Thursday, February 11, 2010

Thoughts on sovereign debt

Today the European Union released a statement about Greece. Absolutely no specifics are given regarding the terms of any Greek bailout, but there was a (slight) surprise:
Euro area Member states will take determined and coordinated action, if needed, to safeguard financial stability in the euro area as a whole. The Greek government has not requested any financial support.
This is a much broader statement than I was expecting; I take it as a blanket guarantee. Euro area members - Germany and France being the largest members as measured by aggregate GDP – will support the stability of the euro-zone, meaning that help will be dished out where needed.

I wanted to look at debt levels, not just in Europe but across the world. I suspected (before I made this chart) that the emerging market space would generally reduce debt levels (consistent with broader trends in countries like Indonesia or Mexico), while developed countries would generally increase debt levels. "Debt" considerations go deeper than gross debt as a % of GDP. I digress.

Below I illustrate two charts of gross government debt as a percentage of country GDP. The first chart illustrates general government debt burden for 68 countries, emerging and developed markets alike. Global Insight forecasts the numbers, which is proprietary information, but you can see the IMF's forecast for free here).


In the chart, there is a 45-degree line: countries above the 45-degree line are expected to increase debt burden spanning the period 2009 and 2012; countries below the line are expected to lower debt burden over that same time horizon.

Global Insight envisages just three “developed” countries to drop debt burden between now (2009 forecast) and 2012: Netherlands (barely), Norway, and Denmark. Any other debt improvements will occur across the emerging market space (there are quite a few countries, by the way).

The second chart illustrates the same pattern of indebtedness, but for the “big spenders”.


I had to separate the big spenders from the rest due to their relative magnitudes of indebtedness. In the big-spenders chart, the Y-values (debt to GDP) span the range of [5%, 255%] rather than [5%, 80%] in the previous chart.

Of the big spenders, Japan is the worst, with debt rising from 229% of GDP expected in 2009 to 230% of GDP by 2012 (this forecast was published before the passage of the Japanese 2010 budget, so indebtedness is likely to be higher still). But it's only the worst. There are other countries, Lebanon, Greece, Iceland, USA, fighting for second place. Looks bad, right?

Well....maybe...sort of. Before you start freaking out, there are things that one must consider.

External vs. domestic debt

Japan has a lot of gross debt but most of it is issued domestically. Total foreign debt - debt held by foreign investors - is expected to be just 22% of GDP in 2009. Having a lot of domestic debt is sometimes okay, as firms, pensions, and households support (define) demand for the debt. On balance, this makes aggregate debt (public plus private) much smaller.

Autonomous monetary policy

This is an important one, and central to Greece’s current situation. If the Greek government could print money – the ECB controls the money supply across the 16-member euro-zone – it would. It would simply print euros pay debt obligations, essentially inflating its way out of debt. Japan and the US can do this, making the risk of default lower.

Of course inflating your way out of debt can cause a much bigger problem if money supply growth gets out of hand. And this method of debt reduction can lead to a much slower and probably more painful way of going bankrupt.

Rebecca Wilder


  1. It is now quite clear that PIGS cannot learn to fly.

    EU leaders showed yesterday that when you do not have ideas you'd better have a plan, a rescue plan in this case. Some said the meeting achieved little more than a political statement, leaving details to be worked out later by EU finance ministers.

  2. Its the kind of language the EUSSR always uses: broad, vague, can mean anything and usually does.

  3. Rebecca, the way to get out of debt is a reasonable and sustainable tax policy. What do you think of and ?

  4. Hi James,

    It's going to take more than increasing taxes to get us (the US?) out of this mess.

    How will the new supply get soaked up? Global growth - that's right. I would keep an eye on economic growth rates. GS is calling for 4.5% growth in 2010 (I believe), which would allow governments to issue non-inflation debt.

    M.G. and fajensen,

    My take is that Greece is in an impossible situation, and that is why the "language" is so vague. Germany knows very well that it is unfathomable that they reduce their deficit by 4 %-points per year when the output gap is as wide as it is.

    Fly - they have been flying? It looks like they are coming down!


  5. Debt to GDP ratios are misleading. It is the volume of current savings (gross private savings and international investment), offered in the market place (including debt monetization), which determines how the Federal budget deficit can be managed.

    There are three basic elements comprising long-term interest rates: a “pure” rate; a risk rate; and an inflation premium. The pure rate presumably reflects the price required to induce lenders into parting with their money in a non-inflationary & risk-free situation. In recent years, a 2-3%figure is often assigned to this element.

    Long-term interest rates are determined not only by the various supply and demand factors that affect short-term rates but also by a unique factor; namely, INFLATION EXPECTATIONS. The expectation that price levels will chronically increase injects an “inflation premium” into long-term rates. Under these assumptions, the present supply of loan funds would decrease (in both a quantitative and schedule sense). That is to say, lenders as a group, reduce the volume of loan funds offered in the markets, and refuse to loan any particular volume of funds (except at higher rates that will compensate for the expected rates of inflation).

    I.e., higher inflation expectations generate higher inflation premiums. The higher the expected rate of inflation, the higher long-term rates will climb.

    Higher interest rates will choke off the economy LONG BEFORE INFLATIONARY FORCES REDUCES THE BURDEN OF DEBT.

    I.e., of the two effects, the supply side is the more important, since it literally establishes the minimum for long-term rates.

    Interest rates respond to influences other than inflation rates, either current or expected (there is a demand side factor (government deficit financing) operating in the loan funds market as well as a supply side factor).

    At the same time supply is decreasing, the demand for loan funds is expected to rise as a consequence of the expected massive increases in federal deficits (for savings), (the larger the deficit, the greater the demand).

    The deficit financing impacts on the supply side (as well as the demand side) will push interest rates up or retard their fall.

    With supply decreasing and demand increasing (in the schedule sense), there is only one way for interest rates to go – UP.

  6. There will come a time ( unpredictable ) when it will be impossible for the government ( federal ) to collect enough in taxes to pay all of its expenses, including interest on the national debt.

    The Gov't can of course borrow an indefinite amount through the Fed. ( concealed greenbacking ) given a few changes in existing law. But that would lead to hyper inflation - i.e., a collapse in the credit of the Gov't.

    So the easy way, is the way the French did it in 1960. Simply say that beginning Jan 1 ( or any other date ), new dollars will be issued, and that each new dollar is worth 100 old dollars. Then follow that up with a largely state controlled economy.

    In 1960, the French economist / mathmetician Jacques Rueff, during Charles de Gaulle's presidency, converted the old franc, to a nouveau franc, equal to 100 of the old franc.

    However, even with this substitution, inflation continued to erode the currency's value, though at lower rates of change, in comparison to other countries. And this new franc equaled 20 cents to a U.S. dollar. The old rate was 5.00 to a dollar.

    In 1960, the French franc, which was one of the weakest currencies, overnight, became one of the strongest. Correcting policies included plans to 1) balance the budget, 2) stablize the currency, and 3) eliminate currency controls.

    The gold content of the franc increased 100%, & 1) foreign exchange rates, and 2) France was on a managed paper standard; externally, on a modified gold bullion standard. With the new policies, France's economy strengthened, and the franc became fully convertible @ approximately its gold par, into gold for foreign exchange and into foreign currencies.

    With the introduction of the euro, the franc in Jan. 1, 1999, was worth less than 1/8 of its Jan. 1, 1960 value

  7. Is it actually true that it would take more than tax increases to balance the budget and start reducing debt?

    In 1957, a year in which the standard of living for Americans and the success of American companies both increased substantially, the top income tax bracket rates were 52% for corporations and 88% for individuals. Is there any evidence that if we returned to such top bracket income tax rates (whether or not the corporate and individual rates were swapped) and changed nothing else, the deficit would not become a surplus and the debt would not decrease?

    You hear a lot about the Laffer Curve in economics, but it's impossible to deny that it presents a correlation very close to zero.

  8. Furthermore, the data collected and presented by strongly suggests that steeply progressive income taxes (as opposed to the much more regressive sales, property, use, and value added taxes) may have a very wide spectrum of extremely positive externalities. Some of these externalities are so positive that if we to quantified them, they likely dwarf traditional economic ideals including growth.

    That argument, that growth is the wrong overarching goal entirely, is made in this video announcing the second edition of The Spirit Level (starting at the two minute mark through about 2:40.)

    So how about it, Rebecca, are you willing to defend growth as an economic ideal more worthy than the size of the middle class?


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