Affiliated with the University of Nicosia |
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THE SOVEREIGN DEBT CRISIS By Monroe Newman
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Professor Emeritus of Economics, Pennsylvania State University |
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With the
news full of the sovereign debt crisis, with governments
mustering remedies for it, and with the streets full of people
objecting to its real and potential impacts, it may be useful to
keep some basics in mind.
-Sovereign debt is the accumulated obligations of
government, the national debt that was accumulated to cover the
past shortfall of government receipts when compared to
government expenditures.
-For every debt, there is an equal asset held by those
who made the loans so we might speak of a sovereign asset crisis
for those who count the evidence of debt, the bonds, as part of
their assets.
-Every time the proceeds of an addition to national debt
are spent, an equal amount of income is generated, initially
equal to the amount of the new asset created as the new
bondholder exchanges money assets for the bond.
-Similarly, every time the national debt is reduced there
are fewer bonds outstanding, to that extent bondholder wealth is
now in the form of money, and someone has less disposable income
to spend to generate income.
-Customarily, the evidence of debt – a bond – has a
limited period before it is scheduled to be repaid (matures) so
much of the activity in sovereign debt consists of selling new
assets to redeem old ones.
-In addition to the activity associated with this rolling
over of existing debt, net additional debt may be accumulated if
governmental outlays exceed revenues. -Persuading
investors to buy all these new assets involves, among other
things, offering them a rate of return that includes a risk
premium which varies with the perceived likelihood that the
scheduled interest payments and redemption at maturity will not
occur.
-Paying this rate of return results in income
redistribution in favor of the asset holders, except in the
unlikely event that they paid extra taxes of an equal amount to
cover the burden of these payments.
-If the asset holders are not nationals of the issuing
country, the redistribution is international, purchasing power
is transferred to those outside its borders.
-An analogous income redistribution occurs if domestic
sources are tapped to redeem (buy back) assets held abroad. What then is the crisis?
Again, it may be helpful to break the possibility of
crisis into its basics.
A crisis can arise if:
-Government is unable to meet its immediate obligation to
make the periodic payments, i.e. interest payments, to the asset
holders of its bonds.
-Government is thought to be unable or unwilling to make
future periodic payments, particularly if to do so requires a
substantial portion of its revenues.
-Government is either unable to find buyers for bonds it
must issue to rollover existing debt or can only do so at
interest rates that are exorbitant.
-Government’s continuing deficits require sale of
additional bonds for which there are insufficient buyers or
buyers who can only be induced to purchase at exorbitant rates. The present crisis has elements of the last
three of these possibilities.
The most common prescription for overcoming
them involves finding willing, rather short term, lenders among
other governments and international organizations. They expect
repayment within a few years, effectively requiring that a
substantial portion of existing and new debt be redeemed or
rolled over by then.
In exchange for their involvement, these lenders are requiring
severe restrictions on future government deficits, with emphasis
on reducing outlays for personnel and government benefits,
programs and services. This concentrates the initial adverse
effects of adjustment within the country’s borders. It is important to note that none of the
burden of this reduction is to be borne by holders of previously
issued government bonds.
In the language common today, interest payments to
bondholders and redemption of bonds are continued because they
are “obligations.”
However, the denigrating designation of “entitlements” is used
to describe promised benefit payments, such as those to
retirees, which are being reduced. Are there
alternative approaches? This is far from the first time that
governments have confronted problems stemming from their
sovereign debt. The
traditional response has been to devalue the currency (or what
is the same thing, issue a new monetary unit), which adversely
affects all those with assets denominated in the “old” units.
This is particularly true of those holding sovereign
bonds and one of the reasons why a risk premium is included in
the periodic interest payments they receive.
A blunt instrument, devaluation has proven painful but
effective, giving breathing space for revisions in government
revenue and expenditure policies.
Clearly, this requires a government having
control over its monetary unit.
Belonging and remaining in a currency zone, such as the
eurozone, precludes this remedy. Faced with the fact that the current
prescription for dealing with the crisis concentrates the
initial adverse effects within its borders, a country might try
an alternative. It
might, for example, treat foreign holders of its bonds
differently than domestic ones. Foreign holders of debt could be told that
their assets have been “renewed,” i.e. will be paid off at some
future date but with no change in their interest rate, so that
their annual interest receipts remain unchanged.
Domestic holders could be given a different rate of
return and redemption rights under certain circumstances.
Obviously, the result will be different
changes in value for the bonds of each group of holders.
Differential impacts characterize every policy and one of the
functions of policy is to decide how each group is affected.
That is one of the prerogatives of sovereignty.
If a country were to take this step, it would
transfer abroad some of the downward pressure on economic
activity that necessarily accompanies the conventional
prescription. Requiring that existing lenders continue in that
role avoids some of the onerous, depressing domestic effect of
the current form of international assistance.
By doing this, the state avoids the costs and
difficulties of rolling over existing foreign-held debt.
However, it would still face a current deficit in a
budget that included the cost of financing existing and new
indebtedness in addition to the other costs of government.
The size of that deficit would be limited by its ability
find holders of new indebtedness. History makes it clear that private foreign
lenders might expect unacceptable risk premiums, or be unwilling
to lend at all. They
would be responding to the “renewal” of existing foreign-held
debt, which they would see as a modified default. How might government deal with this?
Reconstituting the taxation system would obviously help,
a task possibly made easier by the fact that no new
international income redistribution would be necessary. In
addition, tax revenues would not be as depressed as they might
be by the fall in income resulting from a larger decline in
government spending. The marketing of bonds domestically would
continue. Those
purchases might increase, thanks both to the knowledge that all
net new proceeds would go to preserve domestic programs and also
to attractive loan terms.
The sum of these two – tax proceeds and other
revenue plus net new bond purchases – would establish the
ceiling on government outlays.
To the extent that they were insufficient to cover
obligations, painful choices would be unavoidable.
As the process is taking hold, it might be necessary to
pay some commitments with short term, interest-bearing
securities and/or a secondary limited currency. In summary,
the overall effect would be a) to transfer abroad to investors
some of the depressive effect of readjustments, b) investors at
home and abroad would continue to be compensated fully for the
anticipated risk they previously accepted, c) make manifest the
need for domestic income producers to support public outlays
through taxation or lending, and d) focus attention on the need
for setting priorities and making changes in the pattern of
public expenditures, separate from any “discipline” imposed from
abroad. Is the foregoing messy and does it have
undesirable aspects?
Of course. The more
important question asks -- Is it less undesirable than the
conventional approach, which makes principal payments to
bondholders obligatory and all other government programs
discretionary and which has more severe depressive effects
domestically. Your
answer clearly depends in part on whether you hold foreign
sovereign debt among your assets.
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