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A NATION IN THE RED
The Government Debt Crisis and What We Can Do About It
By MURRAY HOLLAND
McGraw-Hill EducationCopyright © 2014 Murray Holland
All rights reserved.
A NATION IN THE RED
To contract new debts is not the way to pay old ones.
The United States through reckless management and spending by Congress has become A Nation in the Red, joining a large group of countries suffering through depressions caused by irresponsible governments. The use of debt by governments is a politically easy way out of increasing taxes that people do not want to pay. It is also a good mechanism to make the economy appear as though it is growing fast when, in fact, it is not. When government borrowing is accompanied by borrowing by the private sector, a robust economy can develop that includes housing and stock market price increases, income increases, tax receipt increases, and so on. This phenomenon is known as a bubble and is a great experience for everyone ... until it bursts. During the buildup of the bubble, banks appear more stable and profitable as their underlying portfolio is performing well and profits look strong. The downside of these buildups is the bust: we have had two since 2000. The first being the dot-com bust that started in 2000, and the second the housing bust that started in 2008. Every time there is a bubble there is a bust or a recession ... and the bust always is more painful than the bubble was fun. The United States of America has borrowed too much money. It is now A Nation in the Red, and nothing good will come of it.
Sovereign debt defaults and crises in the economy, currency, and banking are all interrelated. Sovereign debt crises occur when a nation in the red determines not to pay interest and principal on its debts. Investors stop lending to that government, and the entire economy of that country goes into depression. Economic crises happen when investment and business activity slow down in a country. When businesses slow down expansion or actually downsize, they fire employees who in turn cannot pay their mortgages or eat out at restaurants; if the downturn is large scale, it can cause banks and other businesses to fail. Currency crises are triggered when the international demand for a currency shrinks or the amount of the currency available increases as a host country prints more of its currency. The value of the currency then falls quickly and deeply, which in turn can hurt the host economy. Banking crises occur when a large number of banks become insolvent. Banks become insolvent when the value of their loans drops significantly due to a fall of economic activity, such as we have experienced since 2008. When people are unable to pay their mortgages and businesses cannot pay their loans, banks that have made these loans may end up repossessing assets that are not worth the loan value. At this point, banks will fail, causing more problems to the economy. To make things worse, these crises usually happen all together, and central banks like the Federal Reserve Bank have to keep it all together by throwing money at the problems.
In their paper entitled "This Time is Different: A Panoramic View of Eight Centuries of Financial Crises," Carmen Reinhart and Kenneth Rogoff reviewed 800 years of sovereign defaults, how they were created, and the devastation left in their wakes. Their work is not unique but is often cited as an excellent compendium of defaults that are readily accessible. Hundreds of historians throughout time have written about sovereign defaults; the point to glean from this historical review is how easy it is to walk into the trap created by sovereign debt. Most countries as they are developing have many debt defaults as well as high inflation, currency crises, and banking crises. Reinhart and Rogoff also point out that debt defaults happen in cycles, which in turn are followed by a "lull" in defaults.
Importantly, Reinhart and Rogoff have charted all countries that have defaulted on their debt throughout history and not surprisingly there is a cycle of defaults. (This is a worldwide phenomenon because the world is connected economically.) The first such cycle happened during the Napoleonic wars. The second was from 1820 to 1840, when almost half the countries in the world were in default, including all of Latin America. The third was from 1870 to 1890. The fourth covered the years 1930 to 1950, which included the Great Depression and the Second World War, when again nearly half of all countries defaulted. There was another default cycle in the 1980s and 1990s due to defaults in emerging market debts. Their analysis goes one step further in combining each country's gross domestic product (GDP) to find out what percentage of global GDP was in default. What they found was that after World War II, countries making up nearly 40 percent of global GDP were in default. This is eerily similar to the world today.
A default is simply the inability to pay a debt when it becomes due, a definition used to judge whether a company, an individual, a country, or an institution is bankrupt. This is the core tenant of the bankruptcy laws in the United States. It is this simple definition that has come to haunt many countries over time and will be the ultimate issue that the U.S. Congress will face soon.
All defaults are not the same. One is an outright repudiation where a country says it will not pay creditors. There is no doubt this is a default. Another is a country saying it is reducing the current interest rate or will simply suspend interest payments for a period of time. Yet another is a country saying it is extending the period of time to repay the principal. Some countries like the United States originally agreed to repay in gold but instead repaid in dollars. Other countries inflate their currencies by printing more to pay the debt. These various "gimmicks" are really one and the same form of default.
In 377 BC, ten out of thirteen Greek municipalities (cities) defaulted on their debt to the Delos Temple. (The Temple of Delos, or Delos Temple, was a religious temple that had made loans to a number of cities around Greece.) This is the first recorded government default on debt borrowed from others. Since then, hundreds of defaults of debt by countries, states, and municipalities have occurred and will undoubtedly continue to happen forever. Greece has defaulted five times since 1800; England three times before 1600; France eight times between 1558 and 1788; China in 1929 and 1939; Nigeria five times since 1960; Russia in 1839, 1917, and again in 1998; and Argentina three times since 1980. The all-time leader in serial defaults is Spain, having defaulted seven times in the nineteenth century alone, and that is after defaulting six times in the previous three centuries. This is just to name a few. How and why does this happen? Can it actually happen to the U.S. federal government? What happens to the U.S. dollar? How does it affect the economy? How does it affect each of us? If you are not asking these questions, you need to read this book.
Table 1.1 is a representative listing of defaults by countries in recent history.
In addition to these defaults, and in order to make observations without having to walk through every detail, there have been dozens of other sovereign defaults. Many African countries, such as Angola, Cameroon, Congo, Egypt, Gabon, Liberia, Nigeria, Madagascar, Malawi, Côte d'Ivoire, Morocco, Mozambique, Niger, Senegal, Seychelles, Sierra Leone, South Africa, Sudan, Tanzania, Togo, Uganda, Zaire, and Zambia, have defaulted on their sovereign debt. Many Asian and Middle East countries, such as Indonesia, Jordan, Philippines, Pakistan, and Vietnam, have defaulted. Iceland defaulted. The current European situation, where we have seen defaults by Greece, Cyprus, Portugal, Ireland, and potentially Spain and Italy, are red flags to the situation facing the United States today. These countries are simply countries that have borrowed too much money.
All these listed defaults are by a country to outside, third-party lenders and do not include what are probably hundreds of defaults that never make headlines, such as sovereign debt to citizens or financial institutions within a country. These are often renegotiated and restructured inside the complex relationship of a government, its central bank, and the institution. For example, Argentina, during its many years of debt problems, would close banks, take gold and dollars held in safety deposit boxes and accounts, and replace them with pesos. This was not considered a default to third-party lenders but was considered outright theft by citizens.
There is no sense in trying to describe each default by each country, or even to list all the defaults by each country. Defaults, it turns out, come in many forms from simple technical glitches in the payment process, which cause a delay in payment (as has happened with U.S. government debt payments), to outright repudiations of debt (as has happened thousands of times throughout history). Particularly interesting examples include the default during the Bolshevik Revolution in Russia in 1917; a default in 1867 when Mexico repudiated the debt incurred by Emperor Maximilian (installed by the French) and again in 1911 after a revolution; and a default in 2012 with a negotiated repudiation of debt that was owed by Greece. This does not include hundreds of other forms of defaults by countries facing the "Debt Trap" (as explained in Chapter 3), which have dug themselves out of a hole by modifying the terms by lowering interest rates or extending the due dates of principal and interest payments. This, of course, is still a default since investors did not receive payment when or as promised. A default list also cannot cover all the instances where countries issued newly printed currency to lenders, particularly lenders within their own borders. This technique, of course, really doesn't solve anything, as the value of the currency falls so fast that the same effect as a default occurs for lenders and the general population. Attempting to classify a sovereign default is a tricky matter, since the actions of the debtor government can turn a default into a forced restructuring of the debt, recession, depression, or currency crisis. It all depends on what actions the government decides to take.
The unavoidable conclusion is that sovereign debt default is almost a common occurrence, and the size of the government has nothing to do with a default. Every country that has become a Nation in the Red faces the pain of the markets and payment of interest on the national debt becomes a significant burden. Until the recent default situation with Greece, Argentina held the record for the largest default at $89 billion. At that point in time, the total debt to GDP was only 48 percent, but the interest rate environment was considerably higher than it is today. The burden of interest expense was too great to keep paying it. We will get into this issue in a later chapter.
Economists love to delve into the details of each default and compare clusters of defaults, countries that continue to default, and countries that have learned better. To me, this is an interesting academic exercise, but the details of it are not going to help me with planning for what is facing everybody in the United States over the next few years and possibly decades. The conclusion I am drawing from all this is that politicians, who of course are the people who borrow all this money, are capable of driving the bus over a cliff all around the world. I do, however, know a lot of smart people who actually think it cannot and will not happen in the United States.
Surely the United States and the individual states have never defaulted on their debt; that would be unthinkable. But they have. Four times in U.S. history the federal and state governments have turned to default to get out of financial trouble. During the Revolutionary War, the states ran up a significant amount of debt to support the war effort. It became clear that they would not be able to pay it back, and the value of the debt dropped significantly, being traded among investors at pennies on the dollar. In 1790, Congress passed a law assuming all the states' debts, amounting to $21 million. Interest on the debt was deferred to 1801, and payment of the principal was extended. This was actually a change in terms of the bonds, a "default," as the original bonds could not have been repaid by the states. After the legislation was signed by President Washington, the value of the bonds skyrocketed, as investors now had a chance of getting their money back. Other "defaults" were timing issues, except for the one in the 1930s, when the U.S. government refused to pay in gold as promised.
THIS TIME IT IS DIFFERENT
There is a mantra in political circles that goes like this: "This time it is different" (which also is the title to the Reinhart and Rogoff book). The view is that both countries and creditors have learned from history how to stay out of the Debt Trap. The assumption is that macroeconomic policies and smarter lending practices will prevent the United States from another wave of defaults. More governments are relying on domestic financing. Reinhart and Rogoff conclude that this thinking is delusional, and I concur. This thinking, I am afraid, is one of the causes of the Debt Trap.
WHY GOVERNMENTS DEFAULT
So why does a government default? The simple answer is that it does not have the cash to pay the principal and interest on money it borrowed when it becomes due. But why? A government has to pay its debts when they become due, just as any company or individual does. It has to pay those bonds with cash. It really doesn't matter where a government gets its cash so long as it pays the bonds according to the terms of the bond. The two primary sources of cash to a government are taxing and borrowing. We all know what taxing is, as all of us pay lots of taxes that come in all shapes and sizes. If a government spends more than it takes in through taxes, it must either borrow the difference or issue new currency. The act of spending more than you take in is called "deficit spending." This deficit has to come from somewhere, so governments have been borrowing it from investors for years. So, who loans them all this money?
Borrowing is managed through well-developed global debt markets. In ancient times, there was no developed market for government bonds, and when individuals loaned money to a government, the government would pay them back. Today, however, the worldwide market for government bonds is enormous: around $49 trillion. These bonds are traded freely and electronically and make up around 60 percent of all debt securities traded around the world. Of the countries with the top 20 economies in the world today, all of them have a significant amount of sovereign debt outstanding. The bonds are bought by banks, pension funds, insurance companies, other governments, companies, and individuals. Government bonds are generally viewed as low-risk investments that can always be counted on to pay on the date promised. But as we know from the previous list of defaults, this is not always true.
So why can't a country simply borrow more from the market to pay the debt that is coming due? Well, this is exactly what countries do, including the United States. Few countries actually have the cash from taxes to pay back their bonds, so they borrow more money to pay back the money they previously borrowed. Not only are they borrowing money to pay the amount that is coming due, they are borrowing additional money to spend. So let's say the U.S. government has a $50 billion bond coming due this Friday. The government will issue $50 billion of new bonds Friday morning and take the proceeds and pay off the bonds falling due. Then it will also issue another $20 billion to get new cash to pay government bills. The markets seem to always loan governments more than they can pay back, and this situation has been true for some time.
To bring the economic analysis a little closer to home, we all know people who have overborrowed on their mortgage, credit cards, cars, and so on. Their income is not sufficient to pay the mortgage, car payment, baby sitters, electric bill, water bill, and food bill. So they start cutting back. They eat at home, don't buy steaks, cut coupons, turn off lights when not in use, use only one water heater, and so on. This clearly saves cash, and they need to do it. They get an offer to roll over credit card debt to a new credit card, which is nothing but reborrowing: if you borrow $10,000 to pay off a $10,000 debt, maybe even at a lower interest rate, in the end you will still owe $10,000. The problem they have is that the mortgage payment cannot be reduced; neither can the car payment and the credit card payments. These fixed-debt payments are just that: fixed. They have to be made regardless of the amount of income one has coming in. So the debtors are enslaved to lives of figuring out how to make each payment each month to keep the whole thing together another month. They may "borrow" from friends and family, or perhaps they'll pawn rings and anything of value. The extent to which these people will go is impressive, but these are just "games" to keep the ultimate crash from actually happening, although everyone knows the crash is going to happen.
Excerpted from A NATION IN THE RED by MURRAY HOLLAND. Copyright © 2014 Murray Holland. Excerpted by permission of McGraw-Hill Education.
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