Like you have also probably been doing I've been loosely following the EU's debt woes --- Greece being mostly in the camera's lens, but also Ireland, Portugal, and of course Italy & Spain from time to time. From the onset the issue has been the kinds and extent of terms imposed on these sovereigns by creditors to obtain additional loans to avoid bankruptcy.
The terms being imposed are specifically those of reigning in these sovereign's spending to bring the ratio of debt to revenue down to a more sustainable level. Whether or not the terms placed on the sovereigns by creditors in order to obtain additional loans are economically in the best interests of reducing the debt to revenue ratio's of these sovereign's is another issue entirely.... an issue I'm not directly addressing in this note.
What I am going to address is who made the loans to the sovereigns in the 1st place, and whether they were actually bearing the risks of not being paid back. This is in the larger sense precisely the issue of risks/reward economics --- the fundamental underpinnings of a capitalist economic system.
Here's the background --- while global economies were expanding, these sovereigns revenues were also expanding, and with the exception of Greece & Portugal, their debt to revenue ratios were as good or better than most of the other EU's. As long as these economies continued to expand or just even maintain GDP's, their ability to pay back on their sovereign notes and loans were not in any jeopardy.
A small aside that's only relevant to adjusting currency values... not the debt or risks taken---- these sovereign's currencies are not however their own... their currencies are the Euro... hence they cannot unilaterally or individually adjust the value of the currency. This is unlike any other sovereign on the globe who issue their own currencies and have complete and autonomous control on adjusting the value of their currency relative to other world currencies.
So under all standard and normal financing methods, each of these sovereign's sell their own treasury notes. The interest rates on those notes at the time of sale are determined largely by market forces as they are generally either directly sold in auction.. .which sets the effective interest rate (price actually paid for the face value (coupon value) of the fixed term notes), or sold at some pre-determined interest rate --- the predetermined interest rate is effectively set by the willingness of the creditors to purchase those notes --- i.e. loan the sovereign's money.
This is no different than any other creditor - borrower relationship. The borrower requests the creditor loan them money for some term. The creditor decides at what interest the money will be loaned for that term. The interest rate decided is totally and wholly decided by the creditor ... the creditor decides the risk of non-payment (of either periodic interest payments or principle at the end of the term, or both) and puts this together with their own & proprietary assessment of their overall risk portfolio, assets on hand, etc.
The economic relationship is simple ---- creditor accepts the risk of non-payment or non-timely payment in return for a period charge on the loan outstanding --- annual or periodic interest. This is the profit the creditor determines they need to make on the use of their funds for a given level of their own assessment of their money at risk. It's the creditor's choice on how they should use their own funds ... assumedly in the pursuit of profit (or in this case it's actually called "rents").
For whatever reasons, and the reasons really don't matter in the least, when the borrower either opts not to pay a periodic interest payment on the loan, or is economically unable to garner the necessary funds to make the periodic interest payment... or even the principle payment at the end of the term of the loan, the creditor is up the proverbial shit creek. They can cajole cajole cajole borrower or get a "court order" to agree that the payment is due and payable, but they have no means of collecting on the judgement or failure to pay. In other words there is no enforcement agency to which the creditor of a sovereign can turn to take physical control of the sovereign's treasury in order to obtain payment of interest &/or principle due..... short of physical agression and war.
But the shit creek they got themselves into is the same creek the creditor decided, on their own, unilaterally & without a gun to their head, to get into. At the time of entry into the creek it was, in the assessment of the creditor, worth diving into the creek as it appeared to the creditor's assessment to be clean enough, and would remain clean enough, that is clean enough considering the interest being charged to bath in the creek.
In real terms the assessment by the creditor of the borrower's "credit worthiness" was all wrapped up in the interest rate and term of the loan. The creditor was being (in & by the creditor's own determination) fairly compensated for the use of their funds over the term of the loan.
The creditor was, as all creditors do, taking a risk in return for a charge that compensated the creditor and encompassed the risk that some or all of the funds or interest due would not be paid.
Now in terms of the risk taken by creditors of loans to sovereign's the risk is relatively and normally much smaller than the risks of loans to other types of borrowers. This is the case because sovereigns all have the legal power to tax their inhabitants, and normally sovereigns have control over the value of their currency, hence the ability to adjust it to make their national output more competitive with other nation's ... which is another way to say, increase revenues by increasing jobs though increasing exports.
The power to tax their inhabitants isn't the same however as having the ability to tax inhabitants. A sovereign's gov't is always and perennially subject to change... either by democratic processes, dictatorial ones, or by coups, civil war's or outside military take-overs (aggressions of war). As such, a sovereign's gov't determines how to exercise their legal power to tax their inhabitants. There is thus always a risk, which is assessed by the creditor, of a sovereign's gov't changing in a fashion that increases or decreases the risk of non-payment of interest or principle over the term of the loan. This risk is assessed by the creditor, and included in the interest charged by the creditor for funds loaned to a sovereign nation.
Risk assessment is just that... an estimate, using whatever means the creditor chooses, of the probabilities that some or all of the interest or principle due of not being paid... either on-time or never, and recognizing from the get-go that there is no direct means of enforcement short of outside military aggression or a military coup.
OK, so it's pretty clear and unarguable that the creditor makes all the calls... they decide the risk and consequent charge for taking that risk in the form of interest rates and term of the loan.
So when a sovereign, for whatever reasons, decides not to pay interest or principle due on -time, or never, the creditor has wholly assumed responsibility for the consequences of it's risk assessment. Their recourse is 1) to not loan any more funds, 2) to extend the term of the loan or interest payment due, 3) or loan more funds to the sovereign at a greater interest rate.
The sovereign borrower has some economic incentives to make good on the interest and principle due... though perhaps extended in time-frame due to circumstances on the sovereign front.
The sovereign's incentive to make good on the loan is that if they do not, they will no longer be able to borrow funds at the normal sovereign risk assessed interest rates in the future. ... that is to say the ability to borrow funds will require greater interest rates be paid to borrow. This is by itself not a serious problem IF the sovereign's long term economic foundation and resources are sound... in other words IF they can in the long term afford to pay such higher interest rates on loans.
However, IF the sovereign's long term natural resources and economic capability are highly dependent on competitive conditions among nations, AND their ability to attract investment and high paying jobs is not compelling then their ability to borrow in the future is severely restricted if not totally eliminated for any practical purpose. The ability of most nations, and especially the peripheral nations in the EU to continue to exist as viable sovereigns depends heavily on their being able to borrow funds as needed ---- to overcome temporary economic set-backs due to natural disasters or in making adjustments to changes in national competitive economic spheres.
The failure of a sovereign to be able to borrow means, in most cases, the gov't running the sovereign is replaced by another gov't leadership that will make concessions deemed necessary for potential and past creditors to re-evaluate (in a positive direction) the risk of non-payment of future loans... .making it possible for the sovereign, under new gov't policies, to obtain new loans and/or extend the terms of the existing loans....often both.
There are cases in the recent history where sovereigns have in fact been forced to change gov'ts (by popular democratic vote) but such changes have not always gone in the direction favored by creditors. Argentina, notably, elected a new gov't that decided to default entirely on all creditor's loans... forgoing the ability to obtain any new loans (since the new gov't's credibility to honor the terms of the loan were zippo). Such occurs when, for example, the population of voters doesn't want to endure the effects of their gov'ts policies to make the kinds of concessions the creditors require in order to continue to obtain loans from them.
When the concessions, which are always born directly by the inhabitants of the sovereign nation, are assessed by inhabitants to be worse than the alternatives, they rightfully reject the concessions... and in the end of negotiations between creditor and borrower, the gov't is forced to change to a position of not agreeing with the creditor's required concessions... hence effectively also forgoing the ability of the sovereign to obtain new loans (at least from those creditors from whom they have outstanding loans, and possibly, probably most other credit sources).
In Argentina's case, it decided to default entirely on their existing debt, thus forgoing the ability to borrow new funds. It did this because it was completely in Argentina's hands to control the value of their own currency. They purposefully devalued their currency .. which increased investment in Argentina, increased jobs and business's for exports, which grew the economy and thus Argentina's tax revenues, hence their ability to offer inhabitants an improved benefits, and not coincidentally, a resumption of creditors willing to loan Argentina funds at the normally low sovereign interest rates.
Greece, Ireland, Portugal, Italy, & Spain (and a host of other peripheral EU currency nations) are not in control of the value of the Euro however, so cannot take the same course taken by other sovereigns in the same position... in other words they cannot adjust the value of their currency to attract new investment, jobs, and increase exports.
These sovereign's have therefore only two options:
- Stay within the EU and continue to use the Euro currency as their own, and thus enact the creditor required concessions in order to continue to extend the terms of existing loans and obtain new ones, or
- Default on the their existing loans from creditors, remove themselves from the EU, thence revalue their own currencies to attract new investment, jobs, and grow exports, eventually following the path shown by Argentina (if they can).
Until last week-end the creditors were in complete control... they were assured of continued interest and principle payments because the gov'ts of these sovereigns had continuously agreed to enact the concessions (being taken out on their inhabitants) that the creditors required to continue to fund to the sovereigns (the funds being used to make payments (interest and principle) on loans coming due... effectively simply extending existing terms of loans in return for a slight increase in interest rates on the new funds.
In real terms however, the creditor's were not taking the consequences of their risks themselves in loaning the funds, but were forcing the consequences (losses) on the inhabitants of the sovereigns. This can only occur when the gov't controlling entities of these sovereigns have a vested interest in keeping the creditors whole... at the direct cost to their inhabitants. What might those vested interests be? As in all other representative democracies, as well as any other form of gov't, the controlling polity is one in the same with the controlling economic interests... who are in fact the beneficiaries of the creditor's interest.. i.e. the investors in the creditors in the first place.
What happened last week-end was a shift in the inhabitants attitudes.... collectively they have decided that the concessions being taken out on them are not theirs to bear. In France the conservative party leader was replaced overwhelmingly by the socialist party leader. In Greece, the past ruling parties gov't lost their majority and a new gov't now has to be forged.
Both cases illustrate an increasing trend ... not just in the peripheral EU nations, but extending into the EU's core (of which France is the 2nd largest core economy behind Germany): The inhabitants bearing the losses which would normally have gone to the creditors, have decided that they shouldn't be the sole or primary & dominant bearer of losses of loans based on risks gone bad that were assessed solely be and for the profit of their creditors.
I don't think this is much or any different than a borrowers who borrowed from a creditor (bank, mortgage bank, or some other person/group) to purchase a residential property where the terms of the loan were decided entirely by the creditor... in which the risks of non-payment, or late payments on the principle and interest due were part and parcel of the interest rates they charged for those loans... and in this case the loans were even being backed by collateral ... the properties for which the loans were being made. When the concessions the borrowers had to ensure to make payments on the loan were greater than the alternative, they chose the alternative --- which was simply to default on the loan, letting the creditor take possession of the collateral. This is not a new phenomena which just occurred in the recent housing bust recession... it's been a standard means by which borrowers have opted out of loans for a long, long time already. I'm reminded of a case I'm intimately familiar with that occurred nearly 15 years ago --- the value of the homes in the development which was over-built with respect to the potential jobs available in the area dropped below their mortgage value by a substantial percentage. One of the owners (whom I know) simply turned the keys back to the bank and walked away. It turned out to be a good move (economically) for the homeowner -- the value of the homes in the development never recovered and even dropped much, much lower during the recent recession induced by the residential mortgage boom/bust. Basically, for the period during which the owner paid on principle and interest due, they were paying "rent" of which only a small portion was being paid toward equity value.. so walking away and defaulting on the loan cost them virtually nothing in real terms. In this case the down payment was near zilch because the developer of the homes in the community "paid" that portion to the bank (and simply charged it back to the price (sales price) of the homes). Don't ask me what sweet-heart deal the developer had with the bank or some other of their creditors (or perhaps it was their own capital).... I'm not familiar with that part.
There is a limit to the concessions the inhabitants of a sovereign nation will accept when the risks born were solely those of the creditors in the first instance. When that limit is reached the gov't of the sovereign changes (one way or another), and the result is a new negotiation of concessions required by the creditor and the sovereign's willingness to pay the interest and/or principle due the creditor.
At present time score 1 for the sovereigns, 0 for the creditors. The risks of creditor's has also gone on Spain's debt since the votes in France and Greece. Basically the composite puts pressure on creditors to ease the concessions being demanded at the present time. Another major pressure on creditor's is that the concessions thus far having been enacted have reduced the entire Euro zone's GDP... making it even more difficult to achieve revenues to make payments on the interest and principle due... which increases the level of concessions required to be born by inhabitants in order for debt payments to be made from the now lower revenues.
The levels of concessions being born by inhabitants therefore is cyclically increasing ... which is not a sustainable condition by anybody's assessment... thus in real terms gov'ts of sovereigns will be forced to change (one way or another) to mitigate the level of concessions being made by their inhabitants in order to make payments on the debt to the creditors. At some point, not yet clear, the creditors are placed in a position of accepting far, far less on their interest and principle due, or having the sovereign's default in entirety and exit the Euro. The EU cannot sustain itself if either Spain or Italy exits the Euro, so in the end analysis, either Germany decides to fund the debt loads to a level sufficient to keep new loan's to the sovereigns viable at low interest rates --- effectively acting as the central bank of last resort. Thus far Germany has chosen, under conservative leadership, to not increase it's share of funds being applied to loan to the sovereign's requiring them. This position is likely to soften as France's and Greece's experience (gov't changed) plays a greater role in the risk of full default and especially if Spain decides it cannot continue to endure the levels of concessions being required.
Fun stuff to watch -- the play of creditors trying to avoid having to take the consequence of their risks gone bad.