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.