by Elliott Morss (bio at end of second article), Amar Bhidé and Edmund Phelps. Bhidé, author of A Call for Judgment, is a professor at the Fletcher School of Law and Diplomacy, Tufts University and Phelps, a Nobel laureate, is a professor at Columbia University. Both Bhidé and Phelps are founding members of the Center on Capitalism and Society, Columbia University, of which Phelps is the director. The Bhidé/Phelps article is presented here with permission of Project Syndicate.
Editor’s note: Both sides of this “debate” agree that the risk to banks holding sovereign debt is a matter of concern. The two sides have come up with different approaches to minimizing systemic risk. We hear first from Bhidé and Phelps.
The Root of All Sovereign-Debt Crises
by Amar Bhidé and Edmund S. Phelps
NEW YORK – The Greek debt crisis has prompted questions about whether the euro can survive without a nearly unimaginable centralization of fiscal policy. There is a simpler way. Irresponsible borrowing by governments in international credit markets requires irresponsible lending. Bank regulators should just say no to such lending by institutions that are already under their purview.
Lending to foreign governments is in many ways inherently riskier than unsecured private debt or junk bonds. Private borrowers often have to offer collateral, such as their houses. The collateral limits the lenders’ downside risk, and the fear of losing the pledged assets encourages borrowers to act prudently.
But governments offer no collateral, and their principal incentive to repay – the fear of being cut off by international credit markets – derives from a perverse addiction. Only governments that are chronically unable to finance their outlays with domestic taxes or domestic debt must keep borrowing large sums abroad. A deep craving for the favor of foreign lenders usually derives from some deeply engrained form of misgoverance.
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 capital or cash on hand. Government bonds, on the other hand, have no covenants.
Similarly, private borrowers can go to prison if they misrepresent their financial condition to secure bank loans. Securities laws require that issuers of corporate bonds spell out all possible risks. By contrast, governments pay no penalties for outrageous misrepresentation or fraudulent accounting, as the Greek debacle shows.
When private borrowers default, bankruptcy courts supervise a bankruptcy or reorganization process through which even unsecured creditors can hope to recover something. But there is no process for winding up a state and no legal venue for renegotiating its debts. Worse, the debt that states raise abroad is usually denominated in a currency whose value they cannot control. So a gradual, invisible reduction in the debt burden by debasing the currency is rarely an option.
The power to tax is thought to make government debt safer: private borrowers have no right to the profits or wages that they need to satisfy their obligations. But the power to tax has practical limits, and governments’ moral or legal right to bind future generations of citizens to repay foreign creditors is questionable.
Lending to states thus involves unfathomable risks that ought to be borne by specialized players who are willing to live with the consequences. Historically, sovereign lending was a job for a few intrepid financiers, who drove shrewd bargains and were adept at statecraft. Lending to governments against the collateral of a port or railroad – or the use of military force to secure repayment – was not unknown.
After the 1970’s, though, sovereign lending became institutionalized. Citibank – whose chief executive, Walter Wriston, famously declared that countries don’t go bust – led the charge, recycling a flood of petrodollars to dubious regimes. It was more lucrative business than traditional lending: a few bankers could lend enormous sums with little due diligence – except for the small detail that governments plied with easy credit do sometimes default.
Later, the Basel accords whetted banks’ appetite for more government bonds by ruling them virtually risk-free. Banks loaded up on the relatively high-yield debt of countries like Greece because they had to set aside very little capital. But, while the debt was highly rated, how could anyone objectively assess unsecured and virtually unenforceable obligations?
Bank lending to sovereign borrowers has been a double disaster, fostering over-indebtedness, especially in countries with irresponsible or corrupt governments. And, because much of the risk is borne by banks (rather than by, say, hedge funds), which play a central role in lubricating the payments system, a sovereign-debt crisis can cause widespread harm. The Greek debacle jeopardized the well-being of all of Europe, not only Greeks.
The solution to breaking the nexus between sovereign-debt crises and banking crises is straightforward: limit banks to lending where evaluation of borrowers’ willingness and ability to repay isn’t a great leap in the dark. This means no cross-border sovereign debt (or esoteric instruments, such as collateralized debt obligations).
This simple rule would require no complex reordering of European fiscal arrangements, nor would it require the creation of new supra-national entities. It would certainly make it difficult for governments to borrow abroad, but that would be a good outcome for their citizens, not an imposition. Moreover, curtailing governments’ access to international credit (and, by extension, inducing more fiscal responsibility) could actually help more enterprising and productive borrowers.
Such constraints wouldn’t solve the current crisis in Portugal, Ireland, Greece, or Spain. But it is high time that Europe, and the world, stopped lurching from one short-term fix to the next and addressed the real structural issues.
Sovereign Debt and Banks: The Bhidé/Phelps Recommendation
by Elliott R. Morss
We hear daily of a new Euro crisis. Almost invariably, the crisis is linked to banks. One might even conclude there is more concern over the welfare of banks than the welfare of citizens when Euro countries are forced to enter into austerity programs enforced by the IMF.
Amar Bhidé and Edmund S. Phelps, on faculties at Tufts and Columbia universities respectively, have recommended that banks not be allowed to buy sovereign debt (“The Root of All Sovereign-Debt Crises”). They argue that such purchases are too risky for banks, and that they are at the root of all sovereign debt crises. I don’t buy it. Read on.
Bhidé and Phelps (B/P) start by making an interesting point: “Lending to foreign governments is in many ways inherently riskier than unsecured private debt or junk bonds.” Typically, there is no collateral for sovereign debt, only “the full faith and credit”…. And as B/P point out: “Only governments that are chronically unable to finance their outlays with domestic taxes or domestic debt must keep borrowing large sums abroad.” Borrower incentives are also different: private borrowers can end up in jail for misrepresentation. And bankruptcy proceedings give all creditors a chance to recover at least part of their loans. None of this applies to sovereign debt: no one person can be put in jail for misrepresentation, and there is no bankruptcy process for this sort of debt.
“Lending to states thus involves unfathomable risks that ought to be borne by specialized players who are willing to live with the consequences…. The solution to breaking the nexus between sovereign-debt crises and banking crises is straightforward: limit banks to lending where evaluation of borrowers’ willingness and ability to repay isn’t a great leap in the dark. This means no cross-border sovereign debt (or esoteric instruments, such as collateralized debt obligations).”
What Is Wrong With Their Argument
There are several problems with their arguments
- They are arguing for the most severe form of market interference – banning a purchase of something; history tells us that such interference rarely works and should be a last resort.
- B/P make it sound like buying government debt is somehow very complex. They talk of “unfathomable risks” and “a great leap in the dark”. What? Excellent information on the economic/financial condition of governments is available from private and public sources (my favorite source is the staff reports coming from IMF Article IV country consultations).
- Even before the bank collapse in 2008, a cursory examination of the financial condition of the Greek government would suggest that buying its debt would be a very risky proposition.
- I quote from an IMF report included in an earlier piece:
“Banks in Greece, Ireland and Portugal have significantly increased their government debt exposure during 2010. Shunned by financial markets and faced with deposit withdrawals, they survive only because the ECB meets in full their demands for liquidity against collateral of rapidly declining quality”.
The real question is: why did banks provide a ready market for new Greek and other troubled Euro country debt when such high risks were so apparent?
Why Banks Bought High-Risk Sovereign Debt
I have addressed this at length in earlier articles. In sum, banks see high returns on Greek debt. Banks like high returns, but they don’t like risks. What do they say to their risk officers? Bank A says we will buy risk insurance from Bank B. Bank B says we will buy risk insurance from Bank A. Alternatively, the banks will accumulate Greek debt, package it, and sell it off for a commission.
What is going on here? Depository institutions have evolved into high risk trading operations. Consider their incentive structures against those of banks that manage their own loans:
- Banks that manage their own loans know their very survival depends on the spread between what they have to pay to get deposits and what they get paid for loans. As a consequence, they don’t make risky loans: no “unfathomable risks” or “great leaps in the dark”;
- The troubled European banks, like the US banks that caused the 2008 collapse, are very different animals. They earn significant sums from trading. Risk? No problem. They can get risk insurance or package the loans and sell them off for a nice commission.
The Morss Solution
Why are we worried about banks? Because they hold deposits and governments want to be sure the deposits are safe. If they do not hold deposits, who cares? Let them go belly-up. As a consequence my solution is very simple – limit government deposit insurance to banks that do very little trading and manage their own loans.
Banks: Flawed Regulation by Amar Bhidé
Comparing Sovereign Debt to Reality by Elliott Morss
Bank Capital is Illusory by Raihan Zamil
What Should Greece Do? by Elliott Morss
EU: Politics Financialized, Economies Privatized by Michael Hudson
The Sovereign Debt Crisis and Currency Sovereignty by Edward Harrison
Euro Crisis: Key Facts and Predictions by Elliott Morss
Global menace: Current Account Dilemma by Michael Pettis
Comparing Ireland 2011 with Argentina 1999 by Pablo Schiaffino and Jose Luis Machinera
European Banks: Comparing Chernobyl to Banking by Dirk Ehnts
Economist Mosler’s Recipe for Greece by Warren Mosler