Recent data on the state of the global economy indicate clearly that the crisis is not over. Contrary to earlier assessments, it now appears that in the years to come the developed economies are bound to experience a deep recession. Hence the calls for the adoption of austerity measures, and the debate over the wisdom of adopting such measures which took place in the last G20 summit..
The proponents of austerity, in particular Republican Right circles in the US, concentrate their political wrath on Public Debt. They perform an audacious rhetorical spin, when they present the collapse of the private financial sector as though it were a result of fiscal profligacy. In this debate the fiscal hawks have a powerful ally: "the markets.”
In the discourse on policy in a market economy the response of "the markets" and its implications is always taken into account. During the last 30 years, a small elite of macro-economic policy makers has created a perception of "the markets” as a global amorphous entity, all-knowing, and above politics.
The financial crisis ended that myth. As the crisis unfolded, "the markets” were more clearly seen as "the financial markets." The mention of names like Goldman Sachs, Lehman Brothers, AIG ,etc. in relation to the financial crisis exposed the fact that “markets” are not driven by a neutral mechanism reflecting independent choices of million of investors around the globe. Rather, it is an amalgam of organizations and their managers who finance experts and decision makers, who in turn influence stock exchanges. A key to understanding how "the markets” can pressure governments to adopt fiscal policies that run contrary to their economies' interests lies in understanding the process by which the financial markets have become the owners and masters of Public Debt. .
The financial roots of democracy
In his book “A Free Nation deep In Debt,” James Macdonald describes how the evolution of public debt is inextricably linked to the evolution of modern democracy.
Public debt owes its origin to the realization of absolute rulers that wars are more easily financed by borrowing from the ruler’s own subjects than from foreign powers or from lending organizations.
The dependence of a regime on its subjects gradually gave the latter a greater say in running the country, giving rise to the “citizen-creditor” and to public debt as the financial foundation of democracy.
In a democracy, public debt (in the domestic currency) is formally and institutionally the obligation of the nation to its citizens. The very same citizens are also the guarantors of the debt. A country is not a limited liability company. The citizen-creditor is at the same time the shareholder and the obligor even if the debt is owned by foreigners. He has trust in his government, which in return is accountable to him.
The level of public debt is a key question of economic policy. The citizen-creditor will monitor the conduct of his or her government to prevent it from embarking on adventures that may jeopardize the value of its debt. By the same token, if the utilization of funds borrowed by the government from its citizens is democratically approved, the citizens view their government debt as risk free, regardless of how such debt might be rated by any foreign agency. In a monetary union like the EMU, there may be additional restrictions imposed on a member country, as part of that union’s policy. That is how public debt has become the anchor of wealth of both individuals and organizations in a democracy. Social security, life insurance, and pension funds, all rely on government debt as fully secured obligations.
The Bank of International Settlement (BIS), which formulates the standards of capital adequacy of financial institutions (Basel), authorizes the regulators in any country that abides by BIS standards to qualify its government obligations as risk-free. Banks and insurance companies do not have to allocate capital against exposure to their own governments. Hence the stability, and much of the profits, of financial institutions depend on government debt.
The question is, how did "the markets” manage to impose on the global discourse on public debt terminology taken from the contexts of “default” and “bankruptcy” of corporations, or from that of the Paris Club, where external debts of debtor countries are arranged and restructured? Greece has been compared to Lehman Bros. and to Argentina. Both comparisons are utterly wrong.
The declining status of public debt
The declining status of public debt is the story of the global economy of the last three decades. The election of Reagan as president in 1980 ushered in a US administration openly hostile to any involvement of government in the economy. This entailed economic policies that hinged on two sacrosanct elements: cutting taxes, and limiting public debt.
Those principles became the foundations of the macro-economic orthodoxy prevailing in the US. Gradually, the same principles became the quintessential characteristics of “good and correct economics” in the rest of the world as well.
The policies drawn from such principles favored the wealthier sections of society who were less dependent on government services. Their share of the national income grew dramatically, while the level of wealth of the less wealthy strata remained stagnant. Government was less and less able to meet the needs of the weaker sectors of society. The wealthy were exempted from paying taxes and had no interest in lending to their government. That left the government with no choice but to borrow in the markets. As a consequence, the financial burden of running a country fell more heavily on the less wealthy, and the markets became the masters of public debt.
To illustrate how dramatic the change in ownership has been, one should note that by the end of WW II, the US public debt was twice its size today, in terms of GDP. American citizens owned almost all of it. Today, US citizens hold directly only 10% of US Government debt. In his review of Macdonald’s book, James Galbraith aptly raises the question: “Can democracy survive when its financial roots have been cut? The scale of public debt is not the issue, but its ownership is. Can a countrywhether the United States or any otherbe truly democratic if it is in hock to banks and foreigners?”
The risk to stability
The Eurozone crisis showed us that ownership of public debt by the markets may even be a risk to the stability of the global banking system.
Greece’s government debt in its own domestic currency was downgraded to “junk”. Because of the regulatory regime of the Eurozone, such downgrading creates a situation in which a bank in one of the Eurozone countries that holds its own government's bonds, and regards them as risk-free as in any other country, may even collapse because of the downgrading. .
The absurdity may even be greater, since the government that will need to bail out such a bank is the very same government whose downgrading brought it down in the first place. Such a situation would be in total violation of the existing Basel framework, and will make the implementation of the new framework (Basel III) difficult, If not impossible.
Indeed, "the markets” showed that they are willing and able to destabilize the entire European banking system on account of their alleged undisclosed holdings of government debt of certain Eurozone countries. They do so with assistance from the “Bloombergs”- a generic name I propose for the media platforms through which they deliver their “message” to the exchanges. Luckily, the European Central Bank has so far withstood the pressure, and continued to relate to Greek sovereign debt as though that debt was not downgraded.
Citizens, take back control
Citizens in the democratic countries need to reclaim control of their government debt, in order to revitalize the democratic institutions that have been weakened in the last three decades. The prolonged recession may require governments to reach decisions of unprecedented importance. Opting for continued assistance to the unemployed and maintaining at least minimally decent living standards, in order to preserve the social fabric, is a choice of no less importance than going to war. Both choices may involve passing a significant debt burden to future generations. These are not purely economic dilemmas. Such decisions should be debated and decided through political discourse in the appropriate democratic institutions, and not in the boardrooms of rating agencies, or under constant threat from "the markets.” The primary lesson from the current crisis is that a country should never become over-dependent on "the markets” to finance its operations.
Easy said, and (fairly) easy done
A country can borrow directly from its citizens in the same way that it collects taxes from them. Such borrowing may be voluntary or mandatory. Mandatory borrowing is a practice adopted by governments from time to time, especially in emergencies. France is currently preparing a major State Loan (Emprunt d'État) called Le Grand Emprunt . The borrowed funds will be used for “investment in the future.” In the center-right UMP ruling party there are those who advocate making such loan mandatory (obligatoire).They hope that it may preempt the likely political pressure to raise taxes on the wealthy.
Greece too can and should be able to borrow directly from its citizens. Now that the Eurozone countries have provided it with protection from "the markets” for at least two years, Greece should organize a State Loan whose purpose will be to repurchase tradable sovereign bonds from the worried “markets.” Such a loan will not increase the overall level of Greece’s public debt, and will help it regain sovereignty over its fiscal affairs, and its status among its fellow Eurozone members.
I doubt very much whether at current yields there will be many sellers of Greek government debt. As soon as "the markets” realize that Greece can manage without them, their assessment of Greece's risk profile will suddenly change. They are in the business of sovereign debt because it is very profitable. In my view, they will fight to retain their share of that business.
Dr. Ehud Kaufman is a former senior banker and was in charge of foreign relations at the Ministry of Finance.
Published by Globes [online], Israel business news - www.globes-online.com - on August 2, 2010
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