THE BLOG

On the Sovereign Debt Crisis

03/18/2010 05:12 am ET | Updated May 25, 2011

This post first appeared at my site Credit Writedowns

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 any house no matter how expensive.  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 taxman

Should 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 taxes 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 maneuver for the U.S. in terms of deficits to prevent a nasty double-dip recession, especially in regards to 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.