I am travelling today and over the next few days and so I am stealing moments at airports etc to write the blog in between other commitments. Today we consider the research evidence available which bears on the question of national government debt default. The question is becoming increasingly pressing in the failed Eurozone and there is clear resistance among the elites to the proposition that Greece, Ireland, Portugal – for starters – might ease their domestic economic woes by defaulting. It is clear from the actions and statements of the political and economic leaders that they are more interested in protecting the private interests of capital than they are in advancing the welfare of the citizens in the nations under attack from bond markets. It is also clear that they have lost grip of the an essential aspect of capitalism – private return means private risk. The boundaries between private and public have become so blurred in the EMU as the elites strive to socialise losses. The reality is the evidence that is available doesn’t support the conservative arguments being used to eschew the default option and, instead, impose fiscal austerity on these economies. The evidence suggests that the costs of default while significant are short-lived and evaporate quickly. It is also clear that austerity also imposes significant costs on a nation that span generations. The comparison in the context of adding up these costs over the long-run is a no-brainer – these nations should default and follow a domestic-led growth strategy by expanding their budget deficits. That would require them to leave the EMU which is also essential if they are to regain their capacity to advance the interests of their citizens. Default is the way forward.
A prominent Eurozone commentator at present is the Italian economist Lorenzo Bini Smaghi who is on the executive board of the ECB. He seems to pop up all over the place (in the press, at conferences, etc) lecturing everyone on how fiscal austerity is the only way to proceed. Before the crisis he held out Ireland as the exemplar of the modern European nation and growth model. What he actually knows about macroeconomics and monetary systems is another matter.
On December 16, 2010 – he wrote in his Financial Times article – Europe cannot default its way back to health – that the costs of default by Greece or Ireland (Portugal hadn’t melted down at that stage) were dire:
… the liabilities of the banking system would ultimately have to be restructured as well … a further loss of confidence and make a run on the financial system more likely. Administrative control measures would have to be taken and restrictions imposed. All these actions would have a direct effect on the financial wealth of the country’s households and businesses, producing a collapse of aggregate demand. Taxpayers, instead of having a smaller burden of public debt to bear, would end up with an even heavier one … the main impact of a country’s default is not on foreign creditors, but on its own citizens, especially the most vulnerable ones. They would suffer the consequences most in terms of the value of their financial and real assets … The democratic foundations of a country could be seriously threatened. Attentive observers will not fail to notice that sovereign defaults tend to occur in countries where democracy has rather shallow roots.
So he concluded that the prospect of long-lived and significant costs of a default has been understood by governments in “Greece, Ireland and several other European countries” and that is why they “have adopted tough recovery programmes and radical reforms. And that is why the other European countries are supporting them. They know that the alternative is much worse for their citizens”.
More recently (May 10, 2011), Bini Smaghi was at it again. In a speech – Monetary and financial stability in the euro area – he said that:
… default or debt restructuring is a dramatic economic and social event for the country which experiences it – I would call it political “suicide” – which leads many into poverty, as experience has shown. It is thus rather peculiar for policy-makers to design policies mainly with the aim of punishing (or rewarding) certain categories of investors, rather than considering the ultimate consequences for the people.
So we get this clash – the interests of “certain categories of investors” (banks etc) versus the interests of the “people”. But Bini Smaghi proposes that debt default punishes the people more than if the government advances the interests of the investors and maintains all liabilities intact.
The evidence or in his words “as experience has shown” does not support his view. In fact, it shows that while it might be “political” suicide (meaning a government will be toppled if it defaults) it is far from being economic suicide (especially relative to the alternative).
Please read my blog – Defaulting on public debt as a way to progress – for more discussion on this point. I include a case study of Argentina in that blog.
In the UK Guardian (May 24, 2011) there is a wonderful article by Aditya Chakrabortty – Is defaulting really ‘political suicide’? – which notes that:
From George Bush to George Osborne, many stupid and disingenuous things have been said during the financial crisis. But some sort of prize really ought to go to Lorenzo Bini Smaghi … When it comes to spouting conventional nonsense, Bini Smaghi has a fine pedigree. In 2007, he wrote: “The Irish example shows that it is possible to prosper in the monetary union while having a higher potential growth rate than the rest of the union.” It was the spectacular wrongness of this conclusion that prompted bloggers to award the eminent central banker a new name: BS.
I concur with the writer’s assessment of Bini Smaghi and those who have similarly concluded his views amount to BS.
It is clear that governments of the struggling EMU nations are listening to his viewpoint though. They have chosen the alternative to default and are implementing harsh austerity programs at the behest of the bosses and lackeys at the ECB, the IMF, and the EU – all of whom hold well-paid, secure positions of privilege.
These programs will have long-lived inter-generational effects on the opportunities and prosperity of the citizens in the respective nations. Families are already being torn apart by the unemployment and lack of job prospects.
The cuts to education will reverberate over several generations. The loss of income will be profound and persist for many years will never be recovered. The loss of wealth and income security for those who enter retirement will impact on their standard of living until they die.
There is no small price to pay in imposing the sort of austerity programs that the establishment in Europe (and the unelected and unaccountable swill in Washington) is insisting these governments pursue.
The Guardian piece quotes an academic who concludes: “It’s the triumph of the banks … The lenders in Greece and abroad are being given preferential treatment over the Greek people”.
Which puts the trade-off I identified above in its correct perspective. At present the interests of the private corporate banks in France and Germany are being put ahead of the long-term interests of the Greek and Irish population.
The legacy the politicians are leaving the children of these nations is so diminished relative to the other options they have (default) – that it is simply astounding that the likes of Bini Smaghi, who has enjoyed a life of privilege, can be even taken seriously.
The Guardian article also provides an excellent technical assessment of the Bini Smaghi argument:
… it’s balls. More precisely, it’s the sort of everyone-says-it-so-it-must-be-true balls that’s been a hallmark of European policy-making ever since the banking crisis broke out.
What research has been done on the question of costs of default? In October 2008, the IMF released a working paper – The Costs of Sovereign Default – which identifies four different types of cost that accompany sovereign debt default. I could easily criticise the methodology and the way in which they have assembled their data but in the scheme of work that is out there the paper is relatively standard and so it is better to concentrate on its conclusions.
Sometimes I wonder about the disconnect between the political statements that the IMF make and the underlying research that it conducts. This paper certainly doesn’t provide any justification to the way the Fund operates at the political level.
The four categories of costs the paper identifies are “reputational costs, international trade exclusion costs, costs to the domestic economy through the financial system, and political costs to the authorities”.
I have an initial problem with their terminology that should be clarified. The IMF use the term “sovereign” to refer to national government debt. From the perspective of Modern Monetary Theory (MMT) the term sovereign has a more explicit meaning. It refers to the status of the currency and the government’s financial obligations.
A nation is sovereign in MMT parlance if it issues its own currency, floats it freely on foreign exchange markets and does not acquire financial liabilities that are denominated in a foreign currency.
While that binary view of things is clear you may get situations where a national government borrows small amounts in foreign denominations. Small here is relative to total export earnings (which mostly add to foreign currency reserves held by a nation). While such a nation has compromised their sovereignty in the MMT sense the practical implications of that are trivial – meaning, they are never in danger of default through lack of foreign currency reserves to service the liability.
But what is clear is that the nations that joined the Eurozone are not sovereign because they effectively use a foreign currency. Further, governments of countries like Argentina in the period before its default in 2001 are not sovereign because they have fixed exchange rate arrangements (and significant foreign currency liabilities) which compromise their domestic policy choices.
So that clarification should be borne in mind. It is true though that the foreign-currency (Euro) liabilities held by the Greek government are real (contractual) and they are problematic because the Greek government cannot easily service them – as of yesterday – the government is largely unable to do so.
So what about the costs of default? After investigating a “number of default episodes by geographical area” from 1824 to 2004 the IMF paper concludes:
… that default costs are significant, but short lived. Reputation of sovereign borrowers that fall in default, as measured by credit ratings and spreads, is tainted but only for a short time. While there is some evidence that international trade and trade credit are negatively affected by episodes of default, we could not trace it to the volume of trade credit, as the default literature suggests. Debt defaults seem to cause banking crises, and not vice versa, but we found weak evidence to suggest the presence of default-driven credit crunches in domestic markets. Finally, defaults seem to shorten the life expectancy of governments and officials in charge of the economy in a significant way.
How to they go about assembling that conclusion?
They initially consider the impact of default on GDP growth and distinguish between nations who have defaulted due to insolvency and those who strategically default. This distinction is interesting. For example, the US can never default on the grounds of insolvency given the currency-issuing status of its government. But the polity might not be “willing” to honour its government’s liability and so that might be considered a strategic default. Japan at one stage – as WW2 was unfolding – defaulted strategically on debt owed to its then new enemies.
The IMF paper finds that:
… on average, default is associated with a decrease in growth of 1.2 percentage points per year … [and that] … the impact of default seems to be short-lived. We estimate a large effect in the first year of the default episode (with a drop in growth of 2.6 percentage points) … [and no significant impact after that].
The last square bracket note is my interpretation of their econometric language to make their conclusion easier for readers to understand.
In terms of the effect of default on GDP growth, the IMF rightly point out that the extant modelling is riddled with “causality” issues. That is, does default lead to low GDP growth or does low GDP growth strain revenues etc which forces a default? The modelling tools available to us econometricians are notoriously weak in isolating these bi-directional possibilities.
The IMF paper attempts to overcome this problem and their subsequent results do not alter their basic conclusion.
They also find that when the default is “strategic” (that is, reflecting a “willingness” rather than an “ability” to pay) the losses are larger. They say “(t)he markets would punish debtors in the latter case, but will be more forgiving in the former case”.
The overall conclusion is that a default lowers GDP growth in the first year rather sharply but the negative consequences dissipate quickly after that. Argentina clearly shows that a domestically-focused policy can restore growth after a major default very quickly.
If you compare the estimated GDP losses from the default with the actual losses we are observing in Ireland (since 2009) and Greece (as examples) it is clear the scale of GDP loss is greater in the latter case (by toughing it out and imposing austerity). Ireland has been in recession for more than 2 years and is still sliding backwards. Greece is not far behind.
Further, the austerity push is dismantling longer-term growth prospects – eroding essential public infrastructure; failing to provide adequate educational and training opportunities to the youth and eroding the morale of the workforce.
The IMF paper then reports on their research into reputation costs. Bini Smaghi and his gang regularly talk of default as being the pariah option – that is, that default leads to an “exclusion from international capital markets”. Bini Smaghi is among many who harp on this point. It is a constant conservative mantra designed to scare nations into continuing to pay up when times are tough.
The IMF declare it a “fact”:
… that default does not lead to a permanent exclusion from the international capital market. In fact, the evidence suggests that, while countries lose access during default, once the restructuring process is fully concluded, financial markets do not discriminate, in terms of access, between defaulters and non-defaulters.
In my case study of Argentina noted above, the default has been largely successful. Initially, foreign direct investment dried up completely when the default was announced. But it didn’t take long for the investors to come back in once the stimulus initiatives that the government took (focusing on restoring the domestic economy to health) led to strong GDP growth and a rebound in confidence.
Argentina demonstrated something that the World’s financial masters didn’t want anyone to know about. That a country with huge foreign debt obligations can default successfully and enjoy renewed fortune based on domestic employment growth strategies and more inclusive welfare policies without an IMF austerity program being needed.
The clear lesson is that sovereign governments are not necessarily at the hostage of global financial markets. They can steer a strong recovery path based on domestically-orientated policies – such as the introduction of a Job Guarantee – which directly benefit the population by insulating the most disadvantaged workers from the devastation that recession brings.
The IMF also asked whether:
… default has a long term impact on credit ratings … [and found that] … that defaults episodes do not have a long-term impact on credit ratings.
So the overall conclusion here is that defaulting nations rather rapidly regain access to international capital markets. I recall a press conference that the Argentinean Finance Minister gave during the crisis period (well after capital markets had started lending again). He was asked to explain the fact that the foreign investors were once again flooding into Argentina seeking profit-making opportunities despite the fact that the government had defaulted and refused to impose an IMF restructuring (scorch the earth) program.
He said it could be explained in one word: “GREED”. The point is that the international capital markets don’t take the ideological positions that the politicians and lobby groups think. They chase the almighty return and they know that growth delivers return. Simple as that.
We are also told by conservatives that a nation that defaults will face onerous borrowing costs in the future as a penalty for their untrustworthy behaviour. There is no consensus in the research literature on this question. The IMF paper find that:
… ratings have a large and statistically significant effect on spreads … [but] … that default episodes have a short-lived impact on spreads …
The point is that there is no substantive and authoritative research that shows borrowing costs to a defaulting nation are higher for lengthy periods after a default. The evidence points to the opposite being the case.
Conservatives also argue that a nation that defaults will suffer trade retaliation – that is, no-one will export to them. Remember that these characters also push export-led growth models as a the primary way in which a nation should develop – which reflects their bias against public sector-led domestic oriented growth.
The IMF paper finds that:
… there is little historical record of countries imposing quotas or embargos on a country that falls in default. The current structure of international capital markets, where investors are increasingly anonymous bondholders who may switch from long to short positions in minutes, makes this traditional assumption more implausible nowadays.
Having dismissed that part of the conservative argument, they recognise that it is still possible for exporting firms to suffer a “deterioration in … credit quality” which would “have consequences similar to those of retaliatory measures”.
What did they find?
… the effect is negative and large only in the first and second year of the default. This result suggests that default does have a negative effect on trade credit but that this effect is short lived.
Okay, so then it once again becomes a comparison between relatively short-lived effects which might occur as the government introduces a domestic-led growth strategy aiming to get people working again and providing some income stability in local currency terms (that is, defaulting and restoring a sovereign fiat currency) and the likely long-lived costs of imposing an austerity program just to meet the profit-seeking needs of foreign capital providers.
In my assessment, this comparison is not being made. The Bini Smaghi’s of the world are trying to throttle the debate and suppress the research in this area because they know that the default-domestic growth option is far superior in terms of the local population than the fiscal austerity option which benefits the international capital providers and the jobs of the politicians and elites.
The IMF also investigates whether a default leads “to banking crises or a domestic credit crunch”. They note that this might arise from “a collapse in confidence in the domestic financial system and … bank runs” or negative effects “banks’ balance sheet” which “lead banks to adopt more conservative lending strategies”.
Their research results:
… do not provide much support for the credit crunch hypothesis … [and they] … conclude that, unlike banking crises, defaults do not seem to have a special effect on industries that depend more on external finance.
So another plank in the conservative argument gone.
The IMF paper further investigates the “political” costs. In this sense, Bini Smaghi’s “political suicide” epitome might has some currency (excuse the pun).
The IMF note that:
Sometimes, politicians and bureaucrats seem to go to a great length to postpone what seems to be an unavoidable default.
Self-interest comes to mind as the possible explanation. After all the leaders and their apparatchiks are the ones who swan off to luxurious hotels in Brussels for emergency meetings and enjoy no real income loss as a result of imposing austerity on their nations.
The IMF note that “a politician concerned about his/her political survival faces a tradeoff that is somewhat different from the one affecting the country itself, say, the representative citizen”.
Their research shows that:
… on average, ruling governments in countries that defaulted observed a 16 percentage point decrease in electoral support … and that in 50 percent of the cases there was a change in the chief of the executive either in the year of the default episode or in the following year. This is more than twice the probability of a change of the chief of the executive in normal times … in tranquil years there is a 19.4 percent probability of observing a change of the IMF governor, but after a default, the probability jumps to 26 percent
The IMF governor relates to the senior economic officials in a nation – “the country’s IMF governor … is typically the finance minister but in some cases the governor of the central bank”.
So self-interest is clearly a motivation for the governments of Greece and Ireland imposing austerity on their citizens.
We should be clear that none of this discussion is of relevance to a sovereign nation (such as, the UK, the US, Japan, Australia, Norway, etc) who never face any solvency risk unless their polity becomes so dysfunctional that they actually determine they are unwilling to honour their liabilities.
The public debate in the EMU is being mis-informed. The costs of the “internal devaluation” strategy are likely to be huge – a deep and prolonged recession, with unemployment driven so high that it generates significant downward pressure on wages and working conditions. Lost pension entitlements; a degraded public infrastructure and a compromised public education system – and more.
It is clear to me that all the Southern European nations should immediately exit the Eurozone and that would mean that all Euro-denominated debt would have to be restructured – that is, the non-sovereign nations would have to default on previous debt obligations as part of their transition back to full sovereignty.
There is a role model to follow – Argentina. Please read my blog – Hyperbole and outright lies – for more discussion on this point.
It is clear that default does not amount to economic suicide. A nation that implements a domestic-led growth strategy as it restores its currency sovereignty is more likely to restore prosperity more quickly than a nation that imposes fiscal austerity (especially when austerity is being imposed in many other economies at the same time).
Most of the problems that the conservatives raise with default turn out to be non-problems and are code for defending the narrow private interests of international capital and the elites that feed off it.
Once sovereignty is restored that nation faces no further revenue constraints in introducing a domestic-led growth strategy. That doesn’t mean that default is costless or easy. It is painful as the IMF paper shows but the pain dissipates very quickly. The pain of an austerity program pursuing internal devaluation is huge and lasts for generations.
I think the best thing a non-sovereign government can do in terms of advancing the interests of its people is to move towards sovereignty as soon as possible. That might involve jettisoning a currency arrangement (such as in Latvia, for example).
It might require exiting a monetary union that has taken the currency-issuing monopoly away (such as the EMU nations). In this instance, that might necessitate a formal default on all debt that was incurred in the currency that the nation is exiting (such as Greece at present).
The reality is that a sovereign government holds all the cards in this situation. Please read my blog – Why pander to financial markets – for more discussion on this point.
There would be short-term costs but by re-establishing the currency sovereignty the nation will always be able to advance the best interests of its domestic economy.
This doesn’t mean that a nation that is short of real resources etc will be able to establish a high material standard of living by moving to sovereignty. The real standard of living is always determined by the access a nation has to real resources. Fiscal policy does not create these resources but can ensure they are more fully utilised and thus more effectively deployed. A poor nation will not become rich just because it is sovereign.
None of this discussion applies to truly sovereign nations who never face any solvency risk.
With all that said, how does the British government which is fully sovereign and has zero default risk justify imposing harsh policy regimes on its own country akin to the Greek and Irish situations? There is no justification.
The latest data from the UK shows that the deficit is increasing (as tax revenue is further eroded by the damage the fiscal position is placing on growth) and private confidence is evaporating. The reality is exactly the opposite to that predicted by the fiscal contraction expansionists. We are a year in now with that government and their program of cuts is only just beginning.
I also come back to the point that I left off with yesterday – risk and return is the basic creed of capitalism. Socialising private losses and privatising gains is not remotely consistent with the capitalism that the austerity merchants pretend to support.
That is enough for today!