在哥伦比亚大学世界领袖论坛上的讲话

“The Sovereign Debt Problem”

As you know I have written several books which serve to explain the crash of 2008. Two years have elapsed since then – it is time to bring the story up to date. That is what I propose to do today.

The theory I shall use is the same as in my previous books, so I shall not repeat it here. The main points to remember are, first, that rational human beings do not base their decisions on reality but on their understanding of reality and the two are never the same – although the extent of the divergence does vary from person to person and from time to time – and it is the variance that matters. This is the principle of fallibility. Second, the participants’ misconceptions, as expressed in market prices, affect the so-called fundamentals which market prices are supposed to reflect. This is the principle of reflexivity. The two of them together assure that both market participants and regulators have to make their decisions in conditions of uncertainty. This is the human uncertainty principle. It implies that outcomes are unlikely to correspond to expectations and markets are unable to assure the optimum allocation of resources. These implications are in direct contradiction to the theory of rational expectations and the efficient market hypothesis.

The extent and degree of uncertainty is itself uncertain and variable. Conditions may range from near-equilibrium to far from equilibrium. Again, it is the variance that matters. In practice markets have a tendency to move towards one of these extremes rather than to hover near a historical or theoretical midpoint between them. In evolutionary systems theory these extremes are called “strange attractors”. My contention is that financial markets tend towards these strange attractors, not to equilibrium. So much for theory. Now for the actual course of events.

***

In the crash of 2008 the uncertainties reached such an extreme that the markets actually collapsed. But that was a short lived phenomenon. The authorities intervened and managed to keep the markets functioning by putting them on artificial life support. In retrospect, the momentary collapse may seem like a bad dream, but it was real enough and two years later we still suffer from its consequences.

Let me explain why.

When a car is skidding you have to turn the wheel in the direction of the skid to prevent the car from crashing. Only when you have regained control can you correct the direction of the car. That is how the financial authorities had to deal with the crash. The underlying cause of the crash was the excessive use of credit and leverage. To prevent a catastrophe they had to avoid a sharp contraction of credit. The only way to do it was to replace the private credit that lost credibility with the credit of the state which still commanded respect. Only after financial markets resumed functioning could they hope to reverse course and reduce the outstanding credit and leverage. This meant that they had to do in the short term the exact opposite of what would be needed in the long term.

The first phase of this delicate maneuver has now been successfully completed. Financial markets are functioning more or less normally with toxic credit instruments replaced or guaranteed by sovereign credit. But the second phase is running into difficulties. Before the economy has recovered and unemployment has fallen, the credibility of sovereign credit has come into question. If governments are now forced to pursue fiscal discipline and tighten monetary and fiscal policy too soon there is a danger that the recovery will stall. That is because the imbalances that have accumulated over a quarter of a century have not yet been corrected. The US still consumes too much and China is still running an unsustainable export surplus vis-à-vis the US. A similar imbalance prevails within the eurozone, with Germany in the surplus position. In addition, the housing and commercial real estate bubbles in the US have not yet been fully deflated and in the eurozone the banks have not yet been properly recapitalized. The deleveraging of the private sector is underway, but it is far from complete. In the US it applies to banks, corporations and households alike. In Europe it is heavily concentrated in the banking sector.

Because the global imbalances which were at the root of the financial crisis still remain to be corrected, the question arises: How much government debt is too much? That is one of the central questions confronting policymakers today.

The discussion is eerily reminiscent of the 1930s. Then the fiscal conservatives led by Andrew Mellon and Irving Fisher were confronted by rebels led by John Maynard Keynes. Now, the division of opinion is more along national lines. The center of fiscal conservatism is Germany, while those who have rediscovered Keynes are located mainly in the United States.

The clash of views has led to a drama which is unfolding differently in different parts of the world. The remarkable unanimity that prevailed in the first phase of the crisis and culminated in the one trillion dollar rescue package that was put together for the London meeting of the G20 in April 2009 has dissipated and political and ideological differences have arisen. Misconceptions are rampant. They complicate matters enormously because it would require global cooperation to correct the global imbalances.

I shall briefly review how the credibility of sovereign credit came to be questioned in various parts of the world and then I shall address the question – how much debt is too much?

***

Doubts concerning sovereign credit first reached a crisis point in Europe and they revolved around the euro. But what appeared to be a currency crisis was in reality more a banking crisis and a clash of economic philosophies.

The euro was an incomplete currency to start with. The Maastricht Treaty established a monetary union without a political union. The euro boasted a common central bank but it lacked a common treasury.

So even though member countries share a common currency, when it comes to sovereign credit they are on their own. Unfortunately, this fact was obscured until recently by the willingness of the European Central Bank to accept the sovereign debt of all member countries on equal terms at its discount window. This allowed the member countries to borrow at practically the same interest rate as Germany and the banks were happy to earn a few extra pennies on supposedly risk-free assets by loading up their balance sheets with the government debt of the weaker countries. For instance, European banks hold more than a trillion euros of Spanish debt of which more than half is held by German and French banks. The large positions came to endanger the creditworthiness of the European banking system, depriving them of the capacity to add to their positions.

Although it was the inability of the banks to continue accumulating the government debt of the heavily indebted countries that precipitated the crisis, but it was the introduction of the euro and ECB’s willingness to refinance sovereign debt that got the banks weighed down with these large positions in the first place. It led to a radical narrowing of interest rate differentials and that, in turn, generated real estate bubbles in countries like Spain, Greece and Ireland. Instead of the convergence prescribed by the Maastricht Treaty, these countries grew faster and developed trade deficits within the eurozone, while Germany reigned in its labor costs, became more competitive and developed a chronic trade surplus. The discount facility of the ECB allowed the deficit countries to continue borrowing at practically the same rates as Germany, relieving them of any pressure to correct their excesses. So the introduction of the euro was indirectly responsible for the development of internal imbalances within the eurozone.

The first clear reminder that the euro lacked a common treasury came after the bankruptcy of Lehman Brothers. The finance ministers of the European Union promised that no other financial institution whose failure could endanger the system would be allowed to default. But Angela Merkel opposed a joint Europe-wide guarantee; each country had to take care of its own banks.

At first, the financial markets were so impressed by the guarantee that they hardly noticed the difference. Capital fled from the countries which were not in a position to offer similar guarantees pushing the countries of Eastern Europe, notably Hungary and the Baltic States into difficulties. But interest rate differentials within the eurozone remained minimal.

It was only this year that financial markets started to worry about the accumulation of sovereign debt within the eurozone. Greece started the process when the newly elected government revealed that the previous government had lied and the deficit for 2009 was much larger than indicated.

Markets panicked and interest rate differentials widened dramatically. But the European authorities were slow to react because member countries held radically different views. Germany, which had been traumatized by two episodes of runaway inflation, was adamantly opposed to any bailout. France was more willing to show its solidarity. Since Germany was heading for elections, it was unwilling to act, and nothing could be done without Germany. So the Greek crisis festered and spread. When the authorities finally got their act together they had to offer a much larger rescue package than would have been necessary if they had acted earlier.

In the meantime, doubts about the creditworthiness of sovereign debt spread to the other deficit countries and, in order to reassure the markets, the authorities had to put together a €750 billion European Financial Stabilization Fund, €500 billion from the member states and €250 billion from the IMF. The turning point came when China re-entered the market and bought Spanish bonds and the euro.

So, under duress, the euro has begun to remedy its main shortcoming, the lack of a common treasury. The Stabilization Fund is very far from a unified fiscal policy, but it is a step in that direction. Member countries are now a little bit pregnant and they will be obliged to take additional steps if necessary. So the crisis has passed its high water mark and the euro is here to stay. But it is far too early to celebrate because the emerging common fiscal policy is dictated by Germany and Germany is wedded to a false doctrine of macro-economic stability which recognizes only the threat of inflation and ignores the possibility of deflation.

This misconception is incorporated in the constitution of the euro. When Germany agreed to substitute the euro for Deutschmark it insisted on strong safeguards to maintain the value of the currency. As a result, the ECB was given an asymmetric directive. Moreover, the Maastricht Treaty contains a clause that expressly prohibits bailouts and the ban has been reaffirmed by the German Constitutional Court. It is this clause that has made the crisis so difficult to deal with.

This brings me to the gravest defect in the euro’s design; it does not allow for error. It expects member states to abide by the Maastricht criteria without establishing an adequate enforcement mechanism. And now, when practically all member countries are in violation of the Maastricht criteria, there is neither an adjustment mechanism nor an exit mechanism.

Now these countries are expected to return to the Maastricht criteria in short order. What is worse, Germany is not only insisting on strict fiscal discipline for the weaker countries but is also reducing its own fiscal deficit. When both creditor and debtor countries are reducing deficits at a time of high unemployment they set in motion a deflationary spiral in debtor countries. Reductions in employment, tax receipts, and consumption reinforce each other and are not offset by exports, raising the prospect that deficit reduction targets will not be met and further reductions will be required. And even if budgetary targets were met, it is difficult to see how the weaker countries could regain their competitiveness vis-à-vis Germany and start growing again because, in the absence of exchange rate depreciation, they need to cut wages and prices, creating deflation. And deflation renders the burden of accumulated debt even heavier.

Deficit reduction by a creditor country such as Germany is in direct contradiction of the lessons learnt from the Great Depression of the 1930s. It is liable to push Europe into a period of prolonged stagnation or worse. That may, in turn, produce social unrest and, since the unpopular policies are imposed from the outside, turn public opinion against the European Union. So the euro, with its asymmetric directive, may endanger the social and political cohesion of Europe.

Unfortunately, Germany is unlikely to realize that it is following the wrong macroeconomic policy because that policy is actually working to its advantage. Germany is the shining star in the economic firmament. It dealt with the burden of reunification by reducing its labor costs becoming more competitive and developing a chronic trade surplus. And the euro-crisis brought about a decline in the value of the euro. This favored Germany against its main competitor, Japan. In the second quarter of 2010 the GDP jumped by 9% annualized.

Germany believes it is doing the right thing. It has no desire to impose its will on Europe; all it wants to do is to maintain its competitiveness and avoid becoming the deep pocket to the rest of Europe. But as the strongest and most creditworthy country it is in the driver’s seat. As a result Germany objectively determines the financial and macroeconomic policies of the Eurozone without being subjectively aware of it. And the policies it is imposing on the eurozone are liable to send the eurozone into a deflationary spiral. But people in Germany are unlikely to recognize this because they are doing much better than the others and the difficulties of the others can be blamed on structural rigidities.

The German commitment to fiscal rectitude is also gaining the upper hand in the rest of the world. Angela Merkel went into the recent G20 meeting in the minority and – with the help of the host country, Canada, and the newly elected Conservative British Prime Minister, David Cameron – came out as the winner. Prior to the meeting President Obama publicly appealed to Chancellor Angela Merkel to change her ways, but at the meeting the US yielded to the majority and agreed that budget deficits should be cut in half by 2013. This may be the right policy but it comes at the wrong time.

The policies of the Obama administration are dictated not by financial necessity but by political considerations. The US is not under the same pressure from the bond markets as the heavily indebted states of Europe. European debtor countries have to pay hefty premiums over the price at which Germany can borrow. By contrast, interest rates on US government bonds have been falling and are near record lows. This means that financial markets anticipate deflation not inflation.

The pressure is entirely political. The public is deeply troubled by the accumulation of public debt. The Republican opposition has succeeded in blaming the Crash of 2008 and the subsequent recession and persistent high unemployment on the ineptitude of government and in claiming that the stimulus package was largely wasted.

There is an element of truth in this narrative but it is far too one sided. The Crash of 2008 was primarily a market failure and the fault of the regulators was that they failed to regulate. Without a bailout the financial system would have stayed paralyzed and the subsequent recession would have been much deeper and longer. It is true that the stimulus was largely wasted but that was because most of it went to sustain consumption and did not correct the underlying imbalances. As I explained earlier, the government was obliged to do in the short run the exact opposite of what is needed in the long run. Now consumption still needs to fall as a percentage of the GDP and fiscal and monetary stimulus are still needed to keep the GDP from falling and to prevent a deflationary spiral.

Where the Obama administration did go wrong, in my opinion, was in the way it bailed out the banking system: it helped the banks earn their way out of a hole by supplying them with cheap money and relieving them of some of their bad assets. But this was an entirely political decision; on a strictly economic calculation it would have been more effective to inject new equity into the balance sheets of the banks. But the Obama administration considered that politically unacceptable because it would amounted to nationalizing the banks and it would have been called socialism.

That political decision backfired and caused a serious political backlash. The public saw the banks earning bumper profits and paying large bonuses while they were badly squeezed by their credit card charges jumping from 8% to nearly 30%. That was the source of the resentment that the Tea Party exploited so successfully. In addition, the administration had deployed the so–called “confidence multiplier” to restore confidence and that turned to disappointment when unemployment failed to fall.

The Administration is now on the defensive. The Republicans are campaigning against any further stimulus and they seem to be winning the argument. The administration feels that it has to pay lip service to fiscal rectitude even if it recognizes that the timing may be premature.

I disagree. I believe there is a strong case for further stimulus. Admittedly, consumption cannot be sustained indefinitely by running up the national debt. The imbalance between consumption and investment needs to be corrected. But to cut back on government spending at a time of large-scale unemployment would ignore all the lessons learned from the Great Depression.

The obvious solution is to draw a distinction in the budget between investments and current consumption and increase the former while reducing the latter. But that seems unattainable in the current political environment. A large majority of the population is convinced that the government is incapable of efficiently managing an investment program aimed at improving the physical and human infrastructure. Again, this belief is not without justification: a quarter of a century of agitation calling the government bad has resulted in bad government. But the argument that stimulus spending is inevitably wasted is patently false: the New Deal produced the Tennessee Valley Authority and the Triborough Bridge.

It is the Obama administration that has failed to make a convincing case. There are times like the present when we cannot count on the private sector to employ the available resources. The Obama administration has in fact been very friendly to business. Corporations operate very profitably, but instead of investing their profits, they are building up their liquidity. Perhaps a Republican victory will give them more confidence; but in its absence investment and employment needs to be stimulated by the government. I do not believe that monetary policy can be successfully substituted for fiscal policy. Quantitative easing is more likely to stimulate corporations to devour each other than to create employment. We shall soon find out.

This brings us to the question I raised earlier. How much room does the government have for fiscal stimulus? How much public debt is too much? This is not the only unresolved question but it is at the center of political debate and the debate is riddled with misconceptions.

That is because the question does not have a hard and fast answer. In saying this I am not being evasive; on the contrary, I am making an important assertion. The tolerance for public debt is highly dependent on the participants’ perceptions and misconceptions. In other words it is reflexive.

There are a number of variables involved. To start with, the debt burden is not an absolute amount but a ratio between the debt and the GDP. The higher the GDP the smaller the burden represented by a given amount of debt. The other important variable is the interest rate: the higher the interest rate the heavier the debt burden. In this context the risk premium attached to the interest rate is particularly important: once it starts rising, the prevailing rate of deficit financing becomes unsustainable and needs to be reigned in. Exactly where the tipping point is located remains uncertain because it is dependent on prevailing attitudes.

Take the case of Japan: its debt ratio is approaching 200%, one of the highest in the world. Yet ten year bonds yield little more than 1%. Admittedly, Japan used to have a high savings rate but it has an ageing and shrinking population and its current savings rate is about the same as the US. The big difference is that Japan has a trade surplus and the US a deficit. But that is not such a big difference as long as China does not allow its currency to appreciate because that policy obliges China to finance the deficit one way or another.

The real reason why Japanese interest rates are so low is that the private sector – individuals, banks and corporations – have little appetite for investing abroad and prefer ten year government bonds at a 1% to cash at zero percent. With the price level falling and the population aging, the real return on such instruments is considered attractive by the Japanese. As long as US banks can borrow at near zero and buy government bonds without having to commit equity and the dollar is not allowed to depreciate against the renminbi, interest rates on US government bonds may well be heading in the same direction.

That is not to say that it would be sound policy for the US to maintain interest rates at zero and preserve the current imbalances by issuing government debt indefinitely. Once the economy starts growing again interest rates will rise and if the accumulated debt is too big it may rise precipitously, choking off the recovery. But premature fiscal tightening may choke off the recovery prematurely.

The right policy is to reduce the imbalances as fast as possible while keeping the increase in the debt burden to a minimum. This can be done in a number of ways but cutting the budget deficit in half by 2013 while the economy operating far below capacity is not one of them. Investing in infrastructure and education makes more sense. So does engineering a moderate rate of inflation by depreciating the dollar against the renminbi. What stands in the way are misconceptions about budget deficits exploited for partisan and ideological purposes. There is a real danger that the premature pursuit of fiscal rectitude may wreck the recovery.