The rules of sovereign debt

Bonds have three features that differentiate them from equity instruments. They involve fixed and contractually binding interest payments. They have a finite maturity. Finally, they place the purchaser on a higher rung of the repayment ladder. This final point is only significant if the issuing entity finds itself in financial difficulties, and in danger of default.

Bonds are collateralized in a way that equity is not. Equity holders become owners of a firm, and as such have a claim on all the company’s assets at all times. Bonds require some of these assets to be set aside at all times to provide for collateral in case the company defaults. This collateral works as a safety net for creditors, ensuring that they have available some assets to cover the contingency of default by the organization issuing the bonds.

Sovereign bonds are a unique example. No collateral is posted explicitly. Unlike a potential mortgage holder, no government must demonstrate that it has adequate collateral set aside in case it faces default.

There is good reason for this. Sovereign debt is typically considered risk-free. The risk this debt is “free” of consists of credit risk. Governments can finance any funding shortfalls in one of two ways. Either by increasing tax rates to pay bondholders, or in more extreme circumstances, bypassing the usual “independence” of their central banks and requesting monetization of their debts. Note that risk-free does not entail that the creditor is free of inflation (if a domestic citizen) or exchange risk (if a foreigner).

Let’s rewind a decade and look at the circumstances facing an individual lending money to a select few European governments. Someone lending money to, say, Greece, was ensured of two things. First, that the Greek government bonds were risk-free in the sense that there was no credit risk involved – the nominal amount of the bond would be repaid. Second, thanks to the independence of Europe’s monetary authority – the ECB – the lender was assured that they faced no inflation or exchange risk. The euro ushered in a period of exchange stability, locked in through an unbreakable currency union. The ECB further promised in its statutes not to monetize the debts of any of its member states.

The unfortunate fact today is that these bondholders are faced with a position where the Greek government is unable to pay its debts. This leaves one option at this point to pursue to satisfy its creditors legally. While the bonds it issued over the past decade (and before) are not collateralized by anything tangible, they are implicitly collateralized by the future taxing capabilities of the Greek government. If the Greek government has a funding problem whereby it faces the possibility of defaulting on its debt, it is obligated to raise taxes to remunerate its creditors.

That this option is not available is clear to any who have looked at the state of Greece’s tax revenues. Taxes are already sufficiently high that a large portion of economic activity hides in the underground economy. In fact, as I outline in chapter 5 of my own edited book Institutions in Crisis: European Perspectives on the Recession, any attempt by PIIGS countries to fill funding shortfalls by increased tax collection will likely result in fewer total tax receipts by driving more entrepreneurs to the underground economy. With Greek tax collectors recently striking, it is uncertain whether the Hellenic nation even has the ability to raise tax revenue, even if the political will demands higher rates.

Some may interject at this point that punishing its citizens for the sins of their government makes little sense. Indeed, I sympathize with this view on many levels. It was not any individual Greek that indebted the government so heavily that it now faces default. Instead it was the hands of a few elected officials that brought about this state of affairs.

Moralizing over whom will pay for the eventual bankruptcy of the nation might seem a necessary step to determine what comes next. It is largely for the want of nothing, however, as it is only mistaken moralizing.

Someone has to pay. Creditors did not do anything wrong – they made an investment that had certain conditions attached to it. They faced no credit risk because they invested in sovereign debt, and no inflation or exchange risk thanks to the ECB’s operating mandates. Individual Greeks did not do anything wrong either. They did not indebt themselves personally at levels too high to support. Increasing their taxes now only wrongs the Greek proletariat by punishing them for the sins of their government.

There is one option left that saves all parties from undue injustice: public spending cuts, both severe and rapid. Reductions in government expenditures decrease the chance that creditors will be left unpaid. Reductions in government expenditures does not increase taxes on ordinary Greeks and cause them harm accordingly. Cuts will remove services that Greeks would no doubt use. Nevertheless, the question is not about how to eliminate all pain (as someone must pay). The question is coming up with an equitable solution. Greeks were never entitled to services far beyond what they could afford. Just like its government was never entitled to just default on its debt without exhausting all options, and just like increasing taxes on ordinary citizens should never have been an option – as it does nothing but forces blanket pain on all citizens regardless of whether it was earned or not.

If the Greek government, or any government for that matter, wants to issue sovereign debt, it needs to learn the rules of the game. Just declaring default – by means of a haircut as is commonly put forward today – breaks the rules by negating the key “collateral” that the sovereign must pledge. In Greece’s case, honoring its debt by further tax increases punishes the people. Steep and immediate spending cuts are the only equitable solution.


  • mrg says:

    Mr Howden,

    I’m pleased that you acknowledge that “punishing [Greek] citizens for the sins of their government makes little sense”.

    However, I cannot agree that “creditors did not do anything wrong”. On the contrary, they made a fundamentally immoral ‘investment’, whereby they loaned to one party on the understanding that repayments would be extorted from a third party. Government debt is the only sort that works this way.

    As well as being immoral, their investment was foolish. Anyone could see that the Greeks were living beyond their collective means. People who make bad investments deserve to lose their money.

    • Robert Sadler says:

      One might also say that the banks loaned out money that was not theirs (i.e. considering the embezzlement nature of modern fractional reserve banks). Its akin to a counterfeiter lending money to the mob.

      Whether the Greek citizens are completely innocent is up for debate. It it wrong to benefit from money you know has been taken by force from your fellow productive citizens, especially if you are entirely unproductive?

  • ehh? says:

    Did they individual people working in Greek public services do anything wrong?

    This whole piece strikes me as a piece written after the point had been decided.

  • Ron Helwig says:

    I was going to post pretty much what mrg said. I would add that anyone believing that there is such a thing as a risk-free investment is a fool.

  • David Howden says:

    Thanks for the comments, which I am mostly in agreement with.

    The foolishness of the investment is not a question open to debate – it’s not my place to pass judgment on that. What’s done is done, and now we need to figure out a just way to rectify the situation as best as possible. You can note, like Ron Helwig, that anyone believing that these investments were “risk-free” was a fool. I don’t think that helps the analysis much, and it ignores the rules of the game – regardless of the “justness” we see in them. Government debt is “collateralized” by the future taxing power of the sovereign (I don’t think that is just, but that is a fact of life right now). Instead of calling people that loaned a now-obviously broke Greek government fools we would do better to ask why they did so (inherent foolishness or immorality don’t provide very good answers). Understanding the incentives – what “risk-free” means on sovereign debt and how other risks were eliminated by the operating statutes of the ECB – furthers our understanding of why this state of affairs came to being.

    Did individual Greek public servants do anything wrong to deserve punishment today? I wouldn’t say so, for many the same reasons as I don’t think creditors of the Greek government did anything wrong. They were both just acting in their best self-interests given the incentive structure in place. If anything, I would say that anyone with a Greek public sector job made a brilliant choice! (Nice benefits, great pay, early retirement, etc. – again, I don’t make the rules of the game, and I wouldn’t chastise someone for playing by them.) But just like I am not guaranteed a job forever if my company can’t pay me (regardless of what my company tells me, or the contract I signed), Greek public workers are not entitled to this privilege if their own employer can’t pay. And that is the unfortunate reality. Some promise has to be broken – Greek employees fall below bond holders on the ladder of retribution, just like I would for my own organization.

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