Fiscal Fallacies – The root of all sovereign debt crises: Amar Bhidé & Edmund Phelps


August 10, 2011.

August 10, 2011.

During the 1970s, former Citibank chief executive Walter Wriston said countries would never go bankrupt or fail. Governments also began to borrow large sums of money in order to fuel their spending, while lenders continued to provide these governments with a seemingly inexhaustible source of funds. Eventually, public debts reached such insurmountable proportions that countries now face the possibility of default or even bankruptcy. How can we solve the structural problems that threaten to consume the global economy?

NEW YORK – The Greek debt crisis has raised questions about whether the euro can survive without an almost unimaginable centralization of fiscal policy. There is an easier way. Irresponsible borrowing by governments in international credit markets requires irresponsible lending. Banking regulators should simply say no to such lending by institutions that are already under their jurisdiction.

Lending to foreign governments is in many ways inherently riskier than unsecured private debt or junk bonds. Private borrowers often have to provide collateral, such as their homes. Collateral limits lenders’ downside risk and the fear of losing pledged assets encourages borrowers to act with caution.

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Corn governments offer no guarantees, and their main incentive to repay – fear of being cut off by international credit markets – stems from a perverse dependency. Only governments that are chronically unable to finance their spending with national taxes or domestic debt should continue to borrow large sums from abroad. A deep-seated desire to curry favor with foreign lenders usually stems from some deeply rooted form of bad governance.

Commercial debt usually has covenants that limit the borrower’s ability to roll the dice. Loan or bond covenants often require borrowers to agree to maintain a minimum level of equity or liquidity. Government bonds, on the other hand, have no covenants.

Similarly, private borrowers can go to jail if they misrepresent their financial situation to secure bank loans. Securities laws require issuers of corporate bonds to disclose all possible risks. On the other hand, governments pay no penalties for outrageous misrepresentation or fraudulent accounting, as the Greek debacle shows.

When private borrowers default, bankruptcy courts oversee a bankruptcy or reorganization process through which even unsecured creditors can hope to recover something. But there is no process of liquidation of a state and no legal place to renegotiate its debts. Worse, the debt that States contract abroad is generally denominated in a currency whose value they do not control. Thus, a gradual and invisible reduction in the debt burden through currency depreciation is rarely an option.

The power to tax is thought to make public debt more secure: private borrowers have no claim to the profits or wages they need to meet their obligations. But the power to tax has practical limits, and The moral or legal right of governments to compel future generations of citizens to repay foreign creditors is debatable.


Lending to States therefore entails unfathomable risks that must be borne by specialized players who agree to assume the consequences. Historically, sovereign loans were the business of a few intrepid financiers, who did good business and were adept in the art of government. Lending to governments against the guarantee of a port or railroad – or the use of military force to secure repayment – ​​was not unheard of.

After the 1970s, however, sovereign loans became institutionalized. Citibank – whose chief executive, Walter Wriston, has said countries don’t go bankrupt – led the charge, recycling a flood of petrodollars into dodgy schemes. This was a more lucrative business than traditional lending: a few bankers could lend huge sums with little due diligence – except for the small detail that governments that resort to easy credit sometimes fail.

Later, the Basel Accords whetted banks’ appetite for more government bonds by ruling them virtually risk-free. Banks took on the relatively high-yielding debt of countries like Greece because they had to set aside very little capital. But, when the debt was well rated, how could anyone objectively value unsecured and virtually unenforceable bonds?

Bank lending to sovereign borrowers has been a double disaster, fostering over-indebtedness, especially in countries with irresponsible or corrupt governments. And, since much of the risk is borne by banks (rather than, say, hedge funds), which play a central role in lubricating the payments system, a sovereign debt crisis can cause widespread damage. The Greek debacle jeopardized the well-being of all of Europe, not just the Greeks.

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The solution to severing the link between sovereign debt crises and banking crises is simple: limit banks to lending where assessing borrowers’ willingness and ability to repay is not a big leap in lending. ‘darkness. This means that there is no cross-border sovereign debt (or esoteric instruments, such as secured debt securities).

This simple rule would not require any complex reorganization of European tax arrangements, nor the creation of new supranational entities. It would certainly be difficult for governments to borrow abroad, but it would be a good result for their citizens, not an imposition. Moreover, restricting governments’ access to international credit (and, by extension, inducing greater fiscal responsibility) might actually help more enterprising and productive borrowers.

Such constraints would not solve the current crisis in Portugal, Ireland, Greece or Spain. But it is high time for Europe, and the world, to stop teetering from one short-term solution to another and tackle the real structural problems.

By Amar Bhidé & Edmund Phelps

Copyright: Project-Union, 2011

Amar Bhidé is the author of A Call for Judgment: Sensible Finance for a Dynamic Economy and a professor at the Fletcher School of Law and Diplomacy at Tufts University. Edmund Phelps, winner of the 2006 Nobel Prize in Economics, has been the McVickar Professor of Political Economy at Columbia University since 1982. Both are founding members of the Center on Capitalism and Society at Columbia University.

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About Amar Bhide and Edmund Phelps PRO INVESTOR

Founding members of the Center on Capitalism and Society at Columbia University.


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