Debt Crisis – What is Really Going on?

Debt Crisis – What is Really Going on?

July 28th, 2011 // 9:25 am @

The media is covered in news of the “Debt Crisis” but little explanation of what that means. I would like to look at what the debt crisis’s is, why it exists, what we need to do to deal with it.

The debt crisis is simply too many governments owing too much money, and concern over their ability to repay. This underlying issue is being turned into crisis by two things. Firstly in the US parts of the government are refusing to sanction further borrowing. And secondly for some countries lenders are either refusing to lend them money or are charging prohibitive interest rates.

There are flowing from this, two major world debt issues in the news these days, the US potential default, and what is called the Euro Crisis. Both of these are outcomes of a wider debt crisis.

But lets start by examining these two immediate crisis, and then look at what is behind them.

US Potential Default

The US congress has imposed on itself and the US government a limit on the amount the government can borrow in total. As of today that limit is $14.3 trillion dollars. To put that in perspective that is over $45,000 per person in the US.

This debt ceiling has been described as the government’s credit card limit, and that is a good analogy.

The problem is that limit is not, as reported going to be hit on August 2nd, it was actually hit back in May. The US treasury has been using some interesting accounting tricks to keep paying bills since then. The 2nd August is when they believe these tricks will no longer be enough.

The problem is the US government spends more than it collects, and has been for years; in fact the last balanced budget (Income matching expenditure) was in 1957.

Most of the US government wants to raise its self-imposed credit card limit. The problem is now that the Republican Party in congress, particularly the newly elected more right wing members (Tea Party supporters), want too, and believe they have a mandate from the electorate to shrink the very size of government and to get to a balanced budget. Therefore they are demanding huge cuts in expenditure and are against any rise in taxation in any form. Exactly what they want varies from significant expenditure cuts to those who actually want the US to default, and presumably then learn fiscal prudence from that pain.

Their argument has merit, cutting the size of the government is something they do have at least a partial mandate to do. And they would argue that if you are trying to cut the out of control spending habits of someone, even a government, raising their credit card limit is hardly a good place to start.

This goal has got rather lost in the political battle for power, particularly in view of next year’s presidential election, and the tea party members near religious zeal to cut government size and reduce taxes.

The goals they wish to achieve may be correct, trying to achieve them by a massive change in government spending in one leap, or even triggering a default is simply irresponsible.

As of today July 28, 2011 some form of at least partial US default (The government not paying some bills) is almost inevitable. Even if it is averted now the issue will be back in a few months as the Republicans are only offering a six-month interim plan, this driven by their desire to have this question again front and center during the presidential election.

The US debt crisis is being internally triggered by a part of the political leadership being determined to stop what it see’s as profligate spending and borrowing. The euro crisis is being driven from another direction.

Euro Crisis

The Euro is a good idea, implemented for the wrong reasons. The idea was good; to have a common currency that allows members to trade with other countries without the risk of currency fluctuation. However like much or Euro integration it is presented as being done for economic reasons, but the real issues are more political. France and Germany covet a more centralized Europe, with them, particularly Germany at its center. From that reason countries such as Greece were allowed to join the Euro, when even by the Europeans Commissions own economic measures they were not ready.

Then Greece and others got in economic trouble, as they have a history of doing. Greece’s economic issues are what is described as “Structural” which is a polite way of saying the basic structure of how the country operates is wrong. The political process is ineffective, use of public monies is woefully inefficient, and business is stifled not encouraged.

And they now lack the traditional way to put back the issue “Devaluation”. This is when a government deliberately allows its currency to become worth less. Making things it exports cheaper, encouraging sales, and things imported from other countries more expensive, slowing such imports.

As part of the Euro Greece has no power to devalue its currency, and it is faced with huge debts, from years of spending considerably more that it earned.

Unlike the US the pressure on countries such as Greece is coming not from internal political pressure, but from lenders either refusing to lend any more or charging very high interests on what has become for them “High risk debt”. This is the same as those of us with good repayment histories can borrow money at low interest, because lenders are confident we will repay it. Those with a higher risk of not being able to repay pay more. To put that in perspective Germany will pay 1/1.5% interest on money it borrows, Greece needs to pay 15% plus.

Those rates drive two massive issues, one is new borrowing is very expensive, but the significantly more serious issue is that Greece, is paying those rates on existing debt. In that situation countries cannot even pay the interest let alone the original loan, and that is where Greece is.

So Greece is in a very real economic sense bankrupt, and if it were you or I it would declare bankruptcy and not pay what it owes. And countries can do this, it is to “Default” and all that means is simply to say to people who you owe money “Sorry not going to pay what I owe”. If you do that as a person or as a country the problem is people will be very reticent to lend you money in the future.

If Greece were not in the Euro zone that would probably be what they would do, at least to some extent. They are however in the Euro zone and if they default, then lenders will get worried about whether other countries will also default, Ireland, Portugal, Spain, Italy and on…

So Germany and France are lending Greece cash in the form of cheap loans in an effort to avoid that melt down. It is however becoming clear there is a limit to what they can do politically. Both France and Germany have elections shortly and explaining to hard working locals why they are bailing out Greece is politically difficult. Under last weeks deal brokered by Germany and France, Greece will default at least partially, although they are trying to avoid the “Default” word.

However the latest deal is not close to being a real answer and a further and more serious Greek default is likely.

Bigger Picture

The issue behind both of these major crises is the same, governments have failed to balance budgets for decades, and that is now catching up with them. This has been triggered by the recent world recession that reduces the tax revenues to governments. Like us having some credit card debt in good times, as our income keeps rising is manageable. When our incomes start to fall this debt can easily become unmanageable. The same basic economics is equally true of you or I or a government.

Why can governments not balance budgets? Well it would seem simple to do, but there is a complex political issue behind the lack of fiscal good management by our governments.

A number of issues drive their imprudence:

  1. Electorates seem to view government spending as merely them spending some inexhaustible pot of central cash. Not the reality that they are spending our money on our behalf. Therefore electorates keep pushing governments to spend more! Another hospital, medical insurance, unemployment pay etc.
  2. Governments want to be reelected so they tend to pander to these requests.
  3. Politicians know explaining the cold hard reality of a balanced budget is unlikely to get you elected
  4. When politicians however fiscally prudent get elected they get caught up in spending. Even George Bush a fiscal hard liner got caught up in his pet spending projects – Wars!

We get the politicians we deserve!

So what is likely to happen? The US, Greece and then possibly other countries will at least to some extent default on part of their debt.

In that case lenders will start to doubt governments will pay their loans back. Then what has traditionally been seen as a low risk place to lend money becomes a risky one, and that means higher interest rates. And as most governments can not balance their budgets now, higher borrowing costs would make that much worse, forcing them to tax more and or cut expenditures, which will make the world recession worse.

So what needs to happen?

Two things need to happen, firstly we need to build real confidence in those lending countries so they will continue to lend at low rates, and then actually deal with the underlying issue.

These two issues are of course linked. Italy produced an “Austerity Budget” in hours a few weeks ago, but it is so obviously designed to look like they are going to do something, rather than actually do something it is useless for building confidence let alone tackling the underlying issue.

Countries need sensible realistic plans and timeline to get to a balanced budget. Britain has set the sensible goal of a balanced budget by 2015, and if it works towards that will have little trouble borrowing inexpensive cash.

But Britain has a major advantage, there is broad political agreement on this goal, and while there will be some dissent on the details of how to do it; there is political will to get there.

The US does not have that political consensus; in fact it has very significant descent on the goals let alone the plan of how to get there. That issue is not limited to the present fiscal battle, this ideological battle for the nature and size of the government is likely to be intense for the foreseeable future.

Greece is sadly even worse; the political system is so dysfunctional, that there is not even the serious debate about the nature and size of government. Even the Germans and French will run out of money and patience with Greece, and a more major default beyond the one being discussed now is inevitable.

Conclusions

Since the 1950’s countries have become use to borrowing as a norm, just possibly this crises may bring that into question or even end it, and when that happens the real political debate begins:

“What is the right role, size and cost for central government in our country”

 

 


Category : Blog &The Future

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