The Rise of Sovereign Risk in Advanced Economies
The Great Recession of 2008-09 was triggered by the excessive debt accumulation and leverage of private agents – households, financial institutions and even a fat tail of the corporate sector – in many advanced economies. And while there is a lot of talk about deleveraging, the reality is that private sector debt ratios have stabilized at very high levels while, as a consequence of the fiscal stimulus to get economies out of a severe recession and the socialization of part of private losses, there is now a massive re-leveraging of the public sector with deficits in excess of 10% of GDP in many advanced economies and debt to GDP ratios expected to sharply rise and in some cases double in the next few years.
Historical experience – as shown in a new book by Carmen Reinhart and Ken Rogoff (“This Time is Different: A Panoramic View of Eight Centuries of Financial Crises”) – suggests that such “balance sheet” crises driven by excessive private sector leverage lead to economic recoveries that are slow, anemic and below trend for many years (as agents/sectors need to save more and deleverage) and often lead, down the line, to serious sovereign debt problems given the massive re-leveraging of the public sector.
In countries that cannot issue debt in their own currency (traditionally emerging market economies) and those who issue in their own currency but cannot independently print money (as in the eurozone where member states don’t have direct and free access to the ECB printing presses) the result of festering fiscal debt un-sustainability often ends up leading to a credit event, a sovereign default or other coercive forms of public debt restructuring.
In countries that borrow in their own currency and can monetize the public debt, a sovereign debt crisis is unlikely. Yet monetization of fiscal deficits can eventually lead to high inflation. And inflation is – like default – a capital levy on holders of public debt as unexpected inflation wipes out the real value of nominal debt at fixed interest rates. Such monetization may not be inflationary if the economy ends up in a “stag-deflationary” trap where stagnation sets in and deflationary pressures from the slack in goods and labor markets are not remedied even by a massive increase in the monetary base (as in Japan in its 1990s near depression).
Thus, the recent problems faced by Greece are only the tip of a sovereign debt iceberg in many advanced economies (and a smaller number of emerging markets). Already bond market vigilantes have woken up in Greece, Spain, Portugal, the UK, Ireland and Iceland pushing higher government bond yields. Eventually they may be roused in countries such as Japan and the U.S., where fiscal policy is on an unsustainable path.
The ageing of the population exacerbates these fiscal sustainability issues in most advanced economies – a particularly serious problem in Europe and Japan – that will lead over time to a fall in population levels and worsen the unfunded public sector liabilities deriving from unfunded social security systems and expensive health care programs for the elderly. Low population growth also implies lower potential economic growth and therefore a worse debt to GDP ratio dynamics and public sector debt sustainability.
Also, while fiscal consolidation is necessary to prevent a fiscal train wreck and to prevent an unsustainable increase in sovereign spreads that would further destabilize the public debt dynamics, the short run effects of raising taxes and cutting government spending tend to cause output to contract, thus further exacerbating the public debt dynamics and the restoration of public debt sustainability. Argentina faced precisely this trap in 1998-2001 when needed fiscal contraction exacerbated the recession and eventually led to default. (See RGE Critical Issue: ‘What Caused Argentina’s Currency Crisis of the Early 2000s?”)
In countries – and in the eurozone – where member states don’t have independent monetary and exchange rate policies – the resumption of growth is further constrained by currency overvaluation and loss of external competitiveness caused by tight monetary policy and strong currency, by loss of long term comparative advantage relative to emerging markets and by a long period of wage growth in excess of productivity growth. Restoring competitiveness via deflation is self-defeating as such persistent deflation occurs only if growth stays negative for many years: so no social/political body is willing to accept years of fiscal sacrifices and painful structural reforms if the outcome is negative growth for many years. Eventually the outcome of deflation and recession is – as in Argentina – default. And if growth does not resume the fiscal problems get worse while near growth stagnation makes it more difficult politically to implement painful fiscal adjustment and structural reforms necessary to restore in the medium term competitiveness and growth. Thus, a vicious circle of public deficits and debt dynamics, current account deficit and external debt dynamics and stagnating growth can set in leading eventually to default on the public and foreign debt of the country as well as exit from the monetary union of fragile economies unable to adjust and reform fast enough.
Provision of liquidity by an international lender of last resort (ILOLR) – the EU/ECB, the IMF or even a new European Monetary Fund – can prevent an illiquidity problem (trouble in rolling over a large stock of short term debt when refinancing of such debt by private investors is at risk) from turning into an insolvency problem. But if a country is effectively insolvent rather than just illiquid such “bailouts” cannot eventually prevent default and devaluation (or exit from a monetary union) – see the experiences of Russia and Argentina – as eventually either the international lender of last resort will decide to pull the plug and stop financing an unsustainable debt dynamic or market investors will trigger a refinancing crisis so that that even an ILOR is unable to stem it given its limited resources.
At the end of the day resolving private sector leverage problems by fully socializing private losses and re-leveraging the public sector is risky as – at best – eventually taxes need to be raised and spending cut with negative effects on growth (i.e., the fiscal stimulus is never a free lunch); and at worst, default or a capital levy in the form of inflation may be the outcome.
Resolving high private and public debt ratios (to GDP/income) is hard to achieve by growing oneself out of a debt problem if growth remains anemic after a balance sheet crisis; reducing debt ratios by saving more lead to the “paradox of thrift,” while a too fast increase in savings lead to a worse recession and makes debt ratios even worse. Thus, unsustainable private debt problems need to be resolved by defaults and debt reductions and conversion of such debts into equity.
The right solution to a debt problem is reduction – via default and restructuring – of excessive debts and their conversion into equity. For households, this could have been done by reducing the principal value of mortgages and providing – via warrants – the upside of a recovery in home prices to the creditor bank; in the case of financial institutions avoiding a public recapitalization of banks (that is a creeping partial nationalization) and other forms of subsidized backstopping of the financial system would have implied more aggressive temporary nationalization of zombie banks and imposing haircuts and conversion of debt into equity for unsecured creditors of such financial institutions. And more aggressive corporate restructuring without government direct or indirect bailout of distressed corporate firms (as in the bailouts of U.S. and European automakers) would have accelerated the process of corporate restructuring and conversion of debt into equity.
If instead private debts are not reduced and converted into equity but rather , as happened, excessively socialized, the ensuing public debt accumulation may eventually lead to direct capital levies (default) or indirect ones (inflation). Thus, advanced economies will face in the next few years serious issues of public, private and foreign debt sustainability together with weakened economic growth.
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2 Responses to “The Rise of Sovereign Risk in Advanced Economies”
What would the optimal policy response be in Europe? Unlike the US, they do not have easy targets for cutting fiscal deficits, since their healthcare costs are reasonable and they don’t spend a lot on the military. Cutting deficits means imposing real pain. Lowering the currencies means a decline in standard of living in what may be a futile race to the bottom.It would be nice to see a comparison of what Europe is doing vs. what it ought to do.
Adding… reducing principal requires either spending money and higher fiscal deficits or taking it out of the hides of the banks with the default risk. Corporate restructuring is something that policy response cannot direct.Also, there are huge differences between Germany, with its trade surpluses and no housing crisis and Spain with its housing crisis and no trade surpluses. So the optimal policy response has to vary from country to country, yet overall result in better growth, lower deficits, and less crowding out of the consumer due to lower debt burdens.