European debt crisis: Causes and Cures

Greece’s debt problems are the fault of its use of the Euro

[Comments from friends have led me to strengthen my arguments in the following slightly revised version of this post.]

Public misunderstandings of economic issues do not go away easily. Recently, I began an e-mail exchange with four Chinese students. Perhaps it is forgivable for them being in one of China’s remote provinces to say with regard to the Greek and Portuguese debt problems: “The root cause is that different developing countries use the same currency, [which] is not appropriate.”[1] While this may sound plausible, some of their other beliefs were totally  bizarre. However, it is not forgivable for the German chancellor, Angela Merkel, to say: “We can’t have a common currency where some get lots of holiday time and others very little.” This is not only ridiculous because Germans have longer vacations than the Greeks (I am speaking only of official time off, not German versus Greek work habits), which they do. It is ridiculous and wrong because it implies that it is not viable for rich people to live in the same country with poor people.

The use of a common currency, the Euro, IS NOT the root cause of Europe’s debt problems. As this does not seem to be obvious to some intelligent people who should know better, let me spell it out in very simple, elementary terms.

A person or family in the United States (or any other country) that spends more than her income for long periods has a potential problem and that problem has nothing to do with the fact that she is using the same currency as everyone else in the country. She may rationally borrow for short periods to cover temporary interruptions in her income or finance large purchases that she has the income to repay over time, but if she continually borrows amounts that she cannot reasonably expect to be able to repay, she and her foolish creditors have a problem. More often (hopefully), debt defaults result from unexpected changes in fortune. All countries have legal procedures (bankruptcy) for dealing with such defaults that avoid sending the defaulter to debtors’ prison. But as long as each person or family lives within its means, there is no reason on earth why their means can’t vary enormously without undermining the harmony of their coexistence. If this is so within countries, it is even more so between them (security concerns aside).

The probability of lending money to someone who cannot repay is directly related to the incentives faced by borrowers and lenders. A debtors’ prison was about as strong an incentive you could have against careless borrowing though they varied a great deal from one country to another. Most took the form of workhouses. In England, a debtor (and often his family) remained in confinement until his debt was repaid. In most European countries he stayed for a maximum of one year. However, from the establishment of the United States, Americans decided that people should be given second chances and abolished debtors’ prisons. In England, the Bankruptcy Act of 1869 abolished debtors’ prisons. We now take second chances for granted. But this does increase the risk that some people will borrow too much.

Who gets credit is almost totally regulated by the requirements of lenders to have confidence that borrowers can and will repay them. No one is forced to lend. Lenders require information from borrowers on their past and expected income and on their track records of repaying earlier loans. They may require collateral to “secure” the loan. Borrowers themselves are deterred from borrowing what they cannot be paid by the penalties imposed by bankruptcy laws should they default even if they aren’t sent to prison. This very fact increases the confidence of lenders to lend in the first place. If the penalties are too severe and/or collateral and other security too costly, less will be lent. A delicate balance is needed to optimize the reallocation of savings to investors (or consumers).

At the end of the day, life is uncertain. Not everything can be foreseen. Some chances are reasonable, however, and worth taking. Some lenders are willing to take larger risks if compensated by higher interest rates on such loans. Thus markets tend to demand higher interest rates (relative to those on safe loans) for riskier loans. Lenders still expect to make a reasonable return on their loans on average with the “risk premium” received from those who repay covering the limited losses on the few who don’t.

Sovereign borrowers, like Greece, are generally considered low risk because they can tax their citizens to repay borrowed money. But as Argentina and Russia have shown there are limits to taxation. Unless lenders (buyers of sovereign debt) think that sovereign borrowers will be bailed out by the IMF or others under all circumstances, they will demand an interest rate that reflects their assessment of the risk that the borrower might default. A higher interest rate for riskier borrowers is a good thing as it provides a financial incentive for the borrower to slow down.

Greece’s adoption of the Euro contributed to its current debt problem only in that it removed one of the risks of lending to Greece—the risk that Greece would devalue its currency and thus reduce the foreign currency value of what it owes (if lenders had denominated their loans in the Greek currency). Greece no longer has its own currency and thus lenders no longer face so-called “exchange rate risk.”

Until recently lenders did not add a risk premium to loans to Greece or Portugal. They charged these borrowers almost the same as they charged the German government. Thus there was little financial incentive from this source for Greece to limit its borrowing. But like any borrower, whether an individual, a company, or a country, the game lasts only as long as lenders believe they will be repaid and borrowers are foolish to borrow what they cannot productively use and repay. That Greece has been foolish is perhaps one of the nicer ways of putting its behavior. Now, finally lenders have become more discriminating and have begun to add large risk premiums to any new loans to Greece and other riskier borrowers. This came late but is welcome.

The above discussion provides background to my views on the proposal now being made by many in Europe to finance national government borrowing with Eurobonds. Rather than individual countries issuing sovereign debt and paying the risk premium the market demands for their particular situation, they would borrow through an EU wide institution, such as the European Financial Stabilization Fund (EFSF). Greece would sell its bonds to the EFSF, which would pay for them with funds raised by issuing its own Euro denominated bonds. EFSF bonds would be backed by the financial resources of the EU (all European member countries collectively) and would thus enjoy the credit rating of the EU rather than of Greece.

Eurobonds (not to be confused with the US dollar denominated bonds of the same name with which many European and other governments and companies have borrowed for half a century) would reduce the cost to Greece of borrowing and would provide a better asset in which central banks and multilateral companies could hold Euro reserves. The latter would facilitate the use of the Euro as an international reserve currency.

The cost of Greek debt service would drop immediately, but without other steps by the Greek government to reduce its bloated budget and to free up the competitive capacity of its economy more debt would be accumulated until it again reached the limits of its ability to service its debts. I outlined the issues and options for Greece in more detail over a year ago (May 2010) at

The ability of Greece to borrow unlimited amounts via the EFSF at safe Eurobond interest rates would remove an important incentive for Greece to adjust and live within its means. Thus the Eurobond idea in this form is a bad idea and Germany is right to oppose it. The financial assistance now being given by the EU and the IMF carries conditions that Greece address the underlying and real causes of its debt problem (excessive government spending and an uncompetitive economy) and it has been making considerable progress toward satisfying those conditions. Such loans (also at low risk free rates) provide an alternative way of imposing incentives for better behavior by Greece to that of high risk premiums for market borrowing.

Because of this perverse incentive effect of opening Eurobond financing to Greece and other EU members with excessive debt, its proponents speak of the need to combine it with stronger EU control over national fiscal policies. It is not clear what form such tighter control might take and it is frankly difficult for me to imagine France or Italy, for example, allowing EU bureaucrats in Brussels to dictate limits on their national expenditures.

“Eurobonds ‘mean telling the people, the citizenry, that you are ready to share risks,’ [Amadeu Altafaj] Tardio [a spokesman for the European Commission’s economic and monetary affairs committee] said. ‘That would be the strongest support for the euro area. It makes sense in the context of a monetary union. . . . Politically it does not seem feasible.’”[2]

It is instructive to contrast the EU situation with that of the United States. The federal government of the U.S. issues debt securities in its name and with its (now slightly down graded) own credit rating (AA+). The stock of its debt outstanding is approaching $15 trillion dollars, almost half of which is owned (lent from) abroad. Each of the 50 states in the United States also borrow by issuing debt securities in their own names and each receives its own credit rating and pays interest accordingly. The money raised by the federal government is to supplement its tax revenue to finance its own expenditures (though the federal government does grant some revenue to the states from its budget). Thus it has full control (I am ignoring the political dysfunction of our current Congress) over its own expenditures and borrowing needs. States have full control over their own budgets and financing.

The situation in Europe is quite different. The Eurobond proposal is not for the financing of the EU budget (comparable to the federal budget in the U.S.), but for the financing of individual country budgets (comparable to states in the U.S.). This is why advocates of Eurobonds couple their proposal with the need to increase EU control over member countries’ budgets. Such control would be comparable to federal government control over state budgets in the U.S. This seems both politically very unlikely in Europe and, in my opinion, undesirable.

There is a version of the Eurobond proposal that does make sense to me. Bruegel, a European think tank, has suggested an approach that differentiates between debt financing member country borrowing that is less than 60% of their GDP and borrowing that is more. Eurobonds proper would only finance borrowing up to the 60% level. Any country wishing to borrow more than that would need to issue their own bonds and pay whatever risk premium the market demanded of them individually. Eurobonds would have priority standing in the event of default. This would restore the market discipline of excessive borrowing that the open-ended Eurobond proposal would remove, and would be easy to enforce.

Reducing the borrowing cost on debt equal to 60% of its GDP would help make the existing stock of debt more sustainable. But unless Greece and other EU members addressed their fundamental problems, the flow of new debt would continue. The market’s assessment of the prospects of Greece defaulting on such additional borrowing (over 60% of its GDP) would determine the risk premium Greece would have to pay for such borrowing and would provide better market discipline of its behavior than a pure Eurobond scheme.

Don’t blame the Euro. Blame the misbehavior of individual countries. Both rich countries and poor countries can participate in the global economy whether using the same currency or not if each lives within its means. When looking for solutions, don’t destroy the costs of bad behavior and thus the incentives for good behavior. This includes the incentives faced by market lenders (banks and others), who, thankfully, are finally taking some loss in the restructuring of Greek debt, but perhaps not enough to be more careful next time nor to reduce the exciting stock of Greek debt to make it sustainable. In the final analysis, only Greece, like any household, can make the changes that will restore its credit worthiness and its place in the global economy.

[1] Email correspondence with Chinese students who found my address on the Internet.

[2] Howard Schneider, “Europe debt crisis forces officials to revisit creation of common eurobonds”, The Washington Post, August 26, 2011, Page A11.

Libya: Part II

What will happen next in Libya and what should we do?

As we attempt to save the Republic by trimming government back to size (back to what we can afford and back to what only government can do), surely we can forego a few of wars the neocons would like to plunge us into. Actually my warning cries as we were sliding into another one in Libya had much more to do with the unlearned lessons of the past about how best to influence future event for the better than with the wasting of more precious treasure (lives and other resources). To his rather bumbling credit, President Obama gave in to the pressures of the warmongers reluctantly and only partially in Libya. Our involvement has been largely supportive of more direct, though also limited, NATO support for the rebels.

But here we are at the beginning of Part II of the Libya drama. The rebels seem to have finally toppled the truly crazed Gaddafi. We can all cheer his demise, but what will follow? Who are the rebels and where are they planning? We actually know more about them than when we first chose to support them (a collection of different tribes, political philosophies, and religious views, some good and some bad). Who will emerge on top and what will the struggle for dominance of the new regime be like? Will the average Libyan be better off or worse off? It is impossible to know at this point.

Craig Whitlock reports some interesting reactions to the Libyan civil war from the area in yesterday’s Washington Post, “Libyan rebels renew hopes of Arab Spring”

“If the shooting quickly subsides and the Libyan rebels are able to build a functioning central government, it would give further encouragement to protesters in the streets of Damascus and Sanaa. But if Libya descends into factionalism or tribal warfare — with scenes reminiscent of Iraq after the fall of Saddam Hussein — then ardor for the Arab Spring could cool again.

“‘People are going to be looking at how this plays out very, very closely,’ said Jon B. Alterman, director of the Middle East program at the Center for Strategic and International Studies. ‘It’s easy to agree that the leader must go. It’s much harder to agree on what comes next.’

“Some Palestinian activists said that their aspirations, too, had been buoyed by the success of the Libyan rebels but that NATO’s involvement had taken the sheen off the results.

“‘It is getting a cautious welcome because it was achieved with foreign intervention rather than by the people themselves, as was the case in Egypt,’ said Hani al-Masri, a political analyst in Ramallah, West Bank. ‘Some people are calling it liberation through occupation. The Egyptian experience was inspiring. In Libya, we have to wait and see.’”

My pessimism about our ability to improve the world (and our safety) with armies does not mean that I think we should do nothing in Libya or elsewhere to promote a better world (rule of law, respect for human liberty and rights). We know a lot about the blessings of liberty and the institutions (not necessarily, or even very often, just like our own) that help promote and preserve it. We have an interest, both humanitarian and national self-interest, in doing our best to share our knowledge and to promote sound governance and free markets in Libya and elsewhere. This is often done best by international organizations such as the International Monetary Fund and the World Bank. It cannot be successfully imposed from outside. It must to the form of support and encouragement to the indigenous forces for good (if we think we know who they are).

I commend to you the op-ed piece on this subject in the The Washington Post by Stephen Hadley on August 18th: “Our chance to shape change in North Africa and the Mideast”.

Short Travel Notes

At my final breakfast at Afex camp this morning two of my colleagues were laughing at some of the silly things people do on the Internet, such as feeding fish and growing crops etc. When I returned to the table with another cup of coffee, they were both staring intently at (I thought) the Nile next to us. Adam noted that, “they are moving at different rates.” Richard replied “and moving in opposite directions. I wonder how they will pass each other?” Adam suggested, “let’s bet on which group goes over the other.” I strained to see what it was they were talking about and could see only the usual uprooted plants floating down the river, all in the same direction.

What are you talking about, I asked. The ants on the string, they replied. Just next to us in the open air dinning hall was a string fence to prevent people from taking a short cut through the garden. Two long lines of ants were walking along the top of the string in opposite directions. Maybe feeding fish on the Internet is not so wacko after all.

On my flight a few hours later from Juba to Nairobi I came across a quote in The Standard (a Nairobi newspaper) that I can’t resist sharing:  “Tanzania’s culture of skepticism and mistrust of Kenya has been going on for over four decades. The late Julius Nyerere, the founding President of Tanzania, once described the capitalist-aligned and aggressive Kenya as a ‘Man eat man society’. [Kenyan] Attorney General Charles Njonjo retorted by terming the then socialist Tanzania a ‘Man eat nothing society.’”

Travel notes from Juba, South Sudan



Ito and I ended our Italian/French/Netherland vacation (see in Amsterdam visiting friends (Bill Wirt, Dolph Westerbos, and René van Hell). While there, we enjoyed the usual sights and the coldest July day in the Netherlands (July 24) since 1903! Then Ito took the plane home to Washington DC while I headed on to South Sudan.

While Amsterdam was having its coldest day, Washington was suffering one of its hottest days in history. The same weekend had the only two consecutive days with lows above 84 decrees ever recorded. The high temperature of 105° at 3:52 pm on July 22 at Washington Dulles was a new all-time record, beating the old record for July 22 of 98° in 1998 by 7°. By the 24th Dulles had “cooled” down to a high of 94° (97° at Reagan National).

The average global high may well have been perfectly normal (I couldn’t find such data if it exists), demonstrating that distribution does matter.

Juba, The Republic of South Sudan

I left Southern Sudan on June 21 and returned on July 27th to the newly independent Republic of South Sudan (on July 9). The introduction of the new South Sudanese Pound (SSP), which our Deloitte team has been helping the local authorities prepare to issue for over a year, had started on July 18th.  The replacement of SDG (Sudanese Pounds) with the new SSP is targeted to be completed by the end of this month (August—a 45 day period).

The establishment of the new Central Bank of South Sudan, though inheriting most of the staff and buildings of the Bank of Southern Sudan (a branch of the Central Bank of Sudan headquartered in the North), is being seriously hampered by the failure so far of the President of the Republic to appoint its new Governor and Board.

The big success on this visit was the launch of foreign exchange auctions after the new central bank law wiped out all of the exchange controls imposed by North Sudan when Southern Sudan was part of it. The Central Bank of Sudan (the central bank for the whole country before the South spit off) was running out of foreign exchange reserves (foreign currency owned by the central bank that it could sell to the market to influence the exchange rate of its currency). It wanted to keep its exchange rate to the U.S. dollar and other foreign currency low so that those holding its currency could buy dollars more cheaply (a so-called “strong” currency). But to do that it had so sell dollars from its foreign currency reserves. When it was running out of dollars, it could no longer support the exchange rate it wanted. So it imposed restrictions on the purposes for which people could buy dollars with the Sudanese Pound (restricting demand) in order to support it’s artificially low (strong) exchange rate. As a result, a spread of up to 1½ percentage points opened up between the official rate and the street (black market) rate.

South Sudan has removed those restrictions and introduced twice weekly auctions of U.S. dollars to the highest bidders. There have been three auctions so far and they are working well as the market gets used to them. The spread between the official and street rate (no longer illegal) has already narrowed to about 25 basis points (a quarter of a percentage point). Today we hit a big bump in the process and the acting governor, responding to political pressure capped the exchange rate for the next auction below the rate of the last one. We expect the announcement of a permanent Governor very soon.

After independence, the Bank of Southern Sudan became the Central Bank of South Sudan (CBSS). The Bank has a fairly large courtyard in the middle where people gather to chat or smoke cigarettes and where the Governor holds large staff meetings. You can see it in the attached picture. I stepped out of my office on to the far edge of the courtyard the other day and was standing next to one of the Bank officials. He was on his cell phone and obviously expecting to meet someone: “Where are you? … You are standing under a tree? … What tree? We have a lot of them.” Every now and then a fairly large monkey drops out of one of them, which always gives me a start.

There seems to be more life around the Bank than before. After all, there is a lot going on (introducing a new currency and starting new foreign currency auctions). Yet the halls of the Bank are still cluttered with employees that are half asleep. I am not really sure what their duties are. Work habits are not very good here. Many of the African Sudanese in the South cling to the habits of the African lion, which lies around and sleeps most of the day, while his lionesses round-up the food and do the dishes so to speak. The entrepreneur spirit is in rather low supply. Many of the businessmen and shopkeepers are Kenyans or Ugandans.

The traditional pastoral and often nomadic lives of many Africans roaming the plains of Sub-Saharan African are not all bad, by any means. You can’t listen to them sing without hearing some happiness there. But it is too easy for those of us not living it day after day to overly romanticize it.

Life at the Afex Riverside Residence at the edge of the Nile remains the same. I continue to be impressed with the timeliness of Deloitte’s team for the morning and after lunch departures of its six cars. In the few minutes before 8:00 am every day except Sunday, thirty or so consultants converge on the car park from several paths and at 8:00 am sharp the cars start pulling out for the drive to the various Ministries (and in my case the Central Bank) at which they work. Often the departure, especially after the lunch break, is virtually simultaneous with all six cars departing from the camp one right behind the other in a caravan. It is an impressive sight.

On irregular trips, the drivers are required to provide a radio report to Base on who is with them and where they are going so that Base knows were every one is. It goes something like this: “Alpha to Base. Alpha to Base…  This is Base.  Leaving Charlie, Charlie, with Bravo D-4 (or whoever) and with, with, and with one “unassigned.”  I am the “unassigned” because I talked Base into not having to carry a bulky two-way radio around, because I almost always travel with colleagues who have one.

A few days back, while eating dinner in the Afex dinning hall—a very pleasant open air facility along the edge of the Nile—a strong gust came up that caused a heavy shower of little black things that covered the dinning room tables, floor, and my plate. I assumed that it was the carcasses of the hundreds of thousands of zapped insects that had given up their lives to the several electric bug killers overhead. I was greatly relieved when I learned that they were little mango seeds that had collected on the canvas roof and were dislodged by the brisk wind.

At dinner this evening our British security officer and another Englishman where telling war stories across the table from me. I was only half listening, but the other Brit’s story about their first-rate French interpreter (they must have been in a French-speaking African country as he is not old enough to be talking about WWII) ended with something like: “he eventually went native on us, drinking red wine and such.” I learn something new every day.

I have been away from home for over a month and need a haircut. My barber for the last 35 years gets very upset if anyone else cuts my hair. During my two month stay in Baghdad in 2004 I was forced to get several and Mike complained for the next two months that it was taking that long to get it back into proper shape. Tuffs of hair now tickle my ears occasionally leading me to fear that a malaria-carrying mosquito has landed there.

Our morning drive from Afex Camp to the Central Bank usually passes a lot of kids on their way to school. The girls and boys dressed in school uniforms is a lovely sight. There is little that is as encouraging and hopeful as seeing young kids smiling on their way to school, especially in a largely illiterate country. So there is hope. There is also little as heart breaking is the face of a child, usually a hungry child, with no hope. The expressionless, unfocused stare of such a child is more than I can bear.

I think that we take hope in American (especially) so for granted that it is hard to imagine a people who have little of it. A great deal of our existence, especially our younger years are filled with the hope that we can build decent enjoyable lives for our selves and our loved ones. What would our youth have been without it? There seems to be a lot of hope in South Sudan now. I hope that it is justified and that it can be sustained.

Should Geithner resign?

Calls for U.S. Treasury Secretary Geithner’s resignation following S&P’s modest downgrading of U.S. government securities are strange. Strange and ignorant. The U.S. Treasury Secretary, our Finance Minister, has nothing to do with our deficit or our debt problem (unless you are blaming him for keeping its maturity shorter than he might). His job is to finance as best he can all of the expenditures our Congress pass and our President sign into law. It would make more sense to call for the resignation of the Congress and the President.

Unlike most countries, in the United States the responsibility to propose a budget to the legislature and to finance whatever the legislature approves are spite between the Office of Management and Budget (OMB) and the Treasury. Most other countries combine the two into their Finance Ministry. The practice else where better aligns incentives to the extent that the level of spending proposed is arrived at in full knowledge of the capacity to finance it.

If calls for Geithner’s resignation are related to debt and deficit problems, the callers need a civics lesson.