowed in foreign currencies and/or surrendered their currency issuing capacities to a common monetary system. So here are some thoughts on when default is a way for a nation to progress.

At the outset, please note and underline that none of this discussion applies to truly sovereign nations (such as, the UK, the US, Japan, Australia, Norway, etc) who never face any solvency risk.

Over the weekend just gone there was an annual economic forum – the Ambrosetti forum – held at Lake Como, Italy.

The UK Telegraph (September 3, 2010) reported from the forum and covered the speech by Hans-Werner Sinn in this article – EU austerity policies risk civil war in Greece, warns top German economist Dr Sinn.

In relation to the problems facing Greece, Sinn claimed that:

This tragedy does not have a solution … The policy of forced ‘internal devaluation’, deflation, and depression could risk driving Greece to the edge of a civil war. It is impossible to cut wages and prices by 30pc without major riots …

Greece would have been bankrupt without the rescue measures. All the alternatives are terrible but the least terrible is for the country to get out of the eurozone, even if this kills the Greek banks … Greece would have defaulted in the period between April 28 and May 7, had the money not been promised by the European Union … There should be a quasi-insolvency procedure for countries. Creditors have to accept a haircut before any money flows for rescue plans, otherwise we’ll never have debt discipline in the eurozone …

It is widely believed that while the ECB has been holding the bond markets at bay by purchasing sovereign debt in secondary markets and Greece has been receiving funds from the IMF in return for inflicting harsh costs on its population the reality is that the Greek government will have to enter some sort of debt restructuring.

All the logic is wrong at present. Greece’s budget deficit and public debt ratio will continue to rise as the austerity chokes off all public revenue growth.

The UK Telegraph notes that the strategy is “viewed as self-defeating by several ex-IMF officials” and that there “is a strong suspicion that the real objective is to bail-out North European banks with heavy exposure to Southern Europe, rather help Greece.”

Please read my blog – Rescue packages and iron boots – for the last time I analysed the views of Sinn. At the time, he was arguing that Greece should sell some its beautiful islands to pay for its fiscal excesses.

As an aside, Sinn has a long history of being opposed to the Welfare State and blames unemployment on excessive real wages and government regulations.

As an aside, he thinks the profligate Southern Europeans should follow the Teutonic lead and work harder and spend less. He thus perpetuates a popular viewpoint.

However, a look at the data doesn’t support the popular view – which is often the case.

First, Germany has not had a free labour market and has used government intervention to minimise the rise in unemployment. The austerity programs championed by Germany that the EMU/ECB bosses are forcing on the Southern states are all about reducing the employment protection that workers enjoy and cuttin their pay and conditions.

Second, Germany has not exhibited fiscal austerity in recent period. Its budget deficit has doubled in size. So Ireland, Spain, Portugal and Greece are imposing harsh fiscal austerity on their peoples but Germany is not following this path.

Third, Germany has long employed an export-led growth model which relies on purchasing power growing in the nations it exports to. As I explain in this blog – Fiscal austerity – the newest fallacy of composition – one nation cannot enjoy export growth if all other nations are contracting as a result of imposed fiscal austerity.

I thought the comments by Mark Weisbrot in the UK Guardian in his article – The fallacy of taking German lessons – were apposite.

In the context of the austerity logic which requires the Southern European nations to have much lower real wages than Germany given its “superior manufacturing productivity”, Weisbrot noted that “it is true that”:

… the gap in unit labour costs has increased even more – since wages in Spain rose faster than in Germany during this period, at the same time that Germany’s productivity was growing faster than Spain’s.

But as a practical matter, this is really an argument that Spain doesn’t belong in the Eurozone with Germany. If Spain had its own currency, it could increase its competitiveness relative to Germany through devaluation, which would make its exports cheaper. The common currency precludes the option of devaluation.

He notes that “internal devaluation” has required a “deep and prolonged recession, with unemployment driven so high that it generates enormous downward pressure on wages”. He notes that Latvia and Estonia both running fixed exchange rate regimes tied to the euro are not making progress in driving their real exchange rate down in this regard despite losing “more then 25% of GDP in just two years … [and] … 20% of GDP” respectively and pushing unemployment to stratoand driving unemployment to stratospheric levels.

But Sinn’s message was clear. He considered that debt default was inevitable and that Greece would be better out of the Eurozone.

At the same forum, the president of the ECB, Jean-Claude Trichet was adamant that Greece would be mad to leave the EMU.

In the UK Guardian last weekend (September 5, 2010) we read –
Exit from eurozone is Greece’s worst option, says Jean-Claude Trichet
– that:

Greece’s exit from the eurozone would be the “worst possible option” … amid concerns over the debt-stricken country’s ability to pull itself out of crisis …

“We created the euro to achieve the single market for the prosperity and stability of Europe … The national governments have to take care of their own national competitiveness within the euro area.”

The problem facing the Eurozone is that despite the austerity measures now in place the metrics that signal the concern bond markets are still deteriorating and social stability is becoming fragile.

The Guardian also noted Sinn’s speech saying:

The “least bad” option, he said, would be for Athens to drop the common currency … All the alternatives are terrible, but the least terrible is for the country to get out of the eurozone, even if this kills the Greek banks.”

Regular readers will know that I argue that all the Southern European nations should immediately exit the common monetary arrangement. But in saying that I am clearly aware that this would mean that Euro-denominated debt would have to be restructured – that is, the non-sovereign nations would have to default on previous debt obligations as part of their transition back to full sovereignty.

There is a role model to follow – Argentina (more on that later). Please read my blog – Hyperbole and outright lies – for more discussion on this point.

In this context, I also read this interesting article from a Pakistani Business and Finance Portal (thanks Jesus!) – Is debt default a pragmatic approach? by one Noor Fatima.

Fatima argues that:

In the prevailing hard times there is an inexplicable and widespread demand for the country to default on its loans. There is also a great deal of confusion in grasping the notion that if countries borrow in difficult economic conditions, should they be permitted to default in the same circumstances? Hence, it is pivotal to comprehend the extent to which non-payment of debt provides a cover in times of adversity and how the national government can make the best possible use of such an opportunity (if given).

She is particularly focusing on the crisis currently besetting Pakistan but the point is generally applicable to nations that are non-sovereign in some way. In Pakistan’s case, the non-sovereignty emerges because the government has borrowed in foreign currencies and faces a chronic shortage of foreign reserves.

Fatima considers the current “devastation caused by floods” makes “the case for opting for default … all the more stronger.” This is because it should “divert debt servicing funds” to try to “fulfill the basic necessities of the 20 million flood-affected people.”

She uses the example of Latin American nations who “opted for default in order to save their economy”.

Instead, the Pakistan Government appears to be maintaining the austerity path imposed on it by the IMF when it lend them foreign reserves last year. As Fatima notes the “government has already announced a cut in the Public Sector Development Programme … to divert funds from it to rehabilitation of flood-hit areas”.

So if debt default is an option what are the costs?

You might like to read this paper – “Idiot’s Guide” to Sovereign Debt Restructuring – published by the International Insolvency Institute.

The Idiot’s Guide notes three distinct problems:

… the holdout, or collective action, problem; the moral hazard problem; and the taxpayer-funding problem.

The first problem relates to the “reputational cost in the world financial community” which makes it important that the default should be consensual – that is, a deal is struck between all parties – but that some parties may exacerbate progress by holding out for a better deal.

The second problem applies to both the State and the lenders. If bailouts are forthcoming, say via the IMF, then both parties may undertake risky positions. There is little robust evidence to support this view.

Finally, we read that the “third problem of sovereign debt restructuring arises to the extent citizens of nondebtor States are taxed to provide the funding that is critical to a debtor State’s economic rehabilitation.”

This problem is a non-problem. Taxation does not fund anything. Nations who contribute, for example, to the IMF just treat it as spending (irrespective of how they account for such transactions). Spending is about crediting bank accounts. Sovereign nations face not revenue constraints in achieving such spending. Taxation is about balance aggregate demand with the real productive capacity of the economy to avoid inflation.

Fatima says that in Pakistan’s case:

… default will pose greater problems in the present crisis. We know that, structurally, it won’t help Pakistan to cope with the economic crisis. The trust deficit will increase and international investors won’t know what to do – to invest or not to invest?

In this regard, she believes that default should be discussed “as a realistic and pragmatic approach” and suggests that debt restructuring “will will be a more pragmatic approach” because while the “outcome is identical for the creditor” (losing part of the loan) it “will show a positive tone of managing the debt issue and with honor and a responsible debtor country’s perspective”.

So a unilateral restructuring is the best way to default according to this logic because the costs of default are likely to be lower.

There are many issues that can be discussed here – both in the case of Pakistan but also for the Eurozone nations. In the last few years I have done some work on Pakistan for the Asian Development Bank and have a good understanding of that economy. Some of what follows is taken from a Report that I wrote for the ABD with Randy Wray and an ADB staff member.

Current Account issues

It is quite clear that the strain of servicing rising foreign debt obligations can lead to a depletion of foreign reserves.

The orthodox (mainstream) interpretation of an increasing current account is summarised as follows. A burgeoning current account deficit is problematic because it indicates that a nation is “living beyond its means” which means that domestic demand is excessive (perhaps driven by budget deficits) and boosting imports. The excessive demand is also seen to fuel inflation that restricts exports.

Further, the mainstream claim that the current account deficit must be “financed” by flows of foreign reserves, which for the most part must be attracted by high returns and a stable political, economic, and social environment.

So the worsening trade account indicates that the consumption of locals in such a nation becomes dependent on the whims of foreign lenders. Further, given that a rising budget deficit might be associated with these trends, the claim is that the national government is increasingly dependent on the foreign purchases of its debt to supplement domestic savers’ purchases of government debt.

In turn, the mainstream argument is that if the nation cannot attract these needed reserves, it must slow its growth to reduce imports; and lower prices and wages to stimulate competitiveness and hence encourage exports.

The mainstream then use the obvious portent of the default on foreign debt obligations to argue in favour of restricting government spending. Thus, both monetary and fiscal policy ought to be tightened to encourage such capital flows even as this reduces the need for them.

When international reserves are depleted and the exchange rate starts to depreciate (which fuels further runs on the currency) there may be no interest rate that is high enough to counter expectations of losses due to depreciation and possible default.

However, if the nation does not wish to default then there no alternative but to restore the reserves of foreign currencies. That is the way the IMF has been able to justify imposing harsh conditions on nations in danger of default in return for foreign reserve supplements.

So if a government does not want to accept the harsh fiscal conditions that the lending agency is likely to impose on the nation, default is the preferred option.

Fallacies about budget deficits

Much of the austerity push is also based on a fallacious interpretation of what a rising budget deficit means.

The mainstream interpret a rising budget deficit in the following way:

  • It is believed that rising fiscal budgets drive interest rates up (through competition for limited loanable funds) while generating inflation (excess demand).
  • High interest rates, in turn, are argued to squeeze out productive investment, making the nation less competitive internationally.
  • This hinders improvement in the trade balance, and competitiveness is further hurt by inflation.
  • According to this logic, there is a fairly direct link from budget deficits to trade deficits – the so-called “twin deficits” hypothesis. This is why the “conventional view” believes it is imperative to reduce budget deficits.
  • According to the logic, that would allow interest rates to fall, inflation to be reduced, lowering pressure on the external balance and exchange rates.

The link between net spending and interest rates is predicated on the notion that sovereign governments have to “finance” any deficit spending, in the same way that a household has to fund spending above income (ignoring asset depletion options).

Modern Monetary Theory (MMT) demonstrates categorically that any such link is purely voluntary and is not required for a sovereign government to maintain a sustainable fiscal strategy based on deficits.

The “twin deficits” hypothesis is further based on crucial assumptions about the private domestic balance (relationship between saving and investment) which have rarely held in practice.

Finally, the “crowding-out” and “twin deficits” arguments are critically based on a supposed relation between government “borrowing” and interest rates and the crucial orthodox assertion that deficits push interest rates higher.

All these statements/beliefs are are wholly without foundation and reflects a fundamental misconstruction of the way interest rates are determined.

I have also noted a lot of comments in recent weeks which suggest that the external sector makes fiscal austerity a required strategy and further that it is fiscal austerity in past periods that have kept balance of payments stable.

The latter belief by the way is historically inaccurate. Balance of payments adjustments for sovereign nations do not usually come about via fiscal retrenchment. Exchange rate flexibility, variations in terms of trade (real effective exchange rates), and variations in growth driven by private spending fluctuations are much more important historically.

Overall, there is a great deal of confusion over international “flows” of currency, reserves, and finance, much of which results from failure to distinguish between a floating versus a fixed exchange rate.

For example, it is often claimed that the US needs “foreign savings” in order to “finance” its persistent trade deficit that results from US consumers who are said to be “living beyond their means”. Such a statement makes no sense for a sovereign nation operating on a flexible exchange rate. For example, a US trade deficit results when the rest of the world (ROW) wishes to net save in the form of dollar assets.

From the perspective of the ROW, exports to the US reflect the “cost” imposed on citizens of the ROW to obtain the “benefit” of accumulating dollar denominated assets. From the perspective of America as a whole, the “net benefit” of the trade deficit consists of the net imports that are enjoyed. In contrast to the conventional view, it is more revealing to think of the US trade deficit as “financing” the net dollar saving of the ROW rather than thinking of the ROW as “financing” the US trade deficit. If and when the ROW decides it has a sufficient stock of dollar assets, the US trade deficit will disappear.

Note that these arguments are predicated on adoption of a floating exchange rate. A country that operates on a gold standard, or a currency board, or a fixed exchange rate is constrained in its ability to use the monetary system in the public interest, because it must accumulate reserves of the asset(s) to which it has pegged exchange rates.

This leads to significant constraints on both monetary and fiscal policy because they must be geared to ensure a trade surplus that will allow accumulation of the reserve asset.

This is because such reserves are required to maintain a credible policy of pegging the exchange rate. On a fixed exchange rate if a country faces a current account deficit, it will need to depress domestic demand and wages and prices in an effort to reduce imports and increase exports. In a sense, the nation loses policy independence to pursue a domestic agenda. Floating the exchange rate effectively frees policy to pursue other, domestic, goals like maintenance of full employment.

Insolvency risk and credit rating

When considering sovereign debt MMT always notes that a sovereign government that borrows only in its own currency faces no solvency risk.

Private debt (or public debt in foreign currency) is a different matter as there is default risk, and it is plausible that the non-government sector in many nations including Pakistan, face higher default risk when there is a recession. In Pakistan’s case, most external debt is government debt.

When the ratings agencies start downgrading or threatening to downgrade a nation, emergency measures provided by the IMF, for example, can help to reassure financial markets.

But from an MMT perspective, we would always emphasise that it is counterproductive for a sovereign government (such as Pakistan would be without the foreign-currency denominated debt obligations) to deal with a debt crisis by imposing austerity on the domestic economy.

It is counterproductive to try to achieve some target budget deficit to satisfy external bond market and/or institutional lenders like the IMF if that chokes off economic growth.

It is far more sensible to design a budget with a view to the economic effects desired, rather than with a deficit target in mind. In other words, tax and spending reform should be formulated to accomplish economic, social, and political objectives rather than to hit a deficit target.

Our view is that governments will not achieve their budget deficit target even if it were to cut drastically spending on social services (education, health, etc.) and development expenditures. This is because such draconian cuts would be likely to throw the economy into a deep recession that would reduce tax revenues.

Further, if this were done, it would have serious repercussions for the nation’s political stability and for its future. A better strategy would be to negotiate with the multilateral agencies a program that would allow the country to service its external debt, and gradually reduce its need for foreign reserves (that is, reduce the trade deficit until it reaches a more manageable level).

During this time, the structure of spending should be analysed, and a realistic development program should be devised which emphasises domestic expansion and domestic production.

Part of this adjustment may have to involve unilateral default on external obligations.

In the aftermath of its financial crisis in 2001-02, Argentina defaulted on a portion of its external debt – a decision which contributed to Argentina’s ability to restore economic growth in the year.

While it is frequently argued that default on debt is dangerous because future access to credit will be denied, that does not appear to be the case, historically. Indeed, entering formal bankruptcy proceedings often eases access to credit markets for households and firms for the obvious reason that relief from debt burdens makes it easier to service new debt.

Bankruptcy laws are adopted not only to protect borrowers, but also to protect creditors by establishing clear procedures regarding the allocation of losses. Bankruptcy laws are also in the social interest, because excessive debt hinders economic performance.

However, sovereign bankruptcy is a murky area. A sovereign government can always service debt issued in its own sovereign currency and there is no default risk and hence no need for bankruptcy. Indeed, it could be argued that it would be illegitimate for a sovereign government to default on such debt. If the government has incurred obligations in a foreign currency, however, it may not be able to service the debt. Hence, there is always default risk.

However, there are no well-established procedures for default. Often a government with excessive foreign currency debt will approach international lenders for help by borrowing foreign currency. Usually, conditionalities are attached that imply additional domestic burdens.

However, there is a long legal history associated with the doctrine of “odious debts”. There is no formal international law dealing with such debts, but there is customary international law – that is, what states have actually done in practice.

Often these concern cases in which a previous government has incurred debts, sometimes with the complicity of creditors, to pay for spending that is perceived to be inconsistent with the public purpose.

I consider it essential that the world leaders form some consensus to create formal procedures that would allow debtor nations to obtain debt relief especially in cases in which creditors are partly responsible for “debt pushing”. Even where no wrong-doing on the part of creditors or debtors is involved, debt relief might be needed where economic conditions have deteriorated more than could have been anticipated by either creditors or debtors. Indeed, bankruptcy courts do not require culpability to order debt relief.

Case study: Argentina 2001-2002 …

In April 1991, Argentina adopted a rigid peg of the peso to the dollar and guaranteed convertibility under this arrangement. That is, the central bank stood by to convert pesos into dollars at the hard peg.

The choice was nonsensical from the outset and totally unsuited to the nation’s trade and production structure. In the same way that most of the EMU countries do not share anything like the characteristics that would suggest an optimal currency area, Argentina never looked like a member of an optimal US-dollar area.

For a start the type of external shocks its economy faced were different to those that the US had to deal with. The US predominantly traded with countries whose own currencies fluctuated in line with the US dollar. Given its relative closedness and a large non-traded goods sector, the US economy could thus benefit from nominal exchange rate swings and use them to balance the relative price of tradables and non-tradables.

Argentina was a very open economy with a small non-tradables domestic sector. So it took the brunt of terms of trade swings that made domestic policy management very difficult.

Convertibility was also the idea of the major international organisations such as the IMF as a way of disciplining domestic policy. While Argentina had suffered from high inflation in the 1980s, the correct solution was not to impose a currency board.

The currency board arrangement effectively hamstrung monetary and fiscal policy. The central bank could only issue pesos if they were backed by US dollars (with a tiny, meaningless tolerance range allowed). So dollars had to be earned through net exports which would then allow the domestic policy to expand.

After they introduced the currency board, the conservatives followed it up with widescale privatisation, cuts to social security, and deregulation of the financial sector. All the usual suspects that accompany loss of currency sovereignty and handing over the riches of the nation to foreigners.

The Mexican (Tequila) crisis of 1995 first tested the veracity of the system. Bank deposits fell by 20 per cent in a matter of weeks and the government responded with even further financial market deregulation (sale of state banks etc)

These reforms loaded more foreign-currency denominated debt onto the Argentine economy and meant it had to keep expanding net exports to pay for it. However, things started to come unstuck in the late 1990s as export markets started to decline and the peso became seriously over-valued (as the US dollar strengthened) with subsequent loss of competitiveness in the export markets.

Lumbered with so much foreign-currency sovereign debt the decline in the real exchange rate (competitiveness) was lethal.

The domestic economy by the late 1990s was mired in recession and high unemployment.

And then the “Greek scenario” unfolded. Yields on sovereign debt rose as bond markets started to panic – a vicious cycle quickly became embedded.

In 2000, the government tried to implement a fiscal austerity plan (tax increases) to appease the bond markets – imposing this on an already decimated domestic economy. The idiots believed the rhetoric from the IMF and others that this would reinvigorate capital inflow and ease the external imbalance. But for observers, such as yours truly, it was only a matter of time before the convertibility system would collapse.

Why would anyone want to invest in a place mired in recession and unlikely to be able to pay back loans in US dollars anyway?

In December 2000, an IMF bailout package was negotiated but further austerity was imposed. No capital inflow increase was observed. Duh!

The government was also pushed into announcing that it would peg against both the US dollar and the Euro once the two achieved parity – that is, they would guarantee convertibility in both currencies. This was total madness.

Economic growth continued to decline and the foreign debts piled up. The government (April 2001) forced local banks to buy bonds (they changed prudential regulation rules to allow them to use the bonds to satisfy liquidity rules). This further exposed the local banks to the foreign-debt problem.

The bank run started in late 2001 – with the oil bank deposits being the first which led to the freeze on cash withdrawals in December 2001 and the collapse of the payments system.

The riots in December 2001 brought home to the Government the folly of their strategy. In early 2002, they defaulted on government debt and trashed the currency board. US dollar-denominated financial contracts were forceably converted in into peso-denominated contracts and terms renegotiated with respect to maturities etc.

This default has been largely successful. Initially, FDI dried up completely when the default was announced. However, the Argentine government could not service the debt as its foreign currency reserves were gone and realised, to their credit, that borrowing from the International Monetary Fund (IMF) would have required an austerity package that would have precipipated revolution. As it was riots broke out as citizens struggled to feed their children.

Despite stringent criticism from the World’s financial power brokers (including the International Monetary Fund), the Argentine government refused to back down and in 2005 completed a deal whereby around 75 per cent of the defaulted bonds were swapped for others of much lower value with longer maturities.

The crisis was engendered by faulty (neo-liberal policy) in the 1990s – the currency board and convertibility. This faulty policy decision ultimately led to a social and economic crisis that could not be resolved while it maintained the currency board.

However, as soon as Argentina abandoned the currency board, it met the first conditions for gaining policy independence: its exchange rate was no longer tied to the dollar’s performance; its fiscal policy was no longer held hostage to the quantity of dollars the government could accumulate; and its domestic interest rate came under control of its central bank.

At the time of the 2001 crisis, the government realised it had to adopt a domestically-oriented growth strategy. One of the first policy initiatives taken by newly elected President Kirchner was a massive job creation program that guaranteed employment for poor heads of households. Within four months, the Plan Jefes y Jefas de Hogar (Head of Households Plan) had created jobs for 2 million participants which was around 13 per cent of the labour force. This not only helped to quell social unrest by providing income to Argentina’s poorest families, but it also put the economy on the road to recovery.

Conservative estimates of the multiplier effect of the increased spending by Jefes workers are that it added a boost of more than 2.5 per cent of GDP. In addition, the program provided needed services and new public infrastructure that encouraged additional private sector spending. Without the flexibility provided by a sovereign, floating, currency, the government would not have been able to promise such a job guarantee.

Argentina demonstrated something that the World’s financial masters didn’t want anyone to know about. That a country with huge foreign debt obligations can default successfully and enjoy renewed fortune based on domestic employment growth strategies and more inclusive welfare policies without an IMF austerity program being needed.

The clear lesson is that sovereign governments are not necessarily at the hostage of global financial markets. They can steer a strong recovery path based on domestically-orientated policies – such as the introduction of a Job Guarantee – which directly benefit the population by insulating the most disadvantaged workers from the devastation that recession brings.

However, the other lesson that Rogoff and his ilk don’t emphasise – is that pegging a currency to another, guaranteeing convertibility and then allowing the financial sector to “dollarise” your economy (drown it in foreign currency-denominated debt) – is a sure way to force the country into financial ruin.

It has nothing to do with the volume of public debt issued in the local currency by a government which has sovereignty in that currency.


To reiterate, none of this discussion applies to truly sovereign nations who never face any solvency risk.

I think the best thing a non-sovereign government can do in terms of advancing the interests of its people is to move towards sovereignty as soon as possible. That might involve jettisoning a currency arrangement (such as in Latvia, for example).

It might require exiting a monetary union that has taken the currency-issuing monopoly away (such as the EMU nations). In this instance, that might necessitate a formal default on all debt that was incurred in the currency that the nation is exiting (such as Greece at present).

The reality is that a sovereign government holds all the cards in this situation. Please read my blog – Why pander to financial markets – for more discussion on this point.

There would be short-term costs but by re-establishing the currency sovereignty the nation will always be able to advance the best interests of its domestic economy.

This doesn’t mean that a nation that is short of real resources etc will be able to establish a high material standard of living by moving to sovereignty. The real standard of living is always determined by the access a nation has to real resources. Fiscal policy does not create these resources but can ensure they are more fully utilised and thus more effectively deployed. A poor nation will not become rich just because it is sovereign.

That is enough for today!

This Post Has 21 Comments

  1. I enjoyed this piece as it is a real-life dilemma facing the PIIGS and indeed initially the thought of becoming sovereign again and restructuring outstanding debt is tempting and possibly attractive. The consequences to the defaulting nation are covered and I generally agree however little is mentioned about the mess that creditors will find themselves in, especially the non-government holders of debt. Pension funds, corporations, charitable foundations etc. Even if Greece were to negotiate (rather than decree) an exit to the EMU and pay 50c in the EUR on outstandings it would have consequences not dissimilar to the Madoff scandal but on a bigger scale; bankruptcies, loss of wealth etc.

    ‘The real standard of living is always determined by the access a nation has to real resources.’
    Not so sure about this. Switzerland has one of the highest standards of living and per capita GDP yet almost no ‘real’ resources unless you count resources to mean an uncanny ability to make watches and chocolate and a banking system so secretive that you could hide your rotting grandma in a vault for decades without being discovered.

  2. Dear Ray (at 2010/09/07 at 21:04)

    You said:

    Switzerland has one of the highest standards of living and per capita GDP yet almost no ‘real’ resources

    Switzerland has a population of 7,647,675 (approx). That is a lot of real resources.

    best wishes

  3. Bill:

    You make a(nother) great point. Economies for centuries have substituted resources as conditions change, but there is no economy without humans.

  4. Bill:
    Great work….

    While I always feel that managed bond defaults and local currency would represent the best option for Greece, I do not know whether or not it would result in hoarding of goods thereby destroying the local currency.

    Did hoarding actually occur in Argentina? How did they manage that? My apology for not researching for the answer.

    Best wishes

  5. I wonder if many countries have adopted Central Bank regulations/laws that do forbid the CB to buy gov. bonds and mandate that the gov. borrow on the market?

    In Sweden we have such law, in fact the CB law is fully in line with a coming “anslush” to the euro. They (political establishment) barefaced lied to the Swedes at the popular vote in 1994 on EU membership. They asserted that EMU/euro was an issue solely for the Swedish parliament to decide, this despite they didn’t negotiated an exception from the mandatory euro as UK and Denmark have.

    Sweden has avoided the euro by not entering ERM/ERM2 that by some reason is voluntary. 2 years in ERM is the final stage before entering the euro. 2004 we did actually have a referendum on the Euro, No 56%, Yes 42%. Resounding no to the euro. But not the tiniest attempt to renegotiate the EU-treaty. 2008 at least 80% in the parliament voted yes to the new Lisbon treaty and still no attempt to get an exception from the mandatory euro. Our politicians maintain to assert that it’s an issue for our parliament to decide. Now and then ECB is blustering about the mandatory obligation in the treaty to do whatever is necessary to adopt the euro for EU members. Now our right wing gov. is talking to make another referendum on the euro. Ill guess with the Lisbon treaty Sweden couldn’t veto a change for participating in ERM, what should we then do, leave EU.

  6. Although I’m a staunch supporter of the European Union I must admit that more and more I’m convinced Bill is right with his advice to countries like Greece to abandon the Eurozone. The whole setup amounts to a big looting of the Greek public by the private banks. According to the BIS release only German banks will receive 2010 5.5 billion in interest from the PIGS countries. That is about half the profit the banks made in 2005. This is ridiculous. On top of austerity there’s a big transfer of money from South to North.

  7. Off topic and from:

    “Whenever the issue of fiscal stimulus comes up, you can count on someone chiming in to say, “Only a moron could believe that the answer to a problem created by too much debt is to create even more debt.”

    That would be me.

    “It sounds plausible – but it misses the key point: there’s a fallacy of composition here. When everyone tries to pay off debt at the same time, the result is contraction and deflation, which ends up making the debt problem worse even if nominal debt falls. On the other hand, a strong fiscal stimulus, by expanding the economy and creating moderate inflation, can actually help resolve debt problems.”

    I believe he has a fallacy. He doesn’t understand the difference between currency and debt.

    “From 1929 to 1933, everyone was trying to pay down debt – and the debt/GDP ratio skyrocketed thanks to contraction and deflation. During and immediately after WWII, there was massive borrowing – but GDP grew faster than debt, and the debt burden ended up falling.”

    Was the USA exporting during and immediately after WWII?

    “Yes, it seems paradoxical – but that’s the kind of world we’re living in. And the refusal of so many people to face up to the fact that we’re in a world where conventional rules don’t apply makes it likely that we’ll stay in that world for a long time come.”

    If models don’t work if an economy is demand constrained instead of supply constrained, maybe the models are not a very good.

  8. About krugman and paradoxes-of-deleveraging-and-releveraging, no mention if some to a lot of supply was destroyed in the war?

  9. For a long time I have advocated debt restructuring/rescheduling as a viable policy for economies without currency seignorage power, especially if debt is in foreign currency and if interest cost is an income outflow for the domestic economy not supported by an equivalent of capital inflow and/or trade surplus. Debt restructuring in the form of a par/discount bond combination with a ‘haircut” designed to equal to secondary market assessment of debt valuation and “mark to market” accounting of portfolios allows for a neutral solution as recorded losses already value the “haircut” of interest and principal. Rescheduling allows for repayment flows to match projected revenues subject to a fiscal policy that targets potential income consistent with full employment. Discounted interest payments will be covered by domestic savings generated by rising income. Repayment of principal in such a rescheduling plan can be in annual tranches after a grace period sufficient for fiscal policy and growth planning to achieve these revenue flows. The whole idea of restructuring/rescheduling is to adjust the interest cost drain in revenue constrained regimes in the absence of seignorage power of monopoly issue of domestic currency, in the presence of fixed exhange rate arrangements with trading partners and if debt is denominated in foreign currency. This adjustment will add fiscal space/capacity as long as real resources are available and underutilized or they can be “imported’ to sustain domestic investment. This program can be assisted by capital markets, if the restucturing/rescheduling plan includes a “haircut” restoration option in the event that sufficient investment is forthcoming to accelerate steady state growth at a premium over the interest rate agreed on the repayment plan. Thus, bondholders will be motivated to support the growth potential of the economy as the ‘haircut” restoration is a forward economic rent to be achieved if the program succeeds.

  10. Panayotis says:
    Wednesday, September 8, 2010 at 9:23
    Debt restructuring in the form of a par/discount bond combination with a ‘haircut” designed to equal to secondary market assessment of debt valuation and “mark to market” accounting of portfolios allows for a neutral solution as recorded losses already value the “haircut” of interest and principal.

    This is ludicrous and unacceptable for 3 reasons.
    1. Secondary market pricing is not entirely about credit risk. Other factors including liquidity and transparency of the bond and outright level of interest rates in the market (due to MP and inflation) have significant effects on the bond price.
    2. Why would anyone ever buy the bond at par in primary when they know the issuer will be sizing up restructuring options the moment it trades at a discount
    3. Haircutting to the mark-to-market discount begets more discounting, begets more haircutting etc etc

    How would you feel if I, as your employer, decided I was going to haircut your holiday pay and entitlements because things weren’t going too well? Is there any difference to the bondholder who might be mr and mrs average super fund?

    Bondholders are secured creditors yet you are moving them below that of taxpayers (equity holders). Raise taxes slightly for all before you welch on your debt obligations.

  11. Bill

    Re – Ray’s comments about Switzerland, do they practice MMT? as they appear to have a pretty good system set up, in that they have one of the worlds largest resource companies Xtrata and a large merchant marine without having a seaport. From what i have gleaned the SNB activley intervenes to keep their currency competitive. Are they an economy and a political system, that Australia should try to emulate? I suppose what I am asking can you do a blog on the Swiss?



  12. Isn’t this already well understood?

    The Greeks themselves thought it was in their interest to default on the payments. The Banks who loaned the money expected the Greeks to default.

    The Banks put pressure on the Euro block (Germany as the principle funding nation), to keep the party swinging. As the German banks would be the ones taking the major haircut, Merkel caved into to lobby pressure. All this despite strong opposition from the people of Greece and Germany.

    Greeks are not happy, Germans are not happy. Banks are happy collecting interest, bring on the next PIIG to the slaughter table.

  13. Andrew you do not understand the situation if you think only banks hold sovereign bonds. PIMCO is the biggest bond fund in the world and its investors are the public and other mutual funds. In the end the public is hurt if/when a sovereign defaults.

    I think the Germans are least happy as their retirement age is increasing so that lazy Greek public servants can shorten theirs.

  14. @Jack
    I wouldn’t say Switzerland THINKS along the line of MMT. They are also obsessed with government debt and celebrate each year (ie 2008) when there’s a surplus. Which is no miracle given that Switzerland runs a current account surplus. Traditionally the SFR is a safe heaven currency. The SNB tries to intervene to keep the SFR competitive with limited success. Once economic times get tough the SNB regularly sits on piles of currency reserves. 2010 232 billion SFR. When Bretton Woods collapsed the SNB even introduced negative interest rates on accounts belonging to foreigners.

    That said I don’t think it is feasible to export the Swiss political system to Australia. Australia is too big and too populous. Imagine how long it would take to implement one law? Every city/town must assemble to vote. A big mess 😉

  15. Bill: “Switzerland has a population of 7,647,675 (approx). That is a lot of real resources.”

    Pakistan has a population of 116,000,000. That’s even more real resources. Wouldn’t it make sense to put Pakistan’s aid money towards paying off their foreign debt obligations? Then their govt could be properly sovereign and make full use of their potential…

  16. Maybe not, I don’t claim to have any detailed economics knowledge.

    Aren’t sovereign bonds just the bonds issued by Governments in a currency other than their own? I thought they were relatively rare and issued by dodgy countries. I’m not suprised banks don’t like to own them. Most bonds are issued in the National currency.

    I take the point that some end beneficiaries of bonds may indeed be private individuals via the bank as an intermediary. It is difficult for private individuals to buy bonds. I have no idea what percentage of bonds are coupon bearing bank assets. In any case they do get a healthy cut of all coupons through intermediary charges.

    I believed the German taxpayers are the unhappy ones. They are the eventual guarantor of extended loan terms. They will hold the bag when Greeks finally default. In the meantime the Greeks are still up to their neck in hock paying up the interest.

    The German banks and depositors with those banks should be happy.

  17. @Ray
    I don’t know how often this must be said: there ain’t such a thing as lazy Greeks. Please consult the relevant OECD tables. Just because the German media reiterates this nonsense on a weekly basis doesn’t mean it is true. The federal government of Greece has two major problems beside being part of the Eurozone. Corruption and a broken tax system.

    Also the raising of the retirement age in Germany has nothing to do with Greek public servants idling in the sun sipping Ouzo. There are two reasons. First the neo-liberal obsession with unit labor costs and international competitiveness. Better to deprive the local population and ship as much output as possible to ROW (rest of the wold). Second the ongoing transfers due to German unification. Unification was and is financed by debt and by the social security contributions of labor.

    Although you’re right that interest on bonds doesn’t only acrue to banks it is nonetheless public welfare for the top-end-of-town. Two-third of Germans don’t have any or only a small amount of financial property. On average < 15.000 Euro. 10% of Germans own 2/3 of all financial assets.

  18. Ray,

    You have reduced the discussion with cheap moralizing. Any sophisticated investor knows the risks involved in situations where conditions have changed that make repayment usustainable ant this is why he demands a premium apriori. There is no guarantee that he will receive it.

    1. Regarding the mark to market adjustment, the relation the the haircut is net of any other minor factors as the major component regards the shortfall from expected default.

    2. Regarding “lazy greek public servants” I guesss you know many of them!

  19. Dear Bill,

    Your blog could be used as a basic plan for my native country – Bulgaria to come back to life as it slowly dying now.
    I’ve just visited it after 10 years in US.
    It was a very sad journey – Bulgarian people are slowly disappearing due to death and immigration. Your own government is worse than foreign aggressor – it is a crime. I am depressed but still believe that something can be done.

    Thank you.

  20. I have recently discovered this blog and am greatly enoying it.

    Interesting to read today alongside Martin Wolf’s latest piece showing the Germany is in really a big beneficiary of the eurozone

    Two comments: Sinn suggests “Greece would have been bankrupt without the rescue measures.” Clearly this is meaningless while Greece is in the eurozone (rescue is implicit), and just wrong if Greece were not as it would have sovereignty.

    Secondly, “default” for sovereign nations is therefore just an extreme form of deleveraging. It is not as if a creditor can force the wind up a country and sell it off in retribution! As Wolf notes, the creditors of Greece, notably the French banks, are just going to have to take a haircut and that is what they deserve for imprudent lending to Greece. They are equally at (de)fault!

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