On Creators of Currency and the Sovereign Debt Crisis
When people talk about the recent sovereign debt crisis they make a lot of sweeping statements about debt and currency which allow them to make false analogies. This does us all a disservice because it creates a false impression about the nature of constraints which government faces in dealing with the credit crisis.
The reality is that different sovereigns face very different constraints because some are users of currency while others are creators of currency. This is the key difference in any sovereign debt situation because insolvency almost always comes via a liquidity crisis and creators of currency have a lot more rope than users do.
Here are the issues in the sovereign debt crisis as I put it in "The origins of the next crisis":
[Nomura Chief Economist Richard] Koo has suggested that Japan’s enormous public sector debt burden owes to the balance sheet recession Japan is suffering and sees a similar dynamic likely to hit the western world. This means the private sector is in a secular deleveraging trend. I outlined some of my thinking based on Koo’s model in the consumer spending post linked above.
But, the flaw in Koo’s remedy is that it relies on fiscal stimulus, which has been used to maintain the status quo ante, resulting in a misallocation of resources and continued overcapacity and economic malaise (see Revisiting the sectoral balances model in Japan).
Moreover, I see the increase in public sector debt in a balance sheet recession as a socialization of losses. If you look at any economy that has suffered steep declines in GDP, what we have seen are a reduction in tax revenue, an increase in government spending and bailouts. This is true in Ireland, the UK, and the U.S. in particular. In effect, what is occurring is a transfer of the risk borne by particular agents in the private sector onto the public writ-large. The magnitude of this risk transfer via annual double digit increases in debt-to-GDP is breathtaking.
Finally, these debt levels are unsustainable for the world as a whole. Japan has been able to run up public sector debt to 200% of GDP because it alone was in a balance sheet recession and its private sector was willing to fund this debt. But, things are vastly different now. Sovereign defaults are likely.
So, private sector debt has been socialized, morphing a financial crisis into a sovereign debt crisis. The question: which governments will default first?
Obviously, the weakest debtors will succumb first. In assessing who the weakest debtors are, you have to focus on two things:
- Who is the debtor?
- What recourse does the debtor have to maintain cash flow?
Who is the debtor? A currency user or creator?
The main reason the Eurozone is the focus of the sovereign debt crisis and the U.S. and the U.K. have escaped relatively unscathed has nothing to do with a Anglo-Saxon conspiracy to tear down the Eurozone; this is something you hear in the European media all the time.
The problem has always been the Eurozone’s faulty construction:
the fatal flaw in the Eurozone was twofold. On the one hand, it created a gold standard like fixed-exchange rate bind which means that the currency depreciation option is moot. Doing so without some sort of fiscal transfer mechanism is reckless because it severely limits the options of countries during economic downturns when the typical policy options are also likely to be most politicized and polarizing. It is like setting up the United States where each state has national sovereignty and there is no central treasury but there is a central bank.
Meanwhile, the Eurozone has restricted the ECB from printing money as a remedy. That leaves default and bankruptcy as the only option in a severe economic slump.
Eurozone countries are users of currency not creators of currency. In fact, the Eurozone setup has a lot of similarities to the gold standard. I like to think of the Euro as gold and the Euro countries as having implicitly retained their national currencies with a fixed rate to the Euro. If you recall, that actually was the setup when the countries pegged their currencies to the ECU before Euro money was introduced.
Now, insolvency for companies or countries, individually or systemically is almost always caused by a liquidity crisis. So, when a liquidity crisis strikes, eurozone countries are vulnerable unless they can generate enough cash through taxation to fund government spending. Sovereign default is where Greece, Ireland, Portugal and Spain would be if not for the bailouts via the ECB. The ECB’s buying up Greek debt is the equivalent of the Fed buying up debt from the state of California. Is this the way you want to deal with crisis? It seems like a moral hazard which invites more of the same in future. This is completely unworkable and is the main reason for the pressure on the peripheral European sovereigns.
Contrast this situation with what you see in the U.S. where everyone is talking about quantitative easing aka printing money, yet yields are incredibly low. If the Federal Reserve starts buying up lots of Treasury securities, the U.S. government can never face a liquidity crisis. That’s a big difference. In fact, it is the main difference between the Eurozone and other advanced economy sovereign debtors. The U.S. is not Spain, the U.K. is not Ireland. Full stop.
What about the debt?
On occasion you might hear someone talk about debt to GDP ratios in this country or that country without identifying whether the debt is private or public sector debt. Directionally, it gives you a sense of the leverage or gearing in that economy. But that’s a problem for a number of reasons.
First, the government can tax. And while over the longer term you can’t get blood from a stone, the power of taxation is helpful over the short-term.
More importantly, governments with fiat currency are not revenue (tax) constrained. Taxes don’t fund government spending.
government creates currency – and, therefore, as it’s creator they can buy stuff with money they create without funding it first.
Taxes give the fiat currency value by forcing people to use that specific currency in order to discharge their tax obligation. From an accounting perspective, they merely expunge a liability on the government’s balance sheet ledger. They don’t fund spending per se. There is a vestigial tie to taxes as a ‘funding’ source in that the U.S. government is required to issue debt in the form of Treasury bonds, bills or notes to cover deficits But this is a relic of the gold standard mandated by Congress which has not prevented the government from deficit spending. Legal tender laws make the currency widely distributed and entrench it as the money of choice within an economy. In a fiat currency system, sovereign government debt doesn’t serve an important currency function like funding deficits.
The currency is the government’s creation and therefore it can always make good on its obligation. Whether it chooses to do so for political reasons (stiffing foreigners, domestic politics) is another question.
A company faced with the same constraints cannot just "print money." Whether this printing causes inflation or an increase in interest rates is beyond the scope of this post. But, I’m sure you can see that neither is a problem right now.
What about Cash flow?
All of the preceding was my way of demonstrating that who the debtor is matters. But, regarding the cash flow question, Christopher Wood’s quote from a few month’s back is a good jumping off point.
The key reason why that’s the endgame is that this credit crisis we saw in the west in 2008 and 2009 has simply been deferred, because 95% of the so-called government policy solutions to deal with this crisis have simply been to extend government guarantees.
So the problem’s been transferred from the private sector to the public sector. It’s just a matter of time before investors revolt against these sovereign guarantees … The crisis is going to happen first in Europe. It’s going to climax in the U.S.
What is he saying? Here’s my interpretation:
- Europe is a basket case – both in terms of the sovereign debt levels and primary deficits. Eastern Europe is worse than the Eurozone. But in the Eurozone, unless you get a massive currency depreciation, over the medium-term the cash flow i.e. tax revenue just isn’t there for the likes of Greece or Ireland. Eurozone countries are users of currency without any sort of political harmony. When the next liquidity crisis comes, will it be bailouts all around or will individual countries like Slovakia balk? This is a disaster waiting to happen.
- Debt levels in other countries are also high. Take the U.S. for example, where private sector debt approaches 300% of GDP. The socialization of losses via bailouts and deficit spending to prop up the bailed out companies has bloated the public sector’s debt levels. There are a number of ways to reduce real debt burdens. The American political class will not allow a Great Depression-like deflation to take hold so they will choose inflation. Eventually, this will lead to an inflationary crisis in the U.S. But this is probably years down the line.
My question is whether there is any way out of this by paying down private sector debts via accumulated savings over time and government debts via the growth that comes with full employment. In "The origins of the next crisis" I said no. The volatility of a highly leveraged global economy makes this impossible. Witness events in Ireland where the socialization of banking sector losses has now come to be seen as an existential threat. Debt revulsion has kicked in as a result.
Here’s what I said in April:
The debt crisis in Greece is a preview of what is to come. Those debtors which attempt to most increase the risk transfer onto the public will soon find debt revulsion a very real problem. And what will invariably happen is that a systemic crisis will ensue. Fiscal stimulus is warranted, but deficit spending as far as the eye can see risks a catastrophic outcome. This is a very different world than we lived in during the asset based economy. But it also a different world than Japan has lived in over the last two decades.
There are four ways to reduce real debt burdens:
- by paying down debts via accumulated savings.
- by inflating away the value of money.
- by reneging in part or full on the promise to repay by defaulting
- by reneging in part on the promise to repay through debt forgiveness
Right now, everyone is fixated on the first path to reducing (both public and private sector) debt. I do not believe this private sector balance sheet recession can be successfully tackled via collective public sector deficit spending balanced by a private sector deleveraging. The sovereign debt crisis in Greece tells you that. More likely, the western world’s collective public sectors will attempt to pull this off. But, at some point debt revulsion will force a public sector deleveraging as well.
And unfortunately, a collective debt reduction across a wide swathe of countries cannot occur indefinitely under smooth glide-path scenarios. This is an outcome which lowers incomes, which lowers GDP, which lowers the ability to repay. We will have a sovereign debt crisis. The weakest debtors will default and haircuts will be taken. The question still up for debate is regarding systemic risk, contagion, and economic nationalism because when the first large sovereign default occurs, that’s when systemic risk will re-emerge globally.
In sum, I see the sovereign debt crisis as far from over. When you see government focused on whether to go for more stimulus or run with austerity as some sort of fix, you know it is just kicking the can down the road. The right approach would be to focus on the lost output from the massive unemployment we are witness to. Much of this is structural. Much of it is not.