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Risk-free no more (part II)

In comparison to the private sector of the economy, the public sector is always and everywhere regarded as inefficient. Governments are notorious for overpromising, overspending and underdelivering. Yet sovereign defaults are much less common than corporate failures. How come?

Public finances differ fundamentally from corporate finances. For starters, governments enjoy a budget flexibility that corporates do not. In times of rising deficits they can raise taxes or impose new ones at will, while a significant part of their expenditure is discretionary.

When fiscal adjustment is not a palatable option, governments can (almost) always run a deficit and borrow money to fund it. Even in the case that investors are unwilling to lend money to the government and/or demand a high interest rate, the latter can as well turn to its own central bank for funding, thus never running into the liquidity problems private businesses often encounter.

Before the abovementioned lines of defence are utilized however, one system feature ensures that they are only utilized in rare circumstances or to a limited extent.

A government that issues debt in its own currency also creates the money and the demand for products and services offered only within its own tax jurisdiction and not anywhere else. It is by construction of this system unavoidable that the money the government borrows (and creates) and spends will be used again within the area where the taxman’s hands can reach. Little by little this money will return to its source and will be used (and destroyed) to repay the debt incurred in the beginning. Therefore, as the state increases its liabilities it also increases the value of its tax assets, without particular concern about the effectiveness of its expenditure and with minimal risk. The same cannot be said about any private business which needs strict controls on how it spends its money and assumes significant risks.

It is only in very rare instances that this system fails and sovereigns default. These cases are usually associated with extreme macroeconomic scenarios, like war, political instability, natural catastrophes or currency crises. Such events may cause a quick and sharp decline in economic activity, a reduction in money velocity and conequently a drop in tax revenue, perhaps while the needs for government spending increase. In extremis a government might find itself unable to control its finances and avoid default. No system can prevent sovereign defaults 100% of the time. But a national currency does help governments avoid getting into serious trouble too often.

This does not mean of course that government efficiency is not relevant. Inflation is the direct outcome of government overspending. When a government spends prudently real GDP rises without inflation picking up. If the government throws taxpayers’ money around the new money only creates nominal growth without real impact. Governments should obviously try to spend prudently and avoid inflation, aiming to increase the welfare of their constituents. Central banks are supposed to serve as a balancing force to that end by juggling interest rates. If a government’s expenditure feeds inflation instead of growth, its borrowing costs may increase without a corresponding increase in revenue. This may pressure the said government to cut down on unnecessary expenses. But in either case, a government’s ability to repay its liabilities is not impacted. Only its spending ability is.

By adopting the euro the governments of the eurozone abolished this systemic feature, since the previously closed system of national currencies has now been opened wide. Balances of payments are no longer balanced. The money they create by borrowing does not necessarily flow within their own tax jurisdiction. In this environment every euro spent matters and governments are required to be double-cautious with public finances. At first this sounds like good news, right? The stronger the incentives for thrift, the more efficient governments should be.

But think twice. Such disincentives to spend have nasty consequences on both sides of a government’s budget. On the expenditure side, social welfare expenses are usually growth inhibitors or inflationary and in this new environment become very risky, very costly. Governments have now a strong disincentive not to spend on social welfare, which as we have witnessed has led to the quick dismantling of the social safety net in Europe’s South. Depending on your beliefs you may consider this a positive outcome, but it does signify a departure from European economic tradition. It is doubtful whether the majority of the European citizens is in favor of this development.

More importantly however and much less controversially, the euro has created a systemic vulnerability on the governments’ revenue side where none existed, one which comes at odds with the core features of capitalism itself. The success of the capitalist system lies in the alignment of efforts, information, rewards, risk and control of individual agents’ economic affairs. Risk is borne by those who can manage it and it is managed by those who choose to do so.

People choose what profession to follow and how much effort to put in their development, depending on their skills and their view of the labor market. Companies choose which markets to enter and how to organize their production according to market needs and their own competitive advantages. Financial institutions decide which assets to invest in and how to fund these investments.

Governments cannot make such choices. Their income depends on the decisions of private agents. The latter may choose to consume or to save, they may invest domestically or abroad, they may leverage or deleverage, they may decide to import goods or export their produce, and yet the government has no say on any of these decisions. It cannot even choose which agents to govern. Yes, sensible policy-making can have an impact on private agents’ behaviour, but policy-making is very far from the direct control companies or individuals have on their own decisions.

So long as governments cannot manage the risks they assume, they will be more vulnerable within the euro area and with them the whole economic system of the eurozone will be more fragile. We cannot be sure what the previous governments’ real expectations from the euro were, but we can be quite sure that none of them was ready to adapt to the challenges of the common currency back at its inception. In fact, it is foolish to expect that institutions with such a radically different culture and such a long history of mismanagement can so quickly turn into agile, thrifty, bottom-line maximizing organizations like private businesses are, without the powers to operate as such.

Unfortunately, the political motivations to keep the euro intact and the popularity of “common sense” economics has so far left governments in the periphery oblivious of this systemic weakness. Instead of boldly acknowledging their inability to perform their tasks without having their own currency, governments have chosen to take “bold” actions to repair their economies – with the known catastrophic results. The stupid notion that governments and citizens alike have to “pay for their mistakes” has so far prevailed.

And governments are not alone in this. Eurozone’s banks have also found themselves in a similar if not worse position. We examine them next.



9 thoughts on “Risk-free no more (part II)

  1. I remember when we changed from Austrian Schillings to the Euro. At that time, I didn’t understand all the fuss about the conversion. Instead, it was very simple to me: we had had the Schilling as a national currency and we would now have the Euro. Just a matter of conversion mathematics.

    What I did not recognize until the crisis began was that we had not changed from one national currency to another. Instead, we had changed from a national currency to a foreign currency. The Euro functions exactly like a foreign currency had functioned in the time before the Euro: if you run out of a national currency, you can print it. If you run out of Euros, it’s even worse than during the times of national currencies. When a national currency country runs out of foreign currency, it can still pay its expenses in the national currency (salaries, pensions, etc.). When a Euro country runs out of Euros, it can no longer pay a single bill.

    I guess I was not the only one who had overlooked the above…

    Posted by Klaus Kastner (@kleingut) | May 23, 2014, 09:57
    • Actually, as I describe above the most important advantage of a national currency is not the ability of the government to print it when it needs it. Governments in the eurozone can also print (create) new money just by borrowing from commercial banks, regardless of what the ECB is doing or not doing (since it is anyway prohibited of directly funding governments). But they can only do so if they can demonstrate they are solvent.

      The reason Greece for example cannot print new euros is because it cannot convince the markets that it is solvent. And it is not solvent because the money it created in the past did not stay in Greece, it was spent or invested abroad.

      Sweden, Poland, Turkey, Brazil cannot run out of their money because no matter how much of it they spend, it will never leave their countries. Foreigners will pick up the demand for their products. And they will spend it and recirculate it in these countries and their governments will stand to collect their taxes.

      The ability to print new money comes as a consequence of this feature. Frankly, I do not mind as much about the government’s ability to print money, there are obvious advantages and obvious disadvantages to it. What I do want is that money does not leave a country. National currencies, that is.

      Oh and btw, isn’t it odd that we commonly refer to the euro as a “foreign” currency to all countries in the eurozone? Shouldn’t it be instead “national” for all countries? And if it is foreign, why do we need to use a foreign currency in the first place? Which countries use a foreign currency instead of their own? Just some questions to ponder…

      Posted by 2mtm | May 24, 2014, 08:53
      • Can’ tell whether we agree or disagree; let’s try again.

        True, the local currencies of Sweden, Poland, Turkey and Brazil can never leave their countries for the simple reason that they are no legal tender outside the borders of their countries. Actually, not even the USD can leave the borders of the USA. Regardless how many Eurodollars, etc. foreigners exchange among each other, in the final analysis, a USD can only be in a bank account of a bank within the US borders (excepting cash, of course).

        However, even if national currencies COULD leave the country (which they can’t), it would still not be that much of a problem because the national governments can always print more of it. THAT (the printing) is indeed the most important aspect of it because as long as a national governments can create money on their own accord (i. e. without the cooperation of a third party), they can always pay their bills in national currency.

        A Euro-country CANNOT print (create) Euros on its own, i. e. without the cooperation of a third party. It either needs commercial banks which are willing to lend to the government or an ECB which makes available ELA-facilities and the likes thereof. If the government of Austria issues a bond in Euros and no one is prepared to buy it, it cannot tell the Central Bank of Austria to buy it against money creation when perhaps the OeNB has run out of Euros, too. At that point, the government of Austria can no longer pay its salaries and pensions. It could issue IOUs, instead, but then we would be back to some kind of a local currency.

        One caveat: I include a country’s Central Bank when I speak of “the government’s ability to print money”. Obviously, it is the Central Bank which is doing the printing (creating) and not the government. If the Central Bank refused to print (create) more national currency, then governments could go bankrupt even in their national currency.

        Posted by Klaus Kastner (@kleingut) | May 26, 2014, 17:59
      • To begin with, I think that we would both agree that money is not created only by central banks, but also by commercial ones. If I take a mortgage, if I buy a car on credit or if I pay for a hotel stay with my credit card, money is still created out of my promise to repay this loan (so not entirely out of thin air, but that is another issue). There is only little qualitative difference between the money issued by the central bank (the monetary base, including banknotes) and the money issued by commercial banks (our deposits, the money supply), as the latter is risky (think Cyprus) and the former is not. But that is also another thing.

        Coming to the question of what is more important, I have two reasons why in my view the closedness of a national currency is more important than the ability to print it.

        First, I would argue that in practice, a government has the option of turning to its central bank for funding only if it can demonstrate that it is solvent. In case the government is using its own national currency this is fairly easy, at least for a developed economy. If it does not have a national currency then it is difficult to demonstrate its solvency and in this case borrowing from either a commercial bank or a central bank is not a given.

        Take Poland and Austria as an example. If the polish government runs into trouble it may decide to turn to its central bank (NBP) for funding. The NBP might be skeptical of the government’s plans. It knows however that no matter what the government uses the new zlotys for, these zlotys will little by little come back to the treasury’s coffers. If these expenses prove to be inflationary, the NBP can later raise interest rates, according to its mandate. If not, no problem for anyone.

        Now let’s assume for the sake of argument that the central banks of the eurozone are also permitted to directly fund their governments. If the austrian government wants to borrow from the OeNB, the latter does not have the assurances that the NBP has because of the different currencies in use. The austrian government may indeed have a better justification and a better plan on how to make use of this money, but still it cannot have any guarantee of how the Austrians are subsequently going to spend this new money. What if they decide to spend all of it in holidays abroad? Where is then the austrian government going to collect taxes from?

        If the OeNB in this case is truly independent and fully mandate-driven, which is indeed a bit theoretical, it will be less likely to fund the austrian government. The risk is just too high, and because the OeNB is mandated to preserve the value of the euro and because it is highly leveraged (like all central banks) it may choose not to buy such a bond.

        In a more realistic scenario, the OeNB would probably be pressured by the austrian government to buy its bonds, but there would be many objections from other parts of the eurosystem, some very carefully worded justifications for this “one-time-only” case, some further concessions from the austrian government and so on. It won’t be too easy, but it won’t be impossible either.
        In contrast, thanks to the zloty, the polish government will find it much easier to get funding from the NBP because of the tax revenue assurances the zloty provides. And actually, thanks to these assurances the polish government will not even have to turn to the NBP, it will borrow directly from the polish capital market.

        My second and stronger argument however, is that a national currency makes it less likely that the government will find itself with a widening deficit and in need of funding, be it from a central bank or not. When the polish government in our example runs a budget deficit it also creates a fully offsetting surplus from tax revenue in the future, over a longer or shorter period of time. When the austrian government however runs a deficit, it may or may not see any surplus afterwards. I argue that for this reason the polish government will be in need of the NBP less often or for smaller amounts than the austrian government will be in need of the OeNB. The zloty offers protection while the euro creates exposure. Also for the same reason it is only rarely that a government is in need of its own central bank, despite widespread government overspending around the world.

        Summing up, I consider that the closedness of a national currency system is both a prerequisite for the printing option to be utilized in times of fiscal stress and also a preventer of fiscal stress. In corporate finance terms, a central bank acts as a credit line to the government, whereas a national currency as an insurance or a hedge. A government that has the option to borrow from its central bank is not more solvent, it is more liquid. But a government that has (quasi-)guarantees on its tax revenues is more solvent and therefore can be more liquid.

        P.S. 1/ From the above you can assume that I consider the credit risk premium on a polish government bond should be lower than that of the austrian government, or any other EZ government. The inflation premium might be higher though.

        P.S. 2/ Strangely, if the austrian government were to default on bonds held by the OeNB it would have to recapitalize it. It is a circular credit exposure which effectively means that the austrian government has no option to default and that these bonds would represent an obligation to the eurosystem, not to the OeNB.

        P.S. 3/ I did not use the USD as an example because I guess that there are some parts of this world, like Latin America, where if you flash some dollars to a local trader he will accept them as a means of payment, without asking too many questions. Illegally, but still…

        Posted by 2mtm | May 27, 2014, 08:32
      • Thinking more about my comment above, I realized I may be causing some confusion about the inflation risk that the central banks try to manage.

        In brief, currency devaluation may be the result either of a decline on the currency’s exchange value (more money chasing fewer products) or of a decline in its intrinsic/fundamental value, that is the collateral backing it. Central banks are concerned with both risks.

        In the case I describe above, a national currency central bank is usually only concerned about the risk of the exchange value of the currency declining. The intrinsic value risk is mitigated by investing only in low-risk government bonds and by the closedness of the national currency system.

        But in the case that the assets it invests in are risky, as is the case in the EZ, the central bank faces both risks, namely exchange and intrinsic value risk.

        What I suggest above is that central banks will avoid taking on intrinsic value risk but will be keener on adding exchange value risk since they can later manage it by tweaking interest rates.

        Perhaps I can give a more detailed explanation in a future post, but now for the economy of space I will have to leave it at that.

        Posted by 2mtm | May 27, 2014, 12:08
      • This is getting far too theoretical. The fact that a national currency cannot leave the country is a given because a national currency is not legal tender in any other country. I should rephrase my point to be exact: it is a national Central Bank of a national currency which can never become illiquid in its national currency for the simple reason that it can create the national currency ‘out of nothing’. All other banks can become illiquid, even in a national currency and, actually, a government can become illiquid in a national currency as well: if the US has a debt ceiling and if that debt ceiling is reached, it can no longer raise debt without violating the law. If there is no debt ceiling, a national government cannot become illiquid in its national currency because, if all fails, it will sell its bonds in national curreny to the national Central Bank which will always buy them with national currency created out of nothing, be it independent or not. It is illusional to think that a national Central Bank will make a creditworthiness assessment of its national government. Both are the full faith and creditworthiness of the country. The Fed financed WWII for the US government. The Fed is currently the largest buyer of US Treasuries (and the largest creditor of the US government). I believe the same goes for the Bank of England.

        Should a national Central Bank be prohibited by its statutes to buy bonds of its government (like the ECB is prohibited to buy Eurozone bonds), than national governments could get into the same problems as the governments of some Eurozone countries have gotten into in the last years.

        Posted by Klaus Kastner (@kleingut) | May 28, 2014, 18:58
      • Not the Fed, not the BOE, not even the central bank of Ukraine, would assess the solvency of their governments before buying their governments’ bonds, in that we agree. But are you suggesting that IF the EZ’s central banks were permitted by their statute to directly fund their governments, they would have bought greek, spanish or portuguese bonds in 2010-11 without performing ANY credit assessment of each government?

        I say that they would make a very thorough assessment and their verdict would in all cases be “denied”.

        Posted by 2mtm | May 28, 2014, 22:10
      • No, the ECB would NOT have purchased these bonds without credit risk assessment even if its statutes had not prohibited it because the ECB is a “Central Bank without a country”. Thus, the ECB would always buy bonds of “other countries” and in such cases, Central Banks do have to make a credit risk assessment (just like Poland would assess the risk of Swedish bonds).

        By contrast, the Fed – like presumably all other Central Banks – is a Central Bank with a country. The US government is the full faith and creditworthiness of the USA and so is the Fed. Since they are both “USA”, they could consolidate and all mutual debts/claims would wash out (Paul Krugman’s point). The only problem is that of the “pockets”. The pockets into which the money goes are not the same pockets as those from which it is taken…

        Posted by Klaus Kastner (@kleingut) | May 29, 2014, 11:59
      • I think that we are broadly in agreement on how central banks would behave, although not necessarily in agreement on the reasons why. Maybe we start from different starting points, heading towards the same conclusions. But this discussion strays away from the main point of my post.

        The main point I wanted to convey is that the euro has put at risk the tax revenue of EZ states, and as a consequence sovereign bonds can no longer be considered risk-free as is the case with countries outside the EZ. The fact that the ECB is prohibited from funding governments indeed further increases the risk of a sovereign default. Crucially, governments have very limited means of managing/reducing this risk.

        Those who advocate that the euro is beneficial to their country, whichever this country is, could do better by considering the less apparent risks that the euro has created, instead of arguing that the elimination of FX risk justifies keeping the common currency instead of reverting to a national one.

        Posted by 2mtm | May 30, 2014, 07:59

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