Managing Essentials

International Failing states and their debt

Until three years ago it was conventional wisdom that states could not go bankrupt but would always be able to settle their debt. Or, to be more precise, normal states cannot fail. There have been quite a few state bankruptcies though with the last major one being Argentine in 2001. However, these events have been dismissed as anomalies that only happen somewhere in the wilderness of Africa or South America. Also from the theoretical side states cannot go bankrupt; it is easy to say why as states can print money. However, the more they do it without a substantial basis in their economies, the less it is worth. Too much inflation hurts the economy and the inhabitants, but surely reduces the nominal debt. In hyperinflation all debt can be paid off with worthless money; this danger is evident. All major industrial countries have consequently been cautious not to experience this phenomenon. They look proudly on their monetary history with currencies now hundreds of years old. The notable exception is Germany, which twice, in 1924 and 1947, had to live through a complete collapse of its monetary system. Not astonishingly German governments are very conservative when it comes to upholding the value of their currency. To borrow money in hard times is not a bad idea for a government, sometimes it even seems unavoidable. Under normal circumstances a state should be able to fund itself out of its tax base, but there are costly special events which will only pay off in the end. These events have historically been wars. World War I was the first to be financed by all sides for a major part by issuing war bonds to the natural lender of first resort for the state, its citizens. The modern state debt model is based on the assumption that spending helps to overcome temporary economic hardship. Why should the state not borrow to overcome a crisis? First, wisely invested money helps the economy and a part of it will flow directly back by taxes paid. To build infrastructure, give credit to small businesses, support research, and fund education immediately serves the labor market. In addition, these investments prepare the ground for more rapid growth in the future. If in fact tax revenue rises, driven by the expected growth together with inflation, states have no problem in repaying their debt and also its interest. This, simplified, is the notion of J. M. Keynes, and places like the Hoover Dam and many highways demonstrate how well it worked in the famous US American New Deal of the 1920s. With this theoretical and historical background, reasonable state debt was regarded in the self perception of states as a safe haven until some years ago, at least when it came to serious countries. In contrast to private and corporate debt, banks did not have to reflect risks taken in this sector by adjusting core capital. Therefore, especially after the banking crisis of 2008 and the pressure on banks to take less risk, state debt became more and more an object of financial trade; however, all trade incorporates an element of speculation. That this speculation got out of hand is due to significant changes in the global economy during the last two decades. Growth is one magic word in the reasoning of understanding state debt. However, the organic growth of many developed countries began to slow down significantly about two decades ago as their markets saturated. Historical powerhouses like France, Germany, and Britain grew by exporting their manufactured goods and services. Until four years ago the USA was criticized for spending too much,

Managing Essentials
International
however, their free spending consumers kept up demand for the exporting Europeans. They were later joined by the seemingly endless masses of consumers especially in China and India. Today, growth and affluence in Europe and the USA depends on the growth and needs of developing nations. In addition, the concept of investing to cope with crisis has changed. Hopefully, the last world war was really the last forever. State debt is nowadays used to create economic stimuli packages looking back to historical examples. In the USA, up to today the Hoover Dam generates energy and highway renovation rests on the basic constructions and routings now more than 75 years old. However, debt taken up nowadays rarely qualifies as a real investment when spent. The money is not used to create epic economic advancement, but is immediately consumed in extensive welfare systems and subsidized industries, or has to be used to pay off old debt. Greece gives an extreme but telling example; Seen as a family and cutting six digits the Greek earn less than 40,000 a year but spend nearly 70,000 also to serve the debt of more than 300,000. If there are hidden treasures which can be monetized is an open question. No industries were created, there is not much to privatize. The most valuable company in terms of the stock exchange listing is Coca Cola bottling operations. Finally, the principal lenders are no longer the citizens. State debt nowadays is more often foreign debt. States sell their bonds like big corporations on the international financial markets and are treated as such. However, one of the most indebted countries is Japan. Despite its debt of more than 200% of the GDP (Germany 80%, USA 100%, and Greece 120 %) and after nearly twenty years of partial stagnation, nobody really seems to worry. The vast majority of this debt is held by the Japanese citizens and they will not let their country down as easily as a foreign investor. The crisis of state debt in the developed world is therefore one of many indicators for the recent global shift in economic development. The developed economies have to cope with the burden of their welfare systems and historic structures. The emerging economies have not only become their creditors, they also decide about the future growth of their debtors with their industrial and tax policies. Of course, the low debt of the emerging economies is due to their young populations and the lack of extensive social welfare systems. In 40 years they may encounter structural problems similar to those of the established economies today; however 40 years is a long time for learning.

Sturzenegger, F. & Zettelmeyer, J. (2007). Debt Defaults and Lessons from a Decade of Crises. Cambridge, MA: MIT Press.