The danger of external debts

Economists and journalists often point to the danger of external public debts — in contrast to internal debts, which are regarded as less troublesome. Japan is a case in point. Japan has an enormous public-debt-to-GDP ratio of more than 200 percent. It is argued that the high ratio is not a problem, because the Japanese save a lot and government bonds are held mostly by Japanese citizens; it is internal debt.

In contrast, Spain with a much lower public-debt-to-GDP ratio (expected to be at 80 percent at the end of this year) is regarded as more unstable by many investors. One reason given for the Spanish fragility is that about half of Spanish government bonds are held by foreigners.[1]

At first sight, one may doubt this line of reasoning. In fact, as an individual living in Spain, I do not care if I get a loan from a Spanish or a German friend. Why would the Spanish government be different? Why care if loans come from Spaniards or from Germans?

Governments are ultimately based on physical violence or the threat of physical violence. The state is the monopolist of violence in a given territory. And in violence lies the difference. Internally held debts generate income for citizens, which can be taxed by the threat of violence. This implies that part of the interest paid on internal debt flows back to the government through taxes. Interest paid on external debt, in contrast, is taxed by foreign countries.

There is another, even more compelling, reason why the monopoly of violence is important: I can force neither my Spanish nor my German friend to roll over his loan to me when it comes due. While the government cannot force individuals outside its territory to roll over loans, it can force citizens and institutions within its jurisdiction to do so. In a more subtle form, governments can pressure their traditional financiers, the banks, to roll over public debts.

Banks and governments live in a relationship akin to a symbiosis. Governments have granted banks the privilege to hold fractional reserve and have given them implicit and explicit bailout guarantees. Further support is provided through a government’s controlled central bank, which may help out in times of liquidity problems. In addition, governments control the banking system through a myriad of regulations. In return for the privilege to create money out of thin air, banks use this power to finance governments buying their bonds.

Due to this intensive relationship and the government’s monopoly of violence, the Japanese government can pressure its banks to roll over outstanding debt. It can also pressure them to abstain from abrupt selling and encourage them to take even more debt onto their books. Yet the Japanese government cannot force foreigners to abstain from selling its debt or to accumulate more of it. Here lies the danger for governments with external public debts such as the Spanish one.

While Spanish banks and investment funds will not flush the market with Spanish government bonds, foreign institutions may well do so.[2] The Spanish government cannot “persuade” or force them not to do so as they are located in other jurisdictions. The only thing that the Spanish government can do — and the peripheral governments are actually doing — is to pressure politicians in fellow countries to pressure their own banks to keep bonds on their books and roll them over.

External public debts also pose a danger for the US government. Foreign central banks such as the Bank of China or the Bank of Japan hold important sums of US government bonds. The threat, credible or not, to throw these bonds on the market may give their governments, especially the Chinese one, some political leverage.

What about a Trade Deficit?

In regard to the stability of a currency or the sustainability of government debts, the balance of trade (the difference between exports and imports of goods and services) is also important.

An export surplus (abstracting from factor income and transfer payments) implies that a country accumulates foreign assets. As foreign assets are accumulated, the currency tends to be stronger. Foreign assets can be used in times of crisis to pay for damages. Japan again is a case in point. After the earthquake in March 2011, foreign assets were repatriated into Japan, paying for necessary imports. Japanese citizens sold their dollars and euros to repair damage at home. There was no need to ask for loans denominated in foreign currencies, thereby putting pressure on the yen.

Japan’s export surpluses manifest themselves also on the balance sheet of the Bank of Japan. The Bank of Japan has bought foreign currencies from Japanese exporters. These reserves could be used in a crisis situation to reduce public debts or defend the value of the currency on foreign exchange markets. In fact, the net level of Japan’s public debts falls 20 percent taking into account the foreign exchange reserve holdings of the Bank of Japan (over $1 trillion). Thus, export surpluses tend to strengthen a currency and the sustainability of public debts.

On the contrary, import surpluses (abstracting from factor income or transfers) result in net foreign debts. More goods are imported than exported. The difference is paid for by new debts. These debts are often held in the form of government bonds. A country with years of import deficits is likely to be exposed to large holdings of external public debts that may pose problems for the government in the future as we have discussed above.

The balance of trade may also be an indicator for the competitiveness of an economy, and, indirectly, for the quality of a currency. The more competitive an economy, the more likely the government can support its fiat currency by expropriating the real wealth created by this competitive economy and will not get into public-debt problems. Further, the more competitive the economy, the less likely that public-debt problems are solved by the production of money.

While an export surplus is a sign of competitiveness, an import surplus may be a sign of a lack thereof. Indeed, long-lasting import deficits may be the sign of a lack of competitiveness, and often go hand in hand with high public debts, exacerbating the lack of competitiveness.

Economies with high and inflexible wages — as in southern Europe — may be uncompetitive, running a trade deficit. The uncompetitiveness is maintained and made possible by high government spending. Southern eurozone governments hired people into huge public sectors, arranged generous and early retirement schemes, and offered unemployment subsidies, thereby alleviating the consequence of the unemployment caused by inflexible labor markets. The result of the government spending was therefore not only a lack of competitiveness and a trade deficit but also a government deficit. Therefore, large trade and government deficits often go hand in hand.

In the European periphery, imports were paid with loans. The import surplus cannot go on forever, as public debts would rise forever. A situation of persisting import surpluses such as in Greece can be interpreted as a lack of political will to reform labor markets and to regain competitiveness. Therefore, persisting import surpluses may cause a currency or public-debt sell-off. In this sense, the German export surplus supports the value of the euro, while the periphery’s import surplus dilutes its value.

In sum, high public (external) debts and persisting import surpluses are signs of a weak currency. The government may well have to default or to print its way out of its problems. Low public (external) debts and persisting export surpluses, in contrast, strengthen a currency.


[1] Another important reason is that the Spanish government cannot use the printing press at its will, because it is shared by other Eurozone governments that might protest. Japan, however, controlls its central bank and thereby the printing press.

[2] It should be noted that ever more new Spanish debt is held exclusively by Spanish banks, because other investors are progressively less interested in financing a government that simply refuses to enact real and effective austerity measures.

This article was previously published at

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7 replies on “The danger of external debts”
  1. says: Paul Marks

    The basic STRUCTURE of the Spainish government is unsustainable.

    Both the unlimited Welfare State structure (based upon the “Christmas Tree of Rights” granted by the the Spanish Consitution of 1978, and the labour market regulations (partly outlined by the same Constitution) that makes mass unemployment unavoidable in Spain.

    An investor looks at more than the debt to GDP ratio – an investor looks to the future and asks “does this structure make sense?”.

    And in the case of Spain (and much else of Europe) the answer has to be “no, it does not”.

    European governments (including the British one) thought they could avoid reality on govenrment spending and regulations – by a loose monetary policy.

    This would create an artificial “boom” which would keep down the benefits bill and would give them bank (and other financial sector) profits to tax.

    This trust in an “easy money”, “low interest rate” policy has been exposed as cruel illusion – but the elite still cling to it.

    Only yesterday in the “Financial Times” Martin Wolf wrote that everyone (he meant everyone in the “liberal” elite) agreed that Germany needed a policy of “higher wages, more demand, more inflation”.

    The “easy money” demand fallacy that would (in reality) lead to mass unemployment and economic breakdown.

    I suspect it is too late for reform – but the attitudes of the “liberal” elite (as shown by such publications as the Financial Times newspaper and Economist magazine) will simply not accept reform.

    On the contrary the remain totally committed to the “demand” fallacy.

  2. Philipp Bagus claims, “In return for the privilege to create money out of thin air, banks use this power to finance governments buying their bonds. Due to this intensive relationship…”. I disagree.

    The proportion of U.S. debt held by U.S. banks seems to be about 2% (a near irrelevance). That’s according to these two sites:

    The proportion of U.K. and Japanese debt held by their respective banks is much higher. But as a GENERAL RULE, governments are not particularly dependent on banks when it comes to borrowing. They are dependent on whoever happens to have a surplus of cash.

    That is they just announce a willingness to borrow at slightly above the going rate, and anyone with cash to spare beats a path to their door. I suggest governments are too not bothered exactly WHO arrives at their door.

    1. says: Paul Marks

      Mostly this “surplus cash” is now money created by the Central Banks (the Federal Reserve, the European Central Bank, the Bank of England….) and it is created either directly to buy government debt, or on the understanding that it will be used indirectly to buy government debt.

      1. Obviously the money created by central banks with which to do QE is created specifically to purchase government debt or “on the understanding” it will be used to buy debt, to use your phrase.

        That apart, I don’t think it is accurate to say that central banks create money “on the understanding” that the money will be used to buy debt. I agree such money will be used to buy debt in a particular circumstance: i.e. when a central bank wants to lower interest rates. On the other hand, just as frequently, they choose to RAISE interest rates: which they do by selling debt and “unprinting” the money collected.

        Another and longer term consideration is that all else equal, central banks create money along with the expansion of the economy (in nominal rather than real terms). Put another way, if an economy is expanding at 2% a year in real terms, and inflation is also 2%, then all else equal, the central bank would need to expand the monetary base, or the amount of “central bank money” at 4% a year. That particular tranche of central bank created money is not created specifically so as to buy government debt.

        Hope I got that right. Probably not!!!

    2. says: Robert Sadler


      You can’t just look at who holds government debt. You must also consider who buys and then sells it. Just continuing your example, in the US there is a list of Primary Dealers; banks, who buy the government debt and then sell it, after taking a margin, to the FED, institutions or foreign governments. Here the banks take on a marketing role for the government. This reflects the fact that US Treasuries have an important role in finance, as the risk-free asset. No other bond has this quality. Also, note that the FED is actually a private bank.

      Keep in mind that former employees of the US banks (such as Goldman Sachs) frequently hold prominent positions at the US Treasury. But I am sure there is no conflict of interest…

      In Europe the picture is dramatically different. According to this article, in 2010 banks held 89% of PIIGs debt:

      Undoubtedly here, banks have provided a crucial role in financing European governments.

      But leaving this aside, after all the scandals of the past five years, and all the support and bail-outs provided to the banking sector, do you seriously believe banks are not a protected institution in society? That the government is not doing all it can to protect its friends at the banks?

  3. Robert, I think who HOLDS government debt is far more important than who administers the buy or sell process. For example if there is a surge in debt buying by households, that is of significance. Whether households can buy direct from the central bank, or whether they have to go via some intermediary is an administrative detail of little economic significance.

    I agree that having former bankers in senior positions in the Treasury is a total absurdity (Geithner being the supreme example). It’s like having Fred the Shred or Bob Diamond as Chancellor of the Exchequer. If that happened in the UK there’d be riots, and quite right. I would personally take part in such riots.

    Re the Eurozone, that’s a totally different kettle of fish to monetarily sovereign countries like Britain, the US, etc.

    Re banks being a protected species, I agree they very much are of that nature, the too big to fail subsidy being perhaps the main example of this phenomenon. In contrast to that, I don’t go along with Bagus’s theory about private banks being allowed to create money in exchange for funding government as and when needed.

    1. says: Paul Marks

      On Central Banking I am sure you are correct Sir.

      I am sure that (at least before the current crises) Central Bankers tell themselves that they are expanding the money supply to “help the economy” (or some such) – rather than just to (directly or indirectly) to fund the government deficit.

      After all Switzerland has no government deficit – yet the Swiss Central Bank acts in the same demented way as the rest.

      As for who holds government debt…..

      Even the mainstreaming George Buchanan destroyed the if-we-owe-it-to-ourselves-it-is-O.K. stuff.

      His work on public (i.e. government) finance showed that even if government debt is owned to domestic households it still has terrible effects.

      Of course this did not stop the Italian and Japanese governments (and general establishments) feeding themselves false comfort – year after year.

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