Understanding Sovereign Debt: Economics Meets Politics – Dr Giancarlo Ianulardo

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

22 comments to Understanding Sovereign Debt: Economics Meets Politics – Dr Giancarlo Ianulardo

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    The Eurozone sovereign debt crisis is rooted in the dysfunction of a monetary union without political union. I couldn’t agree with the author more.

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    Thanks for clearing that up. I’ve always found the debt crisis confusing, so it’s a breath of fresh air to read something to detailed.

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