While discussions of banks and lending typically focus on private sector lending, lending to businesses and consumers, the oldest and one of the largest forms of bank lending is to governments. Lending to governments is called “sovereign debt” since it’s a loan to the “sovereign”, the ruler. Unfortunately, analyses and discussions of government debt are confused and just plain wrong. This is because it is very easy to understand a private loan – we have all had or can easily imagine that experience. However, loans to governments are very different beasts.
Government debt is very different and often misunderstood. People often believe that governments, like a private individuals or businesses, can go bankrupt and default on their bonds. A government being unable to pay bondholders either the interest or principle when it is due can only happen if the government is not sovereign. That is, a government default can ONLY happen if the government is not sovereign in the currency used for the bonds. What we mean by “not sovereign” in the currency used is that one of two conditions exist, or both:
- The government borrowed money in a different currency from the one it issues itself. For example, this typically happens with small developing or less-developed countries. They have their own currency but the money they borrow and the bonds they issue are in U.S. dollars. They collect taxes in local currency and can issue new money in the local currency. But, if the exchange rate between their currency and the dollar changes against them, the burden of paying the debt can become onerous and impossible since it will take increasing amounts of real resources to pay the external creditors.
- The government that is borrowing does not issue or designate its own currency. The government and nation does not have a central bank that is independent of other nations’ control. For example, in the U.S., the national government issues and designates its own currency – the U.S. dollar. Further, the central bank, The Federal Reserve System, is responsible only for this nation. Therefore, the U.S. government cannot default. It could always issue new money to pay off the bonds when due (or have The Fed do it). On the other hand, the government of the State of California or Michigan could go bankrupt and default. That’s because state governments do not create or define their own currencies – they use the national currency.
Governments that are sovereign in their own currency and have their own central banks, governments such as the U.S., Canada, the U.K., Japan, or Australia, cannot default or go bankrupt as long as they always issue bonds denominated in their own currency.
Note: I realize that for many people this is difficult to accept, especially since so many politicians and even some economists erroneously claim otherwise. It also seems somewhat counter-intuitive. But it’s really not. The key to correct thinking about sovereign government bonds is to not think of them as debt. Instead, think of sovereign government bonds as being just another form of currency. Only instead of the currency in your pocket, this currency pays interest if you hold onto it. Think about it. That paper dollar in your pocket is a promise by the government/central bank that you can exchange it for another paper dollar issued by the same folks. If you have a $1000 government bond in your safe deposit box, it too is a promise by those same people that you can exchange that bond in the future for either another bond or 1000 of those paper dollar promises. Your choice, but either way it’s just a paper promise to exchange for another promise.
This difference between sovereign currency national governments and non-sovereign currency government debt is why interest rates on the two types differ so much. Interest rates paid by Japan, the U.S., Canada and other sovereign currency countries is incredibly low. For example, as this is being written in early 2012, the U.S can borrow dollars for 10 years at less than 2% per year – a rate lower than the expected inflation rate, in effect making the real rate of interest zero. Bond markets are signalling that they want more U.S. government debt because it is a safe investment – the U.S. government cannot default unless it chooses to. On the other hand, governments that are not sovereign in their currency and that have very high levels of debt – governments like California, Greece, and Ireland, are finding very, very high interest rates. The high interest rates reflect the risk of default.
Prior to 1999, European countries were likewise sovereign in their own currencies. Italy had the lira, France the franc, and Germany the Deutschmark. But in January 1999, a group of European countries, a subset of the European Union, exchanged their currencies for the Euro. The Euro is controlled and issued by the European Central Bank. The European Central Bank is supposed to be an independent private bank, but in practice is heavily influenced by the German and French governments since they are the largest economies in the Eurozone and have the largest banks.
Since 1999, Eurozone countries have issued bonds denominated in Euros, not their old sovereign currencies. For a while, this proved a great opportunity as large global-scale banks in France, Germany, and Holland were able to provide Euros to buy the bonds. This brought a surge of investment into many of the “periphery” smaller Eurozone economies such as Ireland, Greece, Spain, and Portugal. Even Italy benefited. In some cases, this surge of investment helped build up productive capacity. But it also helped fuel a speculative bubble in real estate (especially in Spain and Ireland) and also significant crony capitalist activities using government debt. As long the economies grew rapidly, the rising borrowing by the periphery from the French-German-Dutch core was OK.
But when the 2008 global banking crisis hit (started in the U.S.), all economies worldwide slowed down. Further, local governments found it necessary to bail out their local banks. Ireland in particular was hard hit. Irish banks had speculated heavily in foreign real estate and mortgages, eventually losing huge sums and becoming insolvent. As these periphery zone banks became insolvent, they risked defaulting on loans from larger French, German, British, and U.S. banks. The Eurozone governments found it necessary to bail out their banks, thus transferring the debt from the banks balance sheets to the governments’. Taxpayers were now on the hook to pay for the loans. Not being able to issue their own currency and facing a Euro Central Bank that increasingly restricted money creation, the governments experienced a rising debt burden.
As the “PIIGS” (Portugal, Ireland, Italy, Greece, and Spain) took on heavier debt, they were urged to cut spending and raise taxes to pay for it. This program of cutting spending and increasing taxes is called “austerity”. Austerity programs nearly always result in a shrinking GDP for a country, which makes collecting tax revenue even harder. It also increases the need for more spending. In general, the only time an austerity program can be accompanied by growth is when the local currency is devalued compared to trading partners’ currencies. But this is not possible in the Eurozone – they all use the Euro.
To avoid default or restructuring of the debts in ways that the banks who bought the bonds would incur losses, the Euro Central Bank, along with the German and French governments have been forcing programs of increasing austerity on the periphery countries with the result that those countries are experiencing continued decline and shrinkage. Unemployment has hit levels unseen since The Great Depression and that in some areas actually are greater than what the U.S. experienced in the Great Depression.
The outcome of this ongoing “European Debt Crisis” is unclear but there are profound economic system implications. In my opinion, one of the most interesting issues to be resolved is the question of how gets to determine the government budgets and priorities of the periphery countries – the Euro Central Bank, the people and their elected parliaments, the global banks that hold the bonds, or the larger countries of Germany and France. If it’s the banks or Germany/France, and austerity rules, then how will the people react? Will they accept it? Will they revolt?
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