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.