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.
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:
- 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.
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.