Who pays? May 13, 2011 at 7:34 am

Why rob a bank?

Because that is where the money is.

That’s Sutton’s law, and a lot of sense it makes too. So, if you are a sovereign without enough money, who do you go to? Someone with money.

This means that there are only a limited number of choices for solving the endebtedness problem in advanced nations. Your choices are one or more of:

  • Individual taxpayers;
  • Individual consumers;
  • Corporate taxpayers;
  • Corporate consumers;
  • Government bond holders;
  • Foreigners.

The last won’t work for ever; you can’t keep increasing your borrowing as a percentage of GDP. Sovereign default or restructuring works, but it stops you from being able to borrow again for some time. Thus central bankers often think that you have to bear most of the burden internally. That makes it a pain allocation problem. Increase taxes; decrease services: these things are unpopular.

Reinhart and Sbrancia point out an interesting mechanism that allows governments to give some of the pain to bond holders without the stigma of a hard restructuring. From their abstract:

A subtle type of debt restructuring takes the form of “financial
repression.” Financial repression includes directed lending to government by captive domestic audiences (such as pension funds), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and (generally) a tighter connection between government and banks… Low nominal interest rates help reduce debt servicing costs while a high incidence of negative real interest rates liquidates or erodes the real value of government debt. Thus, financial repression is most successful in liquidating debts when accompanied by a steady dose of inflation.

Think of this as a subtle form of taxation. By providing negative real returns, governments can slowly take money from bond holders. Of course solving a government endebtedness problem this way also requires spending to grow less slowly than inflation, which is difficult. But it does provide a mechanism which many advanced nations will find attractive. The Bond Vigilantes don’t think we are there yet. But I suspect that we will be in due course.

5 Responses to “Who pays?”

  1. David,

    Inflation would be the face-saving solution. Creditors take their lumps without looking like they were had by the debtors. But how does it work in a monetary union with very unequal growth and inflation rates between members? One could imagine Germany’s real returns on Greek debt being penalized by domestic wage-induced inflation without the issuer, by definition deflationary in this case, receiving any benefit.

    It’s hard to see any option that isn’t the one being pursued… fund the laggard, pocket the carry, file it all under hold-to-maturity and wait for a really long time, repeating when needed.

    An alternative, unlikely approach might have the EU incorporate the Balkan states – as if the place were to need more tiny nations – and induce the the same old catch-up bubble there so that Greece would actually share a border with economic growth. In the end (if experience is any guide), this passes the problem on to Serbia, et al.


  2. […] Ex Macchiato has a lovely post that takes the debate a little further. As he points out, governments face limited options when it […]

  3. Charles

    That is the best argument to Turkish EU entrance I have yet heard. Of course the French will never let it happen, but it probably would allow the union to grow its way out of trouble.

    I don’t quite understand the mechanism whereby the US has a relatively uniform inflation rate and the EU doesn’t. Obviously labour mobility is part of it, and services are both rather localised and rather important contributors to inflation, but still there does seem to be something there to understand.

    Kind regards


  4. The other alternative is to force pension fund managers and banks to hold your debt.

  5. The big question in all this is how much European electorates can take. Take a look at the demonstrations in Spain, where the pain is barely beginning, and you get your answer.

    Inflation is the only way out, once you consider the politics of this.