Country Debt Enablers and the Greek Conundrum



Governments have several tricks up their sleeves:

  • Governments encourage citizens to regularly purchase government debt via a “payroll savings plan.”
  • Governments define general categories of assets that financial institutions must own — a requirement that is virtually only met by government bonds.
  • Greek banks are in the process of pilfering cash held in individuals’ private safe deposit boxes and replacing it with a bank IOU.

For a country such as Greece with little penchant to tax and a greater penchant to spend, financing its fiscal deficit is an ongoing chore. But when it comes to financing those deficits, governments have tricks up their collective sleeves — ones not available to the private sector.

What makes it relatively easy is that most government debt “sales” are not a sale at all. There is no counter-party buyer that is able to judge the value of the debt being accepted into its portfolio and price it accordingly. Rather, government debt placement tends to be crammed down onto some balance sheet, either private or public, rather than “sold” on a market.

Put another way, governments seek to eliminate the market test and, as a result, their debt is placed at yields that doesn’t reflect the risk that a market would ordinarily require. This accounts in part for the trivial “market” yields on deeply indebted government debt across the world. For example, for ten year durations, Spain and Italy’s government debt yields are well those of the U. S. which themselves are suppressed.

This ability to cram debt down cheaply enables the accumulation of government debt to the point that the only deterrent to doing more so has become the willingness to tax sufficiently to be able to pay the suppressed interest cost. And when that market test can’t be met, all hell breaks loose — as it has in Greece.

Here is how the government debt enablers work:

The first trick is for governments to encourage its citizens to regularly purchase government debt via a “payroll savings plan.” That is, convert private savings immediately into non-marketable government debt much like the U.S. did with large-scale Savings or War Bond programs during WWII.

These programs are initially voluntary but morph into mandates. For example, during WWII, the U.S. government required 100 percent compliance among employees of defense-related businesses — to participate, or risk losing your government contract.

During Vietnam, a more egregious cram-down occurred when the arms most easily twisted into participating in “voluntarily” government debt purchases were those of the soldiers themselves. Those conscripted to military service bore the dubious distinction of both fighting and financing the war via mandatory saving bonds in lieu of pay.

But “voluntary” government efforts to lock into private savings are not just for wartime. Recently, for example, the Middle Class Task Force of the Obama White House proposed to “strengthen middle class finances” via voluntary savings funneled into a “Safe Investment Choices” program (p. 25). Of course, with the government acting as your investment manager, to them there would be no conflict of interest in funneling your private savings into wonderful “riskless” U.S. Treasuries, which is what was proposed.

Much the same regularly occurs for government “trust” funds, whether they are part of social insurance or for other future services such as Medicare, Medicare, or the highway trust fund.

From there, public capital markets are tapped though the sale of government bonds but with either a whiff of coercion or special enticement, so the market test is deeply biased.

For example, a factor in the marketability of government bonds at yields attractive to the issuer depends on the currency in which the bond’s payments are denominated.

From an investor perspective, Greece’s bonds — payable in Euros — are considerably more desirable than if they were denominated in Greek Drachma. This is because the Euro’s value is supported by the demand for Euro currency to purchase the goods of more successful European exporters. However, the ability to piggyback off the relative strength of the Euro currency to sell Greek bonds doesn’t require Greece to remain in the Euro currency. Countries, for example, regularly finance their debt denominated in the U.S. dollar without being part of the U.S.

So the importance of remaining in the Eurozone for Greece is to court the purchases of their debt by the European Central Bank (ECB) and other Euro government’s intent on defending the benefits of European economic integration as a means to provide disincentives for European conflicts, as occurred in the past.

Another consideration regarding a government’s ability to finance its debt and contain its cost is the credit rating of its sovereign debt. Hence, governments regularly pressure private credit rating agencies to issue pristine ratings whether or not their debt is pristine. Here, too, Greece benefits from being in the Eurozone.

Getting the Euro sovereign ratings under control is important because the ECB purchases of country debt require investment-grade ratings. When it appeared that private rating agencies would not deliver the necessary investment-grade ratings, the ECB contemplated creating its own rating system to produce whatever rating it wanted.

Apparently a way has been found to elevate Euro sovereign debt ratings because, as the ECB notes, Euro sovereign debt ratings have seen a “persistent upward trend for counties with weaker fiscal fundamentals.” Clearly, ratings are being manipulated to Greece’s and other countries’ benefit to allow ECB purchases.

But there are more tricks in the tool chest to sell government debt. When sovereign debt can’t stand on its own two feet and be sold in amounts and affordable yields to finance a fiscal short fall, then governments must get more creative. And they do.

Under the guise (or, rather, the subterfuge) of insuring the “safety and soundness” of financial institutions, government-styled financial regulation requires those institutions to purchase and hold government debt as a “riskless” asset — which, ostensibly, protects the investing public.

The way this is done is to define general categories of assets that financial institutions must own — a requirement that is virtually only met by government bonds.

For example, “risk-based” capital requirements motivate financial institutions to include a larger proportion of “riskless” government debt in their portfolios, which allows banks to operate with less capital. This mutually convenient arrangement (facilitating government debt issuance to banks that are thus able to reduce its capital requirement) at this stage of the Greek game is haunting bank depositors.

They see the banks holding overly generous amounts of wobbly Greek government debt and (correctly) fear the banks don’t have the assets left to make good on their deposits. This is what led to Greece’s bank deposit runs, causing depositors to get in line and withdraw their money as quickly as possible. In these circumstances, the government deposit insurance guarantees that would supposedly cover their losses are vacuous, which further intensifies the panic.

The need to provide the cash to feed the bank deposit run from Greek banks has been funded via emergency “liquidity” loans from the ECB, though the banks have now run out of eligible assets to pledge as collateral against these cash loans as required by ECB rules. As a result, the banks have been in the process of pilfering cash held in individuals’ private safe deposit boxes and replacing it with a bank IOU.

The next step of obtaining other people’s money to keep the government afloat is for governments to borrow from each other. For the U.S., this is relatively easy because the U.S. dollar is still a reserve currency, and those foreign governments that wish to hold foreign exchange reserves translate their dollars into interest-bearing U.S. Treasuries. But Greece is not equally fortunate. Its bonds don’t qualify as a foreign reserve.

So in the category of borrowing from sovereigns, Greece has had to lean further on the IMF, the EU, and the ECB to (once again) forgive past debt and (again) refinance the rest on cheaper terms and longer durations and to seek additional cash. But it’s clear with Greece’s economy laboring to carry its existing debt that additional debt would no more be serviced than its past debt obligations. Greece is beyond the “bang point” — the point at which the debt prevents the economy from attaining a growth rate sufficient to generate needed tax revenues to service the interest on existing debt.

Having run out of resources and lenders, the issue is this: Is it in the interest of the Eurozone to keep Greece afloat? On this matter, Greece has resorted to upping the ante by threatening to ally itself with the Russians, playing off its strategic geopolitical position at the southeast corner of the Eurozone. It’s Europe’s first line of defense. This is perhaps what has caused some sentiment within the Eurozone to continue supporting Greece, but the amount of tribute is not trivial. The forgiveness of a portion of the 186 billion Euro debt and an additional 86 billion Euro loan have been discussed.

The alternative for Europe, which is growing in favor, is the therapeutic value of finally saying no to additional Greek financings. This would mean absorbing the default on 186 billion Euro of loans made to Greece and to cut Greece off from further Eurozone or ECB borrowing. Cutting off access to the Euro currency and ECB loans would force Greece to return to its own currency. This has been cleverly dubbed “Grexit,” and would result in Greece providing banks with Drachma to satisfy bank deposit withdrawals.

By cutting off additional financial assistance to Greece, the goal here would be for Greece to serve as a model of what happens to governments whose penchant to spend exceeds its penchant to collect taxes, for which Greece is not alone.

Ironically, this tough love is in Greece’s best interest because with its own currency, Greece can make its olives, shipping, tourism and anything else as cheap as it wishes for the global markets. By also defaulting, this would greatly diminish the taxes needed to pay interest and principle on the mountain of past debt.

The Catch 22 is that Greece would need to run a balanced fiscal budget even if it were to be debt free (via default). That is, government spending in the future would be limited to tax proceeds because the market would not touch Greek debt denominated in either Euro or Drachma for years to come.

So the Greek endgame is as follows: unemployment of 25 percent, negative economic growth four years running amounting to a depression, a private banking and wealth meltdown, significant emigration of its youth, who face a 50 percent unemployment rate, and a likely need to go back to a post-WWII square-one to reestablish its economy based on its own currency while living on its own resources. This has become Greece’s fate for debt overindulgence.

But if Europe offers more debt assistance, Greece’s debt load only mounts. As a consequence, Greece will be worse off because it is well beyond the “bang point” — the ratio of the country’s debt to income is rising to nearly 200 percent given the very recent collapse in GDP. And as a consequence, European lenders have almost no chance of collection.

Upon reflection, Greece’s switching to the Euro currency in 2002 only facilitated its ability to borrow more than it could handle and ultimately begot greater pain and suffering. Not much different from private parties that leverage off of connections and overdose on debt and end up with lower income and a cram-down of assets when bankruptcy is reached.

Will Greece’s debt demonstration project influence populations not to elect populist leaders who are ultimately unable to deliver as promised and accept the adverse consequences from trying?

Or will they go further left and be unable to finance themselves any longer — even when using their tricks of the trade — and seize the last remaining sources of private wealth and party until they, too, are spent? We shall soon see.


The views expressed are those of the author and not necessarily The University of Texas at Austin.

About The Author

Lew Spellman

Professor, Department of Finance, McCombs School of Business, The University of Texas at Austin

Lewis Spellman received his BBA and MBA from the University of Michigan and his MA and Ph.D. from Stanford University. His research interests include...

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