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1) The Problem of Sovereign Debt
Just as economic agents such as individuals, households and firms may take out a loan, sovereign states need to borrow when they run deficits. When the revenues are not sufficient to cover spending, the only solution is to borrow and make a promise to repay the debt in the future. Borrowing money is the same on an individual and collective level but with one crucial difference, a difference arising from the word “promise”. In a well functioning legal system, firms and individuals do not need to be trustworthy; they only need pledgeable assets which can be seized by national courts if the agent does not abide by the terms of the contract. No such thing as a “court” is available at the international level, but still individuals and countries are lending to other sovereign states. It is perfectly possible that a state could renege on its obligation, yet thanks to sovereign immunity it would suffer no consequences. Thus for almost thirty years economists have questioned the very existence of sovereign debt in the absence of enforcement by third parties.
Why does sovereign debt exist at all if there is no enforcement mechanism?
Two main answers were proposed by economists in the 1980s. According to the first “carrot” approach, lenders are able to obtain repayment because they are able to promise renewed lending, or more “carrots”, in the future if the debt is repaid. This is a reputational based approach. Indeed, according to this theory borrowers want to enjoy a stable level of consumption which is not possible when the income varies because of adverse economic conditions. Thus when sovereign states are forced to borrow during hard times, they need to repay their debt in order to avoid being cut off from future credit.
The second approach is a “stick” based one. According to the proponents, reputation is insufficient in sustaining loans owing to the possibility that countries could get money from lenders, save it in “Swiss banks”, declare default and use the proceeds of the “Swiss accounts” in the future. Only direct punishments (trade sanctions or even gunboat diplomacy) can sustain lending.
However, subsequent empirical research has shown that there is very little evidence of direct punishments, if any, and certainly not in recent times. Thus a different mechanism needs to be put in place.
Notice that the availability of a credible enforcement mechanism is in the interest of both creditors and debtors. Creditors can be assured of repayment, whilst as a consequence of this debtors will receive the loans in the first place. In the ‘90s economic theory explained the existence of sovereign debt using more sophisticated game theoretical models. These have revitalised reputational models and have explained the very existence of debt with the “cheating the cheater” mechanism. In practice, this theory demolishes the “Swiss bank” approach; it argues that if a Swiss bank honours the deposit of a defaulting government all the other lenders will not honour their debts towards the Swiss bank. Thus the criticism raised against reputational models no longer works. Though formally correct, this solution to the “Swiss bank” problem implies that a highly coordinated mechanism among creditors is in place.
In order to explain sovereign debt a more direct mechanism has to be found and recent literature has started to pay increasing attention to the political element. Indeed the missing element in the previous discussions has been the political one.
The decision to repay or default by a government differs radically from a similar decision by an individual agent because in the case of the government it is a political decision taken by political actors who are the agent of the voters-citizens who elected them.
Since political leaders try to maximise the possibility of remaining in power they will need to take decisions which do not hurt the median voter’s mood (and interests). This political economy element is present also in non democratic countries. Even here, political leaders make decisions that will not hurt political or economic elites and are unwilling to make decisions that could spark revolution. We will focus here only on democratic countries, with particular concern on the Eurozone crisis.
2) Sovereign Debt Crisis in the Eurozone
The first key to understanding the present Eurozone debt crisis is to clarify that these are different crises. Countries involved in the crisis at the moment are Greece, Ireland, Portugal, Spain and Italy. Ireland and Spain have suffered a private sector crisis hitting the banking sector (Ireland) and the housing sector (Spain). The governments in these two countries have run large deficits to support the private sector bankruptcy, transforming the private debt into public debt. Though public finances were in order before the 2008 crisis with low debt to GDP ratio, the latter started to increase dramatically because of large deficits and this has led to a confidence crisis. In Greece, public finances were out of control; large public spending and low tax revenues led to an accumulation of debt, decreasing the confidence of foreign investors. Portugal may be considered as a half way case between the two preceding ones, with not so sound public finances (though not so dramatic as in Greece) but also private debt problems. Finally, Italy represents still another situation. The government had already accumulated a massive debt to GDP ratio at the beginning of the ’90s, when a debt restructuring process began. Since then, the Italian government has run almost always primary surplus (taxes were above public spending), and the deficit that has occurred at the end of each year has only been due to interest payments on the stock of the outstanding debt. Deficit to GDP ratio is the second best in the Eurozone after Germany and the government is committed to running a balanced budget (zero deficit) by the end of 2013. The main problem in Italy is the low growth rate. This has dramatically affected the Italian economy in the last 20 years, (since the fiscal consolidation began), with an average structural gap of 1% GDP below the Eurozone each year. In other words, with good deficit to GDP ratio Italy can commit to repaying its creditors each year, but is struggling to reduce the stock of debt (which has been stabilised but is still at a high level). Thus if a shock hits the economy the debt may become explosive (though at the moment it is under control).
If one uses the debt to GDP ratio as an indicator, it is clear that a low denominator GDP negatively affects the ratio, but notice that this is not the only way to consider a country’s fiscal stance. Indeed it is not clear why one should compare a flow variable (GDP) with a stock variable (debt). Another option would be to compare two stock variables; liabilities (debts) and assets (private and public wealth of a nation). If this option was used, Italian sustainability would be seen very differently given the high savings (excluding government bonds) accumulated by Italians.
3) Political Economy of Debt
How can politics help us to understand the way ahead?
So far, we have seen that incentives do matter. However in the case of sovereign debt there may exist not only external incentives in the form of direct or indirect punishments by foreign lenders, but also domestic punishment in the form of firing the political leaders if their decisions are not aligned with the median voter’s interests. In this respect, the first thing to say is that we need to focus not on the aggregate stock of debt but mainly on external debt, i.e. debt not owned by domestic citizens. This means that the composition of debt is crucial. High external and low domestic debt make debt repayment far more unsustainable because domestic taxpayers realise they will have to pay a huge amount of taxes to repay debt, which is mainly held by foreigners. In some cases, defaulting on foreign debt may become extremely popular. The case of Greece is symptomatic of this unsustainability. Indeed ¾ of Greek debt is owned by foreigners, whilst only ¼ is owned by domestic agents. In the latter category, ½ are domestic banks and ½ are private citizens. This means that no more than 13% of private domestic citizens are owners of public debts. In these conditions it is easy to understand that domestic citizens do not want to repay the debt if this involves high sacrifices in terms of wage and pension cuts. A referendum in Greece which is now being discussed would only ratify this refusal. If the government calls a referendum it will lead to default and loss of European support, if the government does not, it may lead to further riots and protests. Something similar happened in 2001 in Argentina when the government cut wages in order to repay debt, leading to massive protests and a new president who immediately defaulted. On the other hand, German and French banks are the main debtholders of Greek debt and this explains their activism. Banks such as BNP would be at risk if Greece was to default and the French government would then have to intervene to recapitalise it. Iceland is another case where citizens were called to express their willingness to repay the debt of the bankrupt Landsbanki bank; they refused to pay for it. The situation would be quite different in countries like Italy where domestic citizens and institutions hold a large share of debt (50% – 60%).
In conclusion, the aim of this discussion has not been to venture into the roots and consequences of the Eurozone debt crisis, but simply to shed some light on the difficult situation in which the countries hit by the crisis now find themselves. One important thing to understand is that sovereign debt is not risk-free. If lenders incautiously lend money to countries with large foreign debts at relatively high interest rates, they must be prepared to bear the consequences of their decisions, just as they were readily prepared to take advantage of the high interest rates.
Preliminary Bibliography to know more
Congleton, R. D. (2002), The Median Voter Theorem, Center for the Study of Public Choice, George Mason University. http://rdc1.net/forthcoming/medianvt.pdf
Gros, D. (2011), External versus Domestic Debt in the Euro Crisis, CEPS Policy Brief, No. 243, 25 May 2011,
and Voxeu, http://www.voxeu.org/index.php?q=node/6550
Kolb, R. W., editor, (2011), Sovereign Debt, Wiley, Hoboken, New Jersey.
Mauldin, J. and J. Tepper (2011), Endgame, Wiley, Hoboken, New Jersey.
Reinhart, C. M. and K. S. Rogoff (2009), This Time is Different, Princeton University Press, Princeton and Oxford.
Stein, J. L. (2011), The Diversity of Debt in Europe, Cato Journal, vol. 33 (2). http://www.cato.org/pubs/journal/cj31n2/cj31n2-2.pdf
This article first appeared in the November 2011 edition of The Witness
 The money-happiness link Much has been said about whether money can buy you happiness; in advance of his book on the subject, colleague and fellow economist Dr Carlos Cortinhas examines some new research on the subject:
Common wisdom has always maintained that money can’t buy you happiness. But science, as it turns out, says otherwise. According to the widely cited work of Richard Easterlin, money does make you happy but only up to a point. Wealth beyond a certain amount does not make us happier: once we’ve achieved a reasonable degree of financial security (internationally, an annual income of roughly $15,000 per year) our basic needs are met and our sense of wellbeing does not improve as income rises. Or so studies by Easterlin and his followers have suggested.
A recent paper by Daniel Sacks, Betsey Stevenson and Justin Wolfers suggests that Easterlin and his followers got it wrong. After poring over data from 140 countries, they concluded that rich people are happier than poor people, people in rich countries are happier than people in poor countries and when countries get richer their people tend to get happier. Therefore, it appears that the happiness effect isn’t relative; it is based on a person’s absolute income.
These results stand in opposition to a number of previous studies on money and happiness that suggested that people were concerned only with the wealth of their next door neighbours. So, if you were keeping up with – or better yet, surpassing – the Jones’s you were fine. By that logic, people in impoverished countries could be happy if they were just a little bit better off than those around them. That conclusion was very appealing to people from prosperous nations.
The data for these studies invariably comes from large scale surveys such as the World Values Survey or the Gallup World Poll that include questions like “All things considered, how satisfied are you with your life these days?” or “Taking all things together, how would you say things are these days—would you say you’re very happy, quite happy, not very happy or not at all happy?”. These answers can then be transformed in a scale that allows for international comparisons and for the study of changing trends over time. An example of this is the findings in the World Values Survey, which has compiled data from over 350,000 people in 97 countries since 1981. This survey found that Denmark is home to the planet’s most contented citizens with Zimbabwe being home to the most miserable.
Source:
Adapted from “Subjective Well-Being, Income, Economic Development and Growth”, NBER Working Paper no. 16441 (October 2010), “The Data Is In, More Money = More Happiness: Justin Wolfers”, (January 2011) at: http://blogs.cgdev.org/global_prosperity_wonkcast/2011/01/18/the-data-is-in-more-money-more-happiness-justin-wolfers/
“Survey Says: People Are Happier” (August 2008), Bloomberg BusinessWeek at: http://www.businessweek.com/globalbiz/content/aug2008/gb20080820_874593.htm
Apologies for my absence of late: things have been rather busy. Still busy, in fact, which explains why I’m just going o post a link to another blog, rather than writing one myself.
More Than 1 Billion People Are Hungry in the World
There’s another reason for linking rather than writing: quality. The link takes you to a post written by Abhijit Banerjee and Esther Duflo, both from MIT and both as good as it gets in terms of economists studying poverty and hunger.
If their article (and all the papers underneath it) is right, then there are huge implications for policy and aid for under-developed countries and people. But not everyone agrees with how economists view poverty. Let me know what you think.
With the Alternative Vote referendum fast approaching, here’s an attempt to demystify the process from my guest blogger, Professor John Maloney, an economics colleague and election expert.
Have you had the official leaflet describing the alternative vote system? In one way it’s doing a good job for first-past-the post, by making the counting procedure under AV sound endless. The bottom candidate drops out, their second preferences are allocated, there’s another count, the new bottom candidate drops out, and so on until one candidate has more then half the votes. Well, in Exeter, there were seven candidates last year. That sounds like anything up to five counts (when you get down to two, one of them must have more than half the vote – unless it’s a tie!). Goodbye to election night and welcome to counting week? In fact it wouldn’t have been as cumbersome as that. Look at the actual Exeter result:
Ben Bradshaw (Labour) 19,942
Hannah Foster (Conservative) 17,221
Graham Oakes (LD) 10,581
Keith Crawford (UKIP) 1,930
Chris Gale (Liberal) 1,108
Paula Black (Green) 792
Robert Farmer (BNP) 673
What’s the first thing that strikes you about these figures, if you put your mind into AV mode? It should be the fact that, even had Mr Oakes received all the second-preference votes of all the bottom four candidates, he would have remained inexorably in third place and the next candidate to be eliminated. In fact, only two counts would have been needed; the original one and then a recount with the second preferences of all five bottom candidates given to either Labour or Conservative.
Who would have won? Ben Bradshaw beyond a doubt. The UKIP vote would have broken heavily for the Tories, but the Green vote would have been largely Labour. As for the Liberal vote it’s hard to say; perhaps even harder to judge is the redistribution of the BNP vote, which might have split quite evenly between the allegedly right-wing Conservative party and the allegedly working-class Labour Party (and also the alleged protest voters’ party, the Lib Dems, had they still been in the frame.) But, unless every opinion poll in the year before the election was wrong, a majority of the Lib Dems themselves preferred Labour to the Conservatives. Quite possibly Mr Bradshaw would have ended up with a bigger majority than he actually got.
But the big imponderable is how far people will use their second, third and fourth choices. Obviously, if no one at all bothered with second preferences, AV would cease to be AV and first-past-the-post would stay in place. But how many people will put down a second choice? And how many people in Exeter would have ranked candidates all the way from one to seven? An opinion poll last summer found that a large minority of voters would not bother to endorse more than one candidate. But an opinion poll taken before the argument had even started may not be a good guide to how people behave if AV becomes the reality. Will candidates woo the voters along the lines of ‘if you can’t put me first please put me second, or failing that third – or even fourth, please?’ What they will probably stop doing is to say ‘please put me first, even if I’m your second choice, because only I can beat party X.’ Indeed supporters of AV have claimed that tactical voting — backing the strongest challenger to the candidate you want to keep out – will disappear, and all first preference votes will now have the additional virtue of sincerity.
There will certainly be less tactical voting. But it’s not obvious there will be no tactical voting. Suppose your order of preference is Tory, Lib Dem, Labour, but you think that the Tory can’t win and that Labour will get the most first-preference votes. Assuming the Lib Dem second preferences are more pro-Labour than the Tory second preferences, you will want the Tory second-preferences to count. How do you achieve that? By making sure that the Tory candidate, your actual favourite, drops out in the first round. Your (tactical) first-preference vote will be for the Lib Dems.
Is this a likely scenario or a university lecturer being tortuous? Nearer the second than the first, no doubt. But some voters might think like that, and it’s another factor which makes the consequences of AV as unpredictable as the result of the referendum itself.
Three-and-a-half years have passed since the banking run on Northern Rock in the UK, two-and-a-half since the collapse of Lehman Brothers in the US. And we’re still waiting for the government’s decision about what to do with the banks.
There’s been some tinkering. The Financial Services Authority, which bore more than its fair share of criticism for the banking crisis, has been broken up. Responsibility for financial stability has been given to the Bank of England: it has a new committee to look after it. The Chancellor has agreed Project Merlin with the banks: a deal that combines bonuses, transparency and lending. The Independent Commission on Banking has made some menacing noises about a possible restructuring of the banking sector; we’ll find out what that might mean in April, when it publishes its interim report. But given the scale of the banking disaster, and the general consensus that Something Must Be Done, it is remarkable that so little has been done so far.
Let me remind you how bad things have been. The 4 days in September 2007 saw the first run on the retail deposits of a United Kingdom bank since Victorian times. Since then, the UK government has committed at least £1.2 trillion to support the banking sector: equivalent to 85% of GDP, over 20 times the annual spend on education, over 10 times annual expenditure on health. Despite all this support, banking is still broken. The latest Bank of England figures are shown in the figure below: the annual change in the amount lent to small businesses (the blue line) and all small-and-medium enterprises (the orange line). With access to credit choked off, it’s not hard to understand why UK growth is so weak.
It gets worse. The Bank of England estimates that UK banks will need to raise up to £500 billion over the next two years just to replace existing funding. That is, none of this funding would be used for new lending: the banks have to run this hard just to stand still.
The underlying problem is that the banks’ capital is still at risk. About half of all loans issued since 2004 are in breach of their covenants. Commercial real estate accounts for about half of the loans outstanding in the UK; and commercial property values are currently around 35% below their peak.
So, something really does need to be done. (But we knew that anyway, even without all of the figures that I’ve just thrown at you.) There seems to be general agreement that banks cannot be allowed to be “too big to fail”. That leaves 2 broad options. The first is that banks gain enough capital that they are never again in any serious risk of failing. One of the causes of the crisis is the extent to which UK banks “levered” themselves: that is, lent more money than they actually had at any given moment. Banks have always done this, but the practice really took off over the last 10 years. The figure below (taken from the Bank of England’s financial stability report in December 2010) shows UK bank leverage over the last 50 years.
The second option is that banks are simply allowed to fail. In practice, that means that holders of senior debt in banks will lose some or all of their money, rather than having their investment protected by taxpayers. Unsurprisingly, they dislike this option. And being, on the whole, wealthy and influential individuals, they have done a pretty good job in convincing policy-makers that this option would simply cause investors to withdraw their money and invest elsewhere. But Denmark has chosen to go this route: when Amagerbanken failed on 7 February, bondholders lost 41% of their investment.
We shall see which option we go for in the UK. We are in the hands of John Vickers, who is heading the Independent Commission on Banking. The bad news is that’s he’s firmly part of the establishment (currently warden of All Souls College in Oxford, former head of the Office of Fair Trading and member of the Bank of England’s monetary policy committee). This may not bode well for taking on the might of the bankers. The good news is that he has some experience of taking on the establishment: he was, after all, behind the move to eliminate the notorious All Souls’ three-hour exam on a single word. The hope is that sorting the banks will be easy in comparison.
It seems a shame to start off my new blog on a gloomy note. But it makes sense to open with the outlook for 2011. And there’s no way round it, I’m afraid. This year is not going to be much fun for most of us.
The problem that we face is an unpleasant combination of high price inflation and low growth. The current headline inflation rate (measured by the Consumer Prices Index, or CPI) was 3.7% in December. National income (measured by the Gross Domestic Product, GDP) fell by 0.5% in the last three months of 2010. It’s not as bad as the mid-1970s, where inflation hit 24% and GDP fell two years running. But that’s hardly a great comfort.
The surge in prices is mainly the result of 3 factors. There is strong demand elsewhere in the world, especially China roaring along at 10% growth, for rubber, cotton and fuel (and food, a bit). Bad weather in advanced countries has reduced the supply of cereals. With demand up and supply down, the simplest of economic models predicts higher prices, which is exactly what we’re seeing. It’s a reminder that the UK is small economy in a global market for commodities. In the UK, this is compounded by rises in taxes (VAT went up to 20% in January) which will add to the prices paid by consumers. By the latest forecasts, the average household in the UK is likely to pay around £950 more in 2011 for the things that it bought in 2010.
This wouldn’t be so bad if everything, including wages, went up at this rate of inflation. But wage inflation is muted: the average wage went up just 1.1% in the last 3 months of 2010. At that rate, the average household income will go up in 2011 by about £350, leaving quite a gap between income and expenditure rises. Worse still, lots of households face benefits cuts. Those reliant on the public sector for their jobs may face unemployment as the reductions in government spending really start to
bite. All in all, real wages (that is, wages after inflation is taken into account) are likely to be no higher in 2011 than they were in 2005.
How will policy-makers respond to all this? The Bank of England can hardly cut interest rates further; and will probably not raise interest rates soon, despite strong inflation. What would be the point? The causes of inflation lie mostly outside the UK. This is good news if you hold debt, like a mortgage; bad news if you’re a net saver. The Government has nailed its colours to the mast of reducing spending and increasing taxes, in order to reduce the deficit that ballooned to save the banks. (That’ll be the subject of a future post, by the way.) In short, not much to cheer anyone up much.
So, if you’ve yet to feel the effects of everything that has hit the UK over the last 2 years, 2011 may come as a shock.
I hope to be a bit less gloomy in my next posts. But with the banking situation to cover, I’m giving no guarantees.
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