On the sovereign debt crisis and the debt servicing cost mentality
Given the spate of articles in the business press about this country or that country facing a potential debt crisis, I wanted to write a bit about sovereign debt crises.
In my view, economic stimulus has been warranted in order stabilize the financial system and prevent economic collapse. However, the price of that stimulus is unsustainably high increases in government debt — in a world in which private sector debt is already critically high. I see the sovereign debt problem as critical, especially in Europe. The sooner we abandon a debt servicing cost mentality, the more likely we are to face up to this challenge.
The debt service mentality
During the boom and bubble which led up to the financial crisis, many in the financial community looked to debt service costs in the private sector as the only relevant metric to gauge whether debt levels were sustainable – both for individuals and in the aggregate. This was bubble mentality which I must take to task now now that we are seeing it crop up in discussions about public sector debts as well. If not, we will likely see some major sovereign bankruptcies in the not too distant future.
The debt service mentality goes a bit like this: Bob and Shirley are looking for a new house. They make $6,000 per month. So they can legitimately afford to pay $2,000 per month for their mortgage. With a 7% interest rate on a 30-year fixed mortgage, that means they can afford to borrow $300,000 – or just over four times income. So, if Bob and Shirley put 10% down on the purchase of a home, they can afford one that costs $330,000.
The problem is when this is the only constraint on borrowing. What happens to house affordability when Bob and Shirley’s 30-year rate drops to 5%? Suddenly, they can ‘afford’ a $375,000 loan. What if they get a 4% rate? Now, they can afford $425,000 in debt – a loan more than 40% larger than at 7% and a massive 5.9 times income. Anyone who has a mortgage recognizes this math as integral to the home buying process.
The lower interest rates go, the more affordable any debt load becomes when debt servicing costs are the only constraint. As rates drop toward zero percent, theoretically Bob and Shirley could afford to buy practically any house. But, of course, interest rates don’t move in one direction. If rates were to move up significantly when Bob and Shirley wanted to move house, they would face a serious problem. In this sense, artificially low interest rates are toxic. And therefore pointing to debt servicing costs as the only metric of affordability and debt constraints is bubble finance plain and simple.
Here I am talking about bubble finance, not Ponzi finance. In the Ponzi finance schemes in the U.S., we saw fixed rates substituted with lower but unsustainable adjustable rates. Eventually affordability became passé as no-doc, zero-percent down, ninja loans became the norm. In the end, the Ponzi debt scheme collapsed in a heap – as it always must. That’s what we saw in the blow-off stage of the bubble after Greenspan lowered rates early this decade. But, the debt servicing mentality is what preceded it.
Relative debt constraints
What is needed is a relative debt constraint like debt to income – or in the case of aggregate figures or sovereign debt figures, debt to GDP. For example, before the bubble in the U.K., one might have seen relative debt constraints like three times income. That meant one could borrow up to three times one’s annual income – no ifs ands or buts. If you worked in the City and received a bonus, you might have convinced the bank to count half of it toward your income for loan purposes.
As prudence was thrown out, these constraints were relaxed. The Bradford and Bingleys of the world used lower interest rates to justify jacking these constraints up to 3.5 times or four times income. Eventually these constraints hit six times in the UK.
How do you compete against that as a bank? All of the business is going to Bradford and Bingley and you are getting stuffed. I guarantee you shareholders won’t like that. As an executive, you better find the holy grail of prudent but profitable lending or follow Bradford and Bingley on the road to easy money. Otherwise, you will be out of a job.
Eventually, even the prudent relax their standards too – that’s how risky behaviour drives out good when risk is rewarded. See my comments in “James Galbraith: How financial stability creates instability.”
Operational and effective constraints
So all of the preceding caused Americans and Britons to run up massive amounts of debt. The same was true in places like Latvia, Spain and Ireland – and to a lesser extent in places like Australia. But I am referring here to the private sector. What about the public sector?
Here too there are limitations. For sovereigns with debt in their own fiat currency, there is not the operational constraint that you and I face. After all, they can go to the backyard and just pick some bills off their money tree – something we can’t do unless we want to go to jail.
Remember, many countries like the U.S. or the U.K. can just print money to meet creditor demands. After all, the only financial obligation of government in a fiat currency system is the payment of more fiat money. This is a confidence game then. Creditors will only accept more fiat money from the debtor if they believe that the money represents good relative future value (i.e. when debt repayment occurs and where value is relative to other currencies or real assets at that time).
So while there is no operational constraint on government because of the electronic printing presses, there is an effective constraint in the form of debt and currency revulsion and price instability (large measures of deflation or inflation). On countries like Greece or Portugal in the Eurozone, the operational constraint is a lot more real than it is on the U.K. because of currency union. The same is true for countries with a currency peg or large foreign currency debts like Latvia, Hungary or Dubai.
Taxes
What is a sovereign government’s income? It is the taxes we pay now and in the future. So this makes tax revenue central to the sustainability of sovereign debt.
How does the Beatles song go:
Let me tell you how it will be
There’s one for you, nineteen for me
‘Cause I’m the taxman, yeah, I’m the taxmanShould five per cent appear too small
Be thankful I don’t take it all
‘Cause I’m the taxman, yeah I’m the taxman
Basically, if the net present value of all of the future taxes fall short of the net present value of expected government expenditures, you have a problem. Again, this problem need not be a hard constraint since the government can issue debt in its own currency. Nevertheless, there is a limit to how much paper money people are willing to take if they worry about the future value of that paper.
That’s what the worries of a sovereign debt crisis are all about. At some point, the central government’s debt become so high that everyone knows they cannot possibly tax the population enough to cover their expenses and service the debt. There are few way outs then – even for sovereigns using their own currency. One can print money, jack up taxes or cut spending drastically. Printing money is inflationary and causes currency and debt revulsion (The inflationary impact depends on the marginal propensity to save in the private sector i.e. the demand for credit). Raising taxes is deflationary as it curbs aggregate demand. And jacking them up far too high invites tax evasion, eventually making money printing the only fallback. And cutting spending reduces aggregate demand, can reduce the future tax base, and risks a nasty debt deflationary spiral. Pick your medicine.
And when I say printing money, I mean ‘monetizing the debt’ by buying up debt with money printed out of thin air or simply printing money to pay creditors. The two are functionally equivalent in a zero interest rate environment (see my post “On debt monetization”).
So, in the short run, we can talk about supply and demand of government debt thinking only about the near-term deficit, budget gaps, and demand for government bonds. We can ignore health care liabilities in the same way we can ignore them for a family’s immediate debt problems because this is not actual debt we have to service. Longer-term, there are constraints like huge unfunded liabilities, making the situation that much more difficult.
Enter the debt service mentality
That’s where the debt servicing mentality enters this picture again. The public sector can get away with deficit spending for much longer than you or I. But, eventually they too must yield.
Japan is the textbook case. With sovereign debt to GDP well over 150% and rising to well over 200% soon, it will need to cut spending, increase tax receipts or print money (or all three) to avoid default. The only reason it has avoided problems is the bid for Japanese Government Bonds (JGBs) and Yen due to a huge current account surplus. What happens when that surplus disappears? What happens if interest rates are normalized?
This is the exact same issue Bob and Dorothy faced. When interest rates are low, debt servicing costs are low as well. But, as soon as rates move higher, you have a big problem. Theoretically, of course, if one takes on debt and ‘invests’ it, receiving a higher rate of return, then one could pile up more and more debt. This is what is commonly known as a “Carry Trade’ – and it is a hallmark of bubble finance underpinned by the debt servicing mentality.
What if the investments don’t succeed? What if they end up as malinvestments?Then you have wasted money and are now in a deeper hole than you were before. I think there is room to manoeuvre for the U.S. in terms of deficits to prevent a nasty double-dip recession, especiallyregarding job creation. But a lot of what we have seen in terms of stimulus has been more dubious in nature; some will be malinvestment. Going forward, we should expect the same. And there has been absolutely no effort to reduce overcapacity in autos, banking, housing or elsewhere in the bailout nation. This is why relative debt metrics like debt to GDP are actually a good thing. They act as a hard constraint on deficit spending that otherwise does not exist.
Keeping this issue in mind, the following on Bruce Krasting’s blog is interesting:
On ABC’s "This Week" show there were some interesting thoughts from Paul Krugman.
He remarked:
“The cost of the deficit is only 1.2% real rate of interest at the Federal level.”
This is economic speak. What Mr. Krugman was saying is that the Government can borrow long term at 3.2% and inflation is 2% so the real cost of debt is only 1.2%.
In response, George Will made the point:"In ten years the interest cost of servicing the debt will go to $700 billion per year!"
Mr. Krugman responded:
In ten years GDP will be $20 trillion, debt service would still be 3.5%. “That doesn’t sound too bad”.
Mr. Krugman believes in the ultimate carry trade. His view is that growth will come from affordable (cheap) debt capital. He thinks that the US can go to 100% Debt/GDP without upsetting the applecart. I think he is dead wrong.
We are at the point where the laws of big numbers start to come into play. For Mr. Krugman’ view to work out we would have to successfully sell an additional $900 billion of debt each year for the next decade. I think that is an impossible task. But what is truly impossible is that that amount of debt can be sold without an increase in the 1.2% after inflation cost of the debt that Mr. Krugman is relying upon. You can just fool so many bondholders for so long before they look elsewhere.
The cost of servicing our debt will likely double. The increase will be a combination of a general rise in interest rates and in increase in the “spread” that the US will have to pay. If debt expense was a modest 6% it would put the cost at $1.2 trillion. I don’t think we will get to that level. We will blow up first.
The Carry Trade is fraught with risk.
So you’re not buying the Modern Monetary Theory argument that national government deficits are normal and good?
So far, I haven’t seen any good rebuttals to the MMT. For example, Japan has run huge government deficits for years, but hasn’t suffered from inflation. The U.S. just used Quantitative Easing to liquidate $300 billion, and there are no signs of inflation. So why not continue to increase the deficit to bring the economy back to full employment? No money need be borrowed to do this. If inflation becomes a bigger problem than unemployment, then we can reverse the program.
Certainly, there is a lot of work that needs doing — cleaning up the environment, policing our cities, et cetera…
In theory, a government could run a deficit of 3% per year in perpetuity and still have a relatively low debt to GDP if nominal GDP kept rising.
So, no, I’m not rejecting the MMT argument that government deficits are normal and good. I don’t believe that is the case (in part for ideological reasons – distrust of big government), but this is not a rejection of that notion.
I am making the case that large 10%+ deficits in North America or Western Europe are unsustainable as nominal GDP could never grow at that rate in those areas.
Well is anybody arguing the 10%+ deficits need to be sustainable? If the deficits are successful, then the government expenditures won’t be needed. The problem as you know is that we’ve had a massive collapse of credit, so 10% of GDP is really quite small in comparison to the deflationary forces at work…
The problem I see is that the debts are being used to prop up existing enterprises rather than being used to increase household income while zombie companies are wound down. This means we are storing up problems for the future rather than alleviating them.
Although we have had inflation in asset prices, which I think is bad and unsustainable…
So perhaps the problem is that we’ve had the wrong government spending, rather than too much government spending…
I agree 100%.
A meeting of the minds!
Thanks for all your posts…
Indeed.
You were talking about the deflationary pressures. One has to be reminded, that STILL, nobody knows how big the hole was, or is, or how big it gets.
These unknown numbers in a global scale + the concerted effort to plug that hole, yet to be judged if they succeeded + the problem of mis-allocation of government (“Die Regierung ist zu nichts zu gebrauchen!”) spending to kick-start the economy = double-dip & sovereign debt failure.
Well, enough spending for now:)) People are now asking for debt consolidation. That is the normal action for what you described here. Bueatiful and stupid things don’t last very much and it they have to end one day. Unfortunately, the suffering people are the majority who need loans from super rich…
“So while there is no operational constraint on government because of the electronic printing presses, there is an effective constraint in the form of debt and currency revulsion and price instability (large measures of deflation or inflation).”
What say, Ed. Does Marshall Auerbach take this principle under consideration sufficiently in his usual discussions about the deficit? One gets the sense with him that almost any level of government indebtedness is acceptable, that there are no such constraints and neither is there any inherent risk. Help me here if you will, kindly.
In a message dated 2/1/2010 11:22:24 Mountain Standard Time,
writes:
“So while there is no operational constraint on government because of the
electronic printing presses, there is an effective constraint in the form
of debt and currency revulsion and price instability (large measures of
deflation or inflation).”
What say, Ed. Does Marshall Auerbach take this principle under
consideration sufficiently in his usual discussions about the deficit? One gets the
sense with him that almost any level of government indebtedness is
acceptable, that there are no such constraints and neither is there any inherent
risk. Help me here if you will, kindly.
No, I don’t think that any level of government indebtedness is acceptable.
That’s the usual caricature of my position. You want government spending
to be neither “too hot” nor “too cold”. We shouldn’t construct policy on
the basis that a government faces NO CONSTRAINT in terms of spending, but
that many of the “constraints” that people normally discuss are not
identified in an honest manner – which is to say that these commentators import
nonsensical notions of “affordability” and “national solvency” (we’re getting
a lot of this sort of talk today in regard to the US and Japan), when they
have no applicability in a post-gold standard world in which government
alone creates currency and extrinsically confers value on it via the
imposition of a tax liability.
The public would not give up goods and services to the government in return
for otherwise worthless coins or paper notes unless there were good
reasons to do so. The primary reason the public accepts what we call “fiat money”
is because it has tax liabilities to the government. If the tax system
were removed, the government would eventually find that its fiat money would
lose its ability to purchase goods and services on the market. In the words
of Abba Lerner (one of the architects of “Chartalism”):
“The modern state can make anything it chooses generally acceptable as
money…It is true that a simple declaration that such and such is money will not
do, even if backed by the most convincing constitutional evidence of the
state’s absolute sovereignty. But if the state is willing to accept the
proposed money in payment of taxes and other obligations to itself the trick is
done.”
Once we accept the reality that the government creates new net financial
assets exogenously, it renders notions of “solvency” to be nonsensical. It
also means that the household analogy is totally fallacious, given that a
household does not have the power to create currency or tax and therefore
faces an external constraint unlike a government. Which brings us to the second
point of chartalism. Again, as Lerner argues: “The central idea is that
government fiscal policy, its spending and taxing, its borrowing and
repayment of loans, its issue of new money, and its withdrawaal of money, shall all
be undertaken with an eye only to the results of these actions on the
economy and not to any established traditional doctrine about what is sound or
unsound.” So we look at the EFFECTS and IMPACTS of government spending.
When we reach full employment and inflationary pressures are beginning to
develop, this is the constraint faced by a government and it should reduce its
spending and/or increase taxation to diminish demand. We’re interested in
full employment and economic prosperity; we’re not auditioning for the role
of finance minister in Zimbabwe, as many of our critics allege.
On the first point, I readily acknowledge that one possible consequence of
increased government spending might be a weaker currency but only on the
basis of changing private preference portfolio shifts. And, as I’ve argued
several times before (_https://www.newdeal20.org/?p=5425_
(https://www.newdeal20.org/?p=5425) )
It unclear what a government should do about that. What would you have the
Fed do? Should they raise rates to defend it? It is unclear that this
would work. The relationship between a given level of interest rates offered by
the central bank and the external value of a currency is tenuous. Consider
Japan as Exhibit A. The BOJ has been offering virtually free money for 15
years and yet the yen today remains a strong currency (much to the chagrin
of the likes of Toyota or Sony).
Of course, higher rates can have an offsetting beneficial income impact
(what Bernanke calls the “fiscal channel”), but it does not follow that a
decision to raise rates would actually elevate the value of the dollar (and
the benefits of higher rates from an income perspective could just as easily
be achieved via lower taxation).
The reality is that private market participants could well view the move as
something akin to a panicked response by the Fed, and the decision could
well trigger additional capital flight, which could weaken the value of the
dollar.
So it is unclear to me what the Tsy or Fed should be doing about the
dollar. My view is that this is a private portfolio preference shift and I don’t
think central banks should be responding to every vicissitude of changing
market preferences. The US government should simply ignore the market
chatter and idle threats from the Chinese and do nothing.
Well spoken, Marshall. Thanks.My understanding is that fiscal deficits yield lower interest rates, because a fiscal deficit is an injection of cash into the private sector. More money => cheaper money. This has certainly been the experience of Japan…
In a message dated 2/1/2010 16:25:39 Mountain Standard Time,
writes:
Well spoken, Marshall. Thanks.
My understanding is that fiscal deficits yield lower interest, because a
fiscal deficit is an injection of cash into the private sector. More money
=> cheaper money. This has certainly been the experience of Japan…
That is correct.
Here’s a link to a piece done by Stephanie Kelton of UMKC, which explains
the mechanics perfectly:
_https://neweconomicperspectives.blogspot.com/2009/06/will-run-up-in-governme
nt-debt-doom-us_17.html_
(https://neweconomicperspectives.blogspot.com/2009/06/will-run-up-in-government-debt-doom-us_17.html)
I appreciate the clarification in all its density, Marshall. I think I know the answer to this question in advance but I’ll pose it anyway: How would you feel about the implimentation of WPA or CCC type jobs programs in the present circumstances?
In a message dated 2/2/2010 09:14:13 Mountain Standard Time,
writes:
I appreciate the clarification in all its density, Marshall. I think I
know the answer to this question in advance but I’ll pose it anyway: How would
you feel about the implimentation of WPA or CCC type jobs programs in the
present circumstances?
Not surprisingly, I would support this, but I would go further. I would
like to see the government offer a permanent Job Guarantee (JG) program.
This sort of program would remain a permanent feature of our economy, in
effect acting as a buffer stock to put a floor under unemployment, whilst
maintaining price stability whereby government offers a fixed wage which does not
“outbid” the private sector, but simply creates a stabilizing floor and
thereby prevents deflation. The JG program would allow for the elimination
of many existing government welfare payments for anyone not specifically
targeted for exemption, and would command greater political legitimacy, as
society places a high value on work as the means through which individuals
earn a livelihood. Minimum wage legislation would no longer be needed as it
would be established via the JG. Labor would welcome the safety net of a
guaranteed job, and business would recognize the benefit of a pool of available
labor it could draw from at some spread to the government wage paid to JG
employees. Additionally, the guaranteed public service job would be a
counter- cyclical influence, automatically increasing government employment and
spending as jobs were lost in the private sector, and decreasing government
jobs and spending as the private sector expanded. So it would represent an
expansion of WPA or CCC type programs.
Of course, whenever I (and others) suggest this, invariably the charge of
“socialism” arises. But the free market has not proved itself able to
provide full employment and it seems to me that this would actually help the
economy function better.
I agree with what many people say: Japan is the canary in the coalmine. If Japan can keep going without defaulting or printing their way out of default then the US can do it.
However, eventually $9 trillion deficit will catch up to you. Krugman’s suggestion that GDP will be $20 trillion is reasonable, but does anyone know if he’s referring to nominal or real GDP?