The Sovereign Debt Crisis and Currency Sovereignty

We have a big summit in Europe over Greece today and a deadline of sorts on the debt ceiling in the US tomorrow. I am scheduled to appear on BBC World News tomorrow to talk about the sovereign debt crisis and these issues specifically. The interview is scheduled for one of the main news programs, GMT with George Alagiah, which begins at 1100GMT – 0700am EDT. Hopefully, I will be toward the end, since 7am is pretty early.

One particular aspect the BBC wants to discuss tomorrow is: What if it does all go wrong? How bad could it actually be? What’s the worst case scenario for the world economy, and do the twin debt crisis in the US and Europe have the potential to drag down China too?

So I am writing this post as a prelude to that interview and those particular questions. I am not going to answer those ‘financial Armageddon’ questions here because to understand where things are headed you need to know how we got here and why. So I want to present the most important issues in the sovereign debt crisis in the US and Europe here.

Framing the issues

The US and the Euro zone face different problems. However, the genesis of the debt crises is the same. In both areas, excessive leverage and private sector indebtedness was used to purchase assets at inflated prices, property being the asset class of greatest importance. When asset markets corrected, they did so violently, which precipitated a credit crisis and deep economic downturn. For fear of an implosion in the financial system, governments decided to socialise a large fraction of the losses from this indebtedness by bailing out large financial institutions instead of allowing these institutions to fail.

In the countries like Spain, Ireland, the US, and the UK, where the property markets seized up the most, governments also socialised the most losses. For example, Ireland now has government debt to GDP well over 100% from a relatively benign 25% mark before the crisis. In the US, Simon Johnson estimates that government debt to GDP increased 40% as a direct consequence of the financial crisis.

Source: Irish National Treasury Management Agency

In April 2010, I said plainly that here we could see the origins of the next crisis.

There are four ways to reduce real debt burdens:

  1. by paying down debts via accumulated savings.
  2. by inflating away the value of money.
  3. by reneging in part or full on the promise to repay by defaulting
  4. 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.

And as contagion in the Euro zone spreads to Spain, Italy and potentially to Belgium or France, we are at that moment when systemic risk will become acute.

The problem in the US is political

In the US, the short-term problem is the debt ceiling. This limitation on government debt has become a political issue which has created a choice between defaulting or cutting spending. But this is an artificial – a political – and self-imposed limitation to prevent excessive deficit spending.

If you march down to the government with your paper IOU with $100 printed on it to demand your money, the government will simply hand you another paper IOU with the exact same amount printed on it. That’s how fiat money works. All US government obligations are substantially identical promises to repay a specific amount of the currency unit of account backed by nothing but taxing authority. So, Treasuries don’t ‘fund’ anything. That’s the confidence trick of fiat currency. If confidence erodes, tax evasion will rise, citizens will begin surreptitiously using other media of exchange to transact and inflation and currency depreciation will spiral out of control.

Clearly the US government cannot involuntarily default on a currency obligation it can manufacture in infinite quantities. The same is true in Japan or Australia. These nations are sovereign in their currency. Bond market participants know this. That is why Italy is under pressure and Japan is not. That is why US yields are under 3% and Spanish yields are not. That is why Ireland could default but the UK will not.

The US government issues Treasuries only because it is forced to do so to create the artificial tie between Treasuries and deficits and the mental connection we make as a result. This is why artificial constraints like the debt ceiling are in place.

So the US crisis is a political crisis, not a solvency or even a liquidity crisis. This debate, then, is not an objective one. And that makes it emotional, intractable, and potentially violent in the same ways that political questions were during other major crises like the American Revolution, the Civil War and the Great Depression.

I argued recently that:

Pendulum swings in policy and ideology are a product of people without conviction on issues taking sides. In today’s context, political and ideological battle lines will harden. Eventually, someone will win these policy battles and policy will tilt one way. Afterwards, one side or the other will be proved right by events. And then we can start all over again with the backfire effect because you can’t disprove a negative. But, those in the middle who lacked conviction about the outcome, who didn’t have a strong view will be convinced by the empirical evidence and they will move the ball forward, backfire effect notwithstanding.

The crisis in Europe is about politics too, but it is also liquidity and solvency

The countries within the euro zone do not have currency sovereignty. Greece doesn’t create the euro. Spain doesn’t create the euro. Ireland doesn’t create the euro.

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.

So for the euro zone countries, the ECB is the difference. Without liquidity provided by the ECB, we would already have witnessed more than one sovereign default in the euro zone. The ECB does have the power to end this liquidity crisis. They have not done so for ideological reasons. They do not want to ‘monetise’ euro zone debt and make the euro a weak currency. The immediate impact of buying up Italian or Spanish or Greek debt would be a rise in the euro-denominated gold and silver price, currency depreciation more generally, and increased inflation expectations. So this is a beggar thy neighbour economic policy – competitive currency devaluation; and that is precisely the kind of action the ECB wants to avoid. However, they must monetise or there will be multiple sovereign defaults within the euro zone.

Meanwhile, just as in the US, fiscal consolidation is seen as the only path to solvency for weaker debtors within the euro zone. But fiscal consolidation lowers economic output and therefore increases deficits in the short-term. This is what we have seen in Greece and Ireland to date. That means debt levels will continue to increase across Europe, sowing the seeds of doubt about solvency in markets and continuing the liquidity crisis that requires ECB intervention. Muddling through means deepening crisis for the euro zone then.

The Germans will never have any appetite for a transfer union. You may hear pro-European noises coming from Germany’s old guard including former Chancellor Kohl, but it is clear that these people are not talking about fiscal union. They are talking about cross-border financial regulation or bailouts via a European Monetary Fund that ensures adherence to the existing stability and growth pact. No Eurobonds, no central treasury, no transfer union. Nein.

Only when all other options have failed and the euro is about to break apart will any of these ideas be entertained by German policy makers. As I have argued on two occasions, that’s the psychology of change and the political economy of large, hierarchical systems like corporations or nation states.

I believe the sovereign debt crisis will deteriorate further for just this reason. And then we will just have to see what the politics of the individual countries in Euroland look like. If austerity brings the economy to a crawl and europopulism is well advanced, the euro will collapse. If not, the Europeans will push forward with greater integration.

Over the medium-term, a credible solution to Europe’s debt crisis must be soft restructurings that reduce interest payments and lengthen maturities for some debtors and hard restructurings that also reduce principal repayment for the most-indebted sovereign debtors.

Over the long term, institutional structures for dealing with recessions and economic crises must be formed that are not reliant on artificial constraints like the stability and growth pact. I have some thoughts on a longer-term solution that meets the test in dealing with the politics, the liquidity issues and moral hazard which I will post soon.

  1. Dave Holden says

    In my view that’s all spot on.

    Two points, firstly, in the UK asset prices haven’t corrected. By the Economists reckoning property is still 30 percent overvalued. In my view that still has to be worked out of the system and the coming “austerity” economics may just do that.

    Secondly, on the issue of Bonds I’m only partially convinced on the use of Japan as an example of the benefits of currency sovereignty. So far is it not true that they’ve been able to fund their debts internally and that period is about to end. The US itself is different in that it benefits from being the reserve currency. I only add this as a question mark as I’m somewhat convinced by the argument but in my view only time will tell.

    1. Neil Wilsn says

      The amount of bonds held by domestic banks, insurance companies and financial institutions in the UK and Japan is very similar – about 2/3rds or so.

    2. Edward Harrison says

      This post doesn’t attempt to use Japan as a positive example of the benefits of fiat currency. See here for example:

      I will talk about fiscal, space, malinvestment and currency sovereignty soon. But Japan demonstrates that currency sovereignty does afford a country a lot of fiscal space – for better or for worse.

    3. David Lazarus says

      UK Property has fallen by 15% which by UK standards is a huge drop, before they climbed as a result of QE, though I think that they are still over valued by 45%. Austerity is beginning to have an impact particularly in the north of the country, even though the cuts have only just started.

      An additional problem is that the Uk economy is crumbling as a result of the recession. Productivity is falling, meaning that the ability of the country to grow out of this crisis is diminishing.

      One problem is that inflating the debt away is also going in the wrong direction. While inflation is eroding the value of that debt, wages are falling so the debt burden is growing even with the lower real values. That will exacerbate the problem for the UK. I foresee a rise in bankruptcies in the UK as austerity takes hold. The model (Canadian) that the coalition have based their policy on, is nothing like the UK, economy. Canada was undergoing austerity when its biggest trading partner was booming, and it was a big resource exporter. Neither apply to the UK now.

      As for Greece I do not think that todays EU communique will solve the crisis. The sums are too small. It also works out well for the banks as it socialises the losses of the banks. This will end very badly. I can see riots on the streets around Europe when Greece eventually defaults. It is extend and pretend on a grade scale.

      1. Dave Holden says

        “While inflation is eroding the value of that debt, wages are falling so the debt burden is growing even with the lower real values.”

        Agreed this is something that I’ve never understood – how can inflating away debt work when wages are falling.

        1. Edward Harrison says

          Dave, the UK after World War II is the best example of a country that did not default as it allowed inflation (and currency depreciation) to erode away the real value of debt. I suspect, Japan will be headed in that direction. The end result is a lowering of the standard of living.

  2. RB says

    simple operational question here. so congress mandates 1 for 1 treasury issuance to link government spending with an obligation. what is the timeline there? does the treasury spend by marking up bank accounts (thereby creating reserves), and this money is then used to purchase the mandated amount of treasury debt ex post? the general assumumption (and implication from the congressional mandate) is that the treasury must first issue the debt before they are technically allowed to spend, which would make it impossible to create new money directly through spending. but i get that gov spending is what puts reserves in the banking system which are the source of funds for treasuries. just a little confused.

    1. Edward Harrison says

      Treasury funds its expenditures on an ongoing basis as you would see a large company doing for instance. And it issues debt as needed. So there is no direct tie between the debt and the expenditure.

  3. Tom Hickey says

    Agreed. Excellent analysis. I would simply add that what began as a financial crisis due to not only imprudent lending but also what Bill Black calls “control fraud” and Minsky “Ponzi finance” morphed into, first, an economic crisis, and now into a political crisis. It is headed toward developing into a social crisis as well.

    The problem began with the lenders and should end with them. There has been no investigation, no prosecutions, and no real reform. Instead, many if not most of the people heavily involved in fomenting the financial crisis are still in charge of institutions that have grown larger. Instead of addressing bank insolvency in the customary way of resolution (Black) financial institutions were bailed out, their problems covered up, and now they are back to business as usually. The effect was a transfer of the liabilities of the financial sector to the public sector, leaving most others underwater. This is resulting in a “balance sheet recession” (Koo) that will not clear through increased saving for a decade or more, as the Japanese experience goes to show.

    Through reports like “Inside Job,” the public is figuring out that lenders are responsible for this and government not only let them get away it but actively participated in the transfer that is now crippling the real economy. Even many that understand the sectoral balance approach are reluctant to see it used without wholesale financial reform, since it will only reward the perps and set the world up for another crisis, even larger and more dangerous that this one.

    Ultimately, this is a crisis of capitalism provoked by financial capital. Michael Hudson points out that never in his wildest dreams did Marx ever imagine that financial capital would become the master of industrial capital. But that is what has happened.

    Washington’s blog, the economic analysis of which I seldom am in agreement with, has an interesting post showing the agreement between the left and right on these issues in surprising ways. There is real outrage brewing on both left and right, and unless the real issues are addressed, the political crisis is going to morphed into a full-blown social crisis and where that will lead is anyone’s guess. I would guess it will not end well and leave a lot of carnage.

    The world is now poised on the edge of a cliff with the US becoming politically unstable, the EZ barely holding together, Japan is paralyzed by the natural disaster, and China contracting, perhaps to experience a hard landing. There are apparently housing bubbles in Australia and Canada judging by standard measures involving affordability and mean regression.

    We have already been here. In 1930, “everyone” thought that the downturn was ending. Then Credit Anstalt collapsed in 1931. What is going to be the Credit Anstalt event this time?

    1. David Lazarus says

      Yes Australia has a vastly overvalued property bubble. Overvalued by as much as 60%. It will be bad as they have already had first time buyer incentive before it peaked. It is currently struggling at the moment. Once that collapses it will wipe out a generation of home buyers. It has basically been a result of banks pumping all their loans towards property. Just one giant Ponzi scheme with a lot of hot Chinese money.

      I am not so sure of Canada but I also think that Canadian banks have been masking problems. There has been a lot of talk of how well they are capitalised and how regulated they are. Though I have heard of problems in mortgages where people have got larger mortgages than they would expect. So some large scale mortgage fraud is possible in Canada.

      There will probably be no criminal investigations in the US until after the next crash, in the next few years. I am very bearish about the US EU UK and Australian economies. The rest of the world will do okay even if there is a slowdown. Debts need to be written off in the west even if it wipes out the “job creators/super rich”.

      I too think that the US is heading towards serious civil unrest. Though look at Syria as to how they might solve it. A big problem that is not being addressed in the US is its oil dependency, because of lobbying by oil companies, and in the past by the automakers. If Saudi Arabia were to revolt then I can see oil prices spiking to such an extent that the US will go into depression. This could also impact many other industries as the world goes into recession. Though the black swan event might be something like a collapse in an Eastern European nation that was off the radar, maybe Hungary or Ukraine. Hungary is important because of euro denominated debts. Ukraine because it is a big grain exporter and that could trigger a food crisis and riots elsewhere.

      Longer term I see a massive reregulation of banking though not until we have been through the Global Financial Crisis 2.

    2. Dave Holden says

      Excellent comment Tom! I agree entirely. I’ll add that it seems electorates the world over have been pulling the political lever one way to find either nothing happening or policy going the opposite way.

      1. David Lazarus says

        Yes and why social unrest will increase because of it. Electorates do not want cuts to their welfare programs. They want cuts in waste and tax increases. Reversing the Bush tax cuts would do much to reduce the deficit, add in capital gains taxes equalisation and you a long way boosting tax revenues.

    3. Dave Holden says

      Didn’t Credit Anstalt end up as UniCredit..

      1. Edward Harrison says

        Credit Anstalt became Bank Austria, which is now a part of UniCredit. They are very active in Eastern Europe. UniCredit isn’t really the successor organization. I should also mention that UniCredito owns HypoVereins, which is the former mother organization of the now state-owned German disaster Hypo Real Estate. So Unicredito does have exposure to a lot of toxic stuff outside of Italy.

    4. fresno dan says

      Tom Hickey “Through reports like “Inside Job,” the public is figuring out that lenders are responsible for this and government not only let them get away it but actively participated in the transfer that is now crippling the real economy”

      Argee 1 trillion (the only number meaningful nowadays) percent!
      “many if not most of the people heavily involved in fomenting the financial crisis are still in charge of institutions that have grown larger”

      It really is astounding – its as if the captain of the Titannic had said, “Ram that ice berg again – we’re not sinking fast enough!!!”

    5. Edward Harrison says

      That’s the question, isn’t it, Tom. I don’t think there are many ways out of this without a systemic which precipitates the kind of wholesale political change we see during major crises. Obama has put himself on the side of continuity and has thus become the Hoover of this downturn. While superficially, we might think of events as similar to 1937 because of the statistical economic recovery, in truth events are more akin to 1931. That makes the Credit Anstalt question pertinent.

      1. David Lazarus says

        Well we have the budgetary constraints of 1937 but we have still not dealt with the crisis of 1930. The easiest solution to the crisis is to remove support from the big banks and allow them to collapse. Each nation needs to cleanse itself of its TBTF banks, with their control of the politicians. Then financial reform will be much easier without banks lobbying against it.

  4. M.G. in Progress says

    Big summit: “much ado about nothing”. The creation of money out of thin air continues. The denial continues. Are some countries and banks always “too indebted to fail”?

  5. fresno dan says

    “However, the genesis of the debt crises is the same. In both areas, excessive leverage and private sector indebtedness was used to purchase assets at inflated prices, property being the asset class of greatest importance. When asset markets corrected, they did so violently, which precipitated a credit crisis and deep economic downturn. For fear of an implosion in the financial system, governments decided to socialise a large fraction of the losses from this indebtedness by bailing out large financial institutions instead of allowing these institutions to fail.”

    OK, I think that is spot on and I can understand that.
    Frankly, the rest of it is beyond me.
    What I don’t understand is that the US debt has increased by trillions – say 4 trillion, or is it 8 trillon – hey, its just trillions. But what did we BUY? Say the US (is there a difference if it is the Fed?) buys a bunch of overpriced houses – all these 200K houses (banks, bondholders, everybody but the taxpayer who is taking it in the as* with a barbed wire wrapped condom – but OK, we have to protect the economy doesn’t lose any money). The ?taxpayer?, i.e., US government owns them?
    So what can’t they be sold at half price, 100K (or less or more), lessen the loss to the taxpayer (2 trillion instead of 4, or 4 instead of 8 trillion)and houses are not left abandoned, people can afford the houses, friends buy house warming gifts, the economy booms.
    What is the reaon this can’t happen? (Goldmans Sachs doesn’t get a fee per sale???)
    I guess what I am not understanding is that the trillions of bailouts did not actually BUY anything. If it did, what???

    1. Edward Harrison says

      Dan, the trillions paid for the functioning of our credit system with too big to fail banks continuing at its core. That means we paid for the solvency of too big to fail banks – and hence the salaries and bonuses of their employees.

      This is a direct transfer from us to them. A large part of it is ex-post financing of deficits caused by the crisis they precipitated. That’s like taxes going up because the city had to rebuild homes after your arsonist neighbor torched his house which jumped to and burned down a bunch of other houses.

      A lot of the money is the opportunity cost for savers of hidden financial subsidies

      The smallest portion is direct capital injections, which have been repaid.

  6. Mario says

    very astute post that puts it all into more appropriate perspectives.

    I am doing my best to “bear down” and weather the brunt of the economic onslaught that seems to be nearly guaranteed at this point. I see no end in sight until the people “feel” their ideas in real life.

    At this point, my prime prayer before all others is that things don’t turn violent and that civil peace stays on the ground for us all. I really don’t want this turning bad.

    The thing is that people don’t understand how this works AT ALL…and they are insistent on their views and refuse to hear the factual realities. In fact most of the people I talk to that are the most emotional and insistent about the debt issues in the US for example are also the same people whose eyes quickly glaze over the fastest whenever sectoral balances or treasury/fed/primary dealer operations are mentioned. They really just don’t want to know anything except fear/debt/suffering/austerity. I guess pain is the only way to gain in their book.

    1. David Lazarus says

      The last thing I want is it to erupt into violence. Though ineptitude from politicians trying to protect the banks from taking losses will guarantee disaster. People are far more accepting of drops in standards of living if everyone including the rich are affected. At the moment the rich are getting richer while everyone else is getting poorer. It was the fear of communism that lead to the New Deal and the creation of the US federal home ownership schemes. With that dream dying in the UK and the US the problem is coming back.

  7. Greg says

    It is all a scam, perpetrated by a predatory banking system abusing its privileged position to cheat the people in the rest of the economy out of their assets. As the scam would be impossible with out the cooperation of governments and the public assumption of private debts, the bankers have necessarily co-opted the democratic process, and corrupted the various governments to their purpose. That is why no one on Wall Street has gone to jail. Our government is corrupted.

    The scam is simple. When a bank makes a loan, money is created. However, more money, the loan plus the interest, is owed. Thus, more money will always be owed than there is to pay off what is owed, so debt will always increase. Only if lenders spend as much or more on goods and services as the interest on the debt, will this not happen. The lenders have not been doing this, and now a state has been reached where service on debt is so great that the lenders cannot do this, and debt is increasing exponentially. Indeed, the main solution proposed is simply the creation of more debt, along with the selling off of assets.

    But even were the Greeks to sell off all their assets and pauperize themselves, they still will not be able to get out from under the debt. Indeed, they will be expected to pay back that debt without the income from those assets, that is, solely from their own labor. Not only is this impossible, it is inhuman. It is debt slavery. What is being perpetrated on the Greeks is monstrous.


    for a more detailed description of the scam.

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