In debt we trust: Curse or blessing for modern economies? Helsingin yliopisto, velkaseminaari 15.4.2015

The short answer is: it depends.   We all know the saying, that if you owe your bank 100 000 dollars you have a problem, if you owe a hundred million dollars, your bank has a problem.   Although it is a huge mistake to directly compare the management of your personal economy with that of a country, this saying with the numbers multiplied a thousand fold does hold an element of truth.   Modern economies are built on debt, as is any monetary economy. With this in mind debt is like oxygen which keeps humankind breathing and alive. Unlike oxygen, however, too much debt can sometimes turn out to be fatal.   Lending and borrowing are interrelated: it is easy to condemn reckless borrowing, but reckless lenders are as much at fault and should also bear the consequences of their risk taking, following all normal market economy rules.   In any insolvency situation there are, or should be, mechanisms to handle such situations so as to minimize the losses to all involved including any damage to the real economy.   Debt resolution mechanisms 

Anybody who borrows more than they can repay is going to end up defaulting – either explicitly or implicitly. From ancient history up until the present moment, we’ve experienced governments defaulting on their debt and building unsustainable debt burdens that have been restructured or cancelled.


One interesting example in today’s context is the so-called London agreement from 1953. Germany received a 50% cancellation of its pre Second World War and post war restructuring debts by creditor countries like US, UK, France, as well as Greece and Spain and a number of other countries. This debt agreement was an important part of rebuilding the West-German economy.


In recent decades various mechanisms have been created to resolve defaults by developing countries:


Today we have The Paris Club where creditor countries renegotiate bilateral official debts. The major challenge of the Club is of course that it only includes rich western states and not countries such as China, who has quickly become an important creditor for many developing countries.


Then we have the London Club, a parallel, informal group of private firms, which meets in London to renegotiate commercial bank debts. One of the main challenges of the London Club is that unlike the Paris Club, there is no permanent membership. At a debtor nation’s request, a London Club meeting of its creditors may be formed, and the Club is subsequently dissolved after a restructuring is in place


For poor countries we have the international debt relief initiatives of HIPC (Highly Indebted Poor Countries) and MDRI (Multilateral Debt Relief initiative), which have provided significant multilateral debt relief in recent years.   Despite of these different mechanisms we still have cases of sovereign defaults which turn out to be tricky and messy. Perhaps the most talked about problem case of recent times is Argentina. The dilemma of course in this case was that a small minority of creditors was able to forestall an otherwise-agreed debt restructuring of an insolvent country.


This relates to a larger systemic issue in the governance of the international economy. All of the debt resolution mechanisms that I just mentioned are mechanisms run by creditors themselves. They are not independent legal mechanisms, which set rules for orderly debt restructuring between creditors and debtors, such as Chapter 9 in the US Bankruptcy code, which is available for financially distressed municipalities.


In international debates, for example by developing countries and the international civil society, there have been calls for a long time for improved debt resolution mechanisms, which would better balance the interests of creditors and debtors. This has been perceived to be important for better enabling the economic recovery and growth of the debt distressed states. One recent example of these types of initiatives is the UN General Assembly resolution from September 2014 on “establishment of a multilateral legal framework for sovereign debt restricting process”, which noted with concern that “the international financial system does not have a sound legal framework for the orderly and predictable restructuring of sovereign debt”.         


Management of the Euro Crisis


The right thing would have been to go for an orderly debt restructuring from the very beginning. This was rejected out of hand, mostly, one can suspect, because of the urgent need to save the German and French banks, which were those most heavily exposed to Greece.


German banks’ foreign claims on Greece were 32 billion in March 2010. French bank’s exposures were even larger: over 50 billion. Since then the weight of public creditors has increased among the creditors of the Greek government. Essentially this move has enabled investors to dodge their investment risk.


The question to ask about the newly establish EU mechanisms, such as the European Stability Mechanism, is whether they are able to prevent new crises.

The Role of Rules

Yes, rules are needed but they should be intelligent and intelligently applied. Unfortunately the EU’s rules are arbitrary rather than intelligent and can when applied mechanically cause huge damage to the real economy by creating unemployment and cutting growth.

In Finland we are or should be more concerned about the mechanical application of EU rules rather than the level of our debt or deficit which is fully under control and no threat to our financial stability.


For example, the “sustainability gap in public finances” has become a subject of a heated debate in Finland. However, it is very difficult to estimate where the line goes between sustainable and unsustainable level of public finances in any single country. EU has defined it to be 60 percent of the GNI. However this is not based on any research or even experience.


All sustainability calculations include many assumptions and variables such as the growth of GDP/GNI, population growth and changes in demography, real interest rates, unemployment rate, demand of social security benefits etc.


Assumptions about the changes in there variables has led to a situation where we have estimates of the sustainability gap varying between 1 and 6 billion euros depending on who has done the math. This uncertainty means, for example, that if the assumed GNI growth were 2 percent instead of 1 the whole sustainability gap becomes next to negligible.


Low Income Countries increasingly able to source financing from financial markets              


Lastly, let me say a few words about debt of poor countries.


Low-income countries have had growing success in obtaining sources of financing other than official development assistance (ODA). Perhaps most prominent is the recent group of countries engaged in first time sovereign bond issuances. The broader macroeconomic trends in these countries suggest that they are better positioned to sustain access to private flows today than during any other period before.


More generally, financing outside of traditional ODA sources are becoming increasingly important for developing countries. Foreign direct investment (FDI) from OECD countries has more than doubled over the last ten years. It is now 1.7 times as large as total ODA. Remittance flows to developing countries, too, are growing rapidly. South-South financing also has an increasing footprint.


Having said this we should be vigilant about debt sustainability. Hard won gains achieved through the international debt relief initiatives of HIPC (Highly Indebted Poor Countries) and MDRI (Multilateral Debt Relief initiative) should not be wasted due to reckless over borrowing.