One of the most comprehensive and best articles to appear so far on sovereign debt is undoubtedly Edward Chancellor’s “Reflections on the Sovereign Debt Crisis,” posted on Zero Hedge. The title is absolutely apt. This is not a “must read” paper because Chancellor has nailed the solution to sovereign debt crises. He’d need to be a judicious amalgam of Houdini and Merlin to achieve that. What makes it exceptional is the wonderful wealth of facts that he has gathered together, charting just how merrily the sovereign debt ball has bounced since, oh, say 1800. For example:
“Foreign loans were the sub-prime securities of the 1920s. A heap of foreign bonds were sold by Wall Street on behalf of several Latin American and Central European states, cities, and provinces. The poor financial condition of many of these borrowers was deliberately glossed over by the issuing banks. Nearly 90% of the foreign bonds sold in United States in 1929 subsequently defaulted…”
One of Chancellor’s most important sources for his piece is Professors Carmen Reinhart and Ken Rogoff’s fascinating book This Time Is Different: Eight Centuries of Financial Folly, which looks at booms and busts down the ages. The nub of all his research, however, seems to be that judging whether or not a country is going to default on its sovereign debt is an extremely difficult thing to do with any degree of accuracy.
History shows that a country may default, but it also shows that it may not. Unsurprisingly, based on statistics alone, those with a poor track record of defaulting in the past are definitely more likely to do it again in the present or near future. So a country’s credit history, much like a person’s credit history, is actually not a bad predictor of its default potential.
That, of course, is only a tiny part of the story. The alternative to an outright default is often for a government to simply monetise the debt, by printing money and inflating away the debt, or at least a goodly chunk of it. This defrauds external bond holders, of course, which is one reason why the Chinese constantly remind the US that they expect it to embrace sound, prudent fiscal policies, just as we in the UK expect extended sunny periods in July and August. We don’t often get it, but we expect it…
Solid, sound political structures are another good indication that a default is unlikely. The UK hasn’t defaulted on its external debt, for example, since the Stop of the Exchequer in 1672, despite the fact that by the early 1820s, as Chancellor notes, “the British national debt relative to the national income was far larger than any country had ever experienced.” The Scandinavian countries too, have a solid “no-default” record as does the US. Latin America, of course, does not. Corrupt governments, weak governments and shaky governments are all fertile ground for loans to become delinquent.
The really different thing about the present sovereign debt crisis, Chancellor says, is that this time, instead of being played out in developing countries, the traditional home of the default, it is the developed world that is teetering on the brink. Moreover, the present situation is a lot more complicated than in the past. The value of outstanding derivatives, for example, is several times global GDP.
However Chancellor points out that the history of sovereign debt is full of woeful prophets predicting the imminent doom of this or that country with a huge sovereign debt. Time and again, the doom does not come to pass (pace Britain in the 1820s again, and Japan more recently – though this last example could be begging the question). He argues that these predictive difficulties should be used as a counterweight to anxieties about the massive US deficit. A US default just is not likely, he concludes. What is much more likely is inflation.
“Public finance is a Ponzi scheme. As long as new creditors can be found to roll over existing loans and provide fresh funds, the debt juggernaut can continue.”
As those lenders holding billions of dollars of US T-bills know only too well, if they all tried to dump the currency simultaneously they would crash the value of their own holdings. Moreover, there just isn’t another global store of value large enough for them to diversify into. That means they are trapped in dollars for the foreseeable future and the only thing they can do with their trade surpluses is to buy more dollars.
So what is the conclusion? The conclusion is that we live in interesting times:
“As a result of the financial crisis, the world’s leading sovereign credit markets have left the world of risk, where probabilities of gains and losses can be measured, and entered the darker province of uncertainty. The future performance of sovereign credits depends on future events and decisions that are unknowable.”
Fun, isn’t it….?
Further reading on international sovereign debt
- Markets ignore ratings agency Greek debt downgrade, by Anthony Harrington [blog post]
- Euro crisis morphs into the sovereigns' subprime, Ian Fraser [blog post]
- Why Printing Money Sometimes Works for Central Banks, by Paul Kasriel
- Measuring Country Risk, by Aswath Damodaran
Tags: derivatives , economic recovery , financial crisis , fiscal stimulus , international differences , sovereign debt