Wednesday, December 07, 2011

Previous Mises Daily IndexThe Risk of Sovereign Debt

The Risk of Sovereign Debt

Mises Daily: Wednesday, December 07, 2011 by


With a 50 percent haircut recently given on the Greek sovereign-debt question, investors are increasingly asking what the real risk of sovereign debt is. It would appear that investors underpriced the risk inherent in sovereign debt, especially that of Europe's periphery. One might even go so far as to say that investors made foolish choices in the past and are now getting their just deserts.

Such statements require an assessment of what the specific risk is of holding sovereign debt, and how specific European institutions affected these risk factors.

Debt is in almost all cases collateralized by some asset. A mortgage is backed by the value of the house that it is borrowed against. Student loans are backed against the future earnings ability of the student (or their parents' income and assets if cosigned). In almost all cases debt is collateralized by the asset that it is used to purchase.

Sovereign debt is slightly different, as no clear asset stands ready to serve as collateral. Instead, borrowing is backed by the future taxing capacity of the state. When investors purchase sovereign debt, they do so knowing that if their plans turn out wrong they will not be receiving some portion of that state's assets as the consolation prize. They purchase the bond knowing that the ability to repay is conditioned by the future economic health of the country, and also by its future taxing power. As there is a general negative relationship between tax rates and economic health there is an upper bound on how much tax revenue can be raised in the future to pay off debts incurred today.

When we say that sovereign debt is "risk free," we mean that there is no credit risk. A state is forever able to pay off its nominal liabilities in one of two ways: either it increases its taxes to raise more revenue (through direct taxes), or it monetizes its debt by increasing the money supply (an inflation tax).

Central banks are, by and large, granted some degree of operational independence in order to avoid the second circumstance. The inflation tax is an extremely attractive way for a state to pay for its liabilities. No one pays it directly, and hence there is a reduced chance for "taxpayers" to see the wealth appropriation. A government given direct control of the printing press has an incentive to give higher rates of inflation than the public desires, if only to pay off the debts it incurs. Central-bank independence removes this option.

Sovereign debt is not risk free; the real payoff may differ from the nominal promise. For domestic-debt holders, this arises when inflation occurs. For foreign-debt holders, this risk mainly arises through foreign-exchange risk. In either case the source is the same — inflation reduces the purchasing power of the currency of denomination and thus reduces the real value of the future payment.

Interest rates are set on sovereign debt with these risks in mind. Importantly, if direct default risk is minimized through the state's future taxing capabilities, the lone risk remaining is through inflation or an adverse exchange-rate movement.

The advent of the European Monetary Union brought about an interesting change to the way that investors calculated these risks.

Twelve years ago, what was the risk of purchasing sovereign Greek debt? Direct credit risk was minimized as the Greek government pledged to pay back its investor by increasing future taxes if need be, or by inflating its woes away. Accession to the European Monetary Union made an important change to this risk perception. The European Central Bank (ECB) has, since its inception, been the model of an independent central bank. It was modeled after the German Bundesbank to be wholly separate from the political realm, and thus faced no conflict of interest with eurozone governments when their debt loads became unmanageable.

With Greece's monetary affairs no longer in its own hands, the risk of the country inflating away the nominal value of its debt was removed. No longer did investors need to concern themselves with investing in a bond that would be prone to the political desire for an easy solution. Inflation risk was automatically hedged.

The exchange-rate risk was also eliminated if the potential investor was from the eurozone. With one common currency for what is now 17 countries, no adverse movements could compromise the investor's earnings. International investors still faced this risk, but luckily any exchange-rate movement against the low-inflation and rule-based euro would be more predictable than the discretionary whims of the old Greek drachma.

The result was a quick and substantial reduction in risk on sovereign debt upon accession to the euro. With inflation and exchange-rate risk largely eliminated, investors needed only to weigh whether or not the future taxing capabilities of a state would be adequate to pay off its debt obligations. With the robust economy of Europe's mid-2000s, this was a fairly certain bet.

Indeed, if insolvency occurs, it generally means that your pledged assets are liquidated to pay off your liabilities. For a country, this means that if your only asset is your future taxing power and your liabilities are ongoing expenditures, the hint of insolvency calls for either increased tax revenues (higher taxes) or lower expenditures (fewer government services). Hence, for an investor in Greece, it was reasonable to assume that if the government found itself nearing insolvency in the future, the country would

  1. reduce government expenditures, or
  2. increase tax revenues to pay off debt holders.

The sharp increase in interest rates over the past few years has made clear that the risk perception of Greek debt (and that of other periphery European countries) has changed drastically. With the ECB still firmly committed against direct bailouts to specific member states, the increase in yields is not directly attributable to inflation risk. Instead, the increase in risk is created directly by the Greek government's refusal to substantially reduce expenditures or increase its tax revenues. In effect, a sovereign debt that was once free of credit risk is now increasingly at risk.

The recent haircut on Greek debt proves this point, and will in fact exacerbate this situation. The haircut has proven that Greek debt is not risk free and that default, if only partial, is a real possibility. Instead of easing investors' fears of a Greek default, events have concretely demonstrated that the risk expectations on Greek debt should be reset higher. Corresponding higher borrowing costs for the small Hellenic nation will follow.


Rodrigo González Fernández
Diplomado en "Responsabilidad Social Empresarial" de la ONU
Diplomado en "Gestión del Conocimiento" de la ONU
Diplomado en Gerencia en Administracion Publica ONU
Diplomado en Coaching Ejecutivo ONU( 
 CEL: 93934521
Santiago- Chile
Soliciten nuestros cursos de capacitación  y consultoría en GERENCIA ADMINISTRACION PUBLICA -LIDERAZGO -  GESTION DEL CONOCIMIENTO - RESPONSABILIDAD SOCIAL EMPRESARIAL – LOBBY – COACHING EMPRESARIAL-ENERGIAS RENOVABLES   ,  asesorías a nivel nacional e  internacional y están disponibles  para OTEC Y OTIC en Chile

Defending the Austrian Explanation of the Great Depression from an Internet Attack

Defending the Austrian Explanation of the Great Depression from an Internet Attack

Mises Daily: Monday, December 05, 2011 by

Scott Sumner is a Chicago-trained economist who has gained notoriety in recent months for his vigorous advocacy of "NGDP targeting" by the Federal Reserve and other central banks. I have criticized Sumner's views before, and he and I have agreed to a formal online debate to be held early next year.

In the present article, I want to respond to a recent post — titled "The myth at the heart of internet Austrianism" — in which Sumner criticized the Austrian explanation of the Great Depression. I will pick apart Sumner's post almost line by line, so I encourage readers to first follow the link and read it in its entirety before turning to my reply.

Sumner opens up his article, "This post is not about Austrian economics, a field I know relatively little about." Thus far, he and I are in perfect agreement.

Sumner then writes,

[This article] is a response to the claim that the 1929 crash was caused by a preceding inflationary bubble. I will show that the 1920s were not inflationary, and hence that there was no bubble that could have caused an economic slump which began in late 1929.

In order to prove that there was no inflationary bubble in the 1920s, Sumner goes through a list of possible definitions of "inflation" and (in his mind) shows that there was no such expansion under any of the definitions.

1. Inflation as price change: Let's start with the obvious, the 1920s was a decade of deflation; prices fell. Indeed the 1927–29 expansion was the only deflationary expansion of the entire 20th century. That's right, believe it or not the price level actually declined during the boom at the end of the 1920s.

This is correct, if by "price" we mean the consumer price index (CPI). A basket of typical household goods did indeed become cheaper from 1927 through 1929. In fact, this was one of my arguments in my own book about the Depression, to show why the modern hysteria over "deflation" is nonsense.

The typical economist or financial pundit today will warn that if prices ever began actually falling, then it would set in motion a vicious downward spiral as consumers postponed spending, waiting for further price falls. Well, this deflationary black hole obviously wasn't occurring in the heyday of the Roaring Twenties, showing that falling prices per se don't wreck an economy.

Ironically, Mises and Hayek themselves pointed to the relatively stable (i.e., noninflationary) consumer prices of the late 1920s to show why their theory (i.e., the Austrian explanation) was better than Irving Fisher's approach.Download PDF Fisher famously thought the US Fed had been doing a smashing job during the late 1920s, because after all it had kept the purchasing power of the dollar relatively stable.

From the Austrian perspective, this apparent stability was an illusion, and was masking the actual distortions building in the economy. (Had the Fed not inflated the money supply, increases in productivity would have yielded much sharper drops in consumer prices during the second half of the decade.)

Having disposed of the first case — where "inflation" refers to rising consumer prices — Sumner then turns to the a different definition for the term, namely a rising stock of money:

2. Inflation as money creation: At this point commenters start claiming that inflation doesn't mean rising prices, it means a rising money supply. I think that is absurd, as that would mean we lack a term for rising prices. But let's assume it's true. The next question is; which money? If inflation means more money, then don't you have to say "base inflation," or "M2 inflation?" After all, these quantities often go in dramatically different directions. Since the internet Austrians seem to blame the Fed, let's assume they are talking about the sort of money created by the Fed, the monetary base. In January 1920 the base was $6.909 billion, and in December 1929 it was $6.978 billion. Thus it was basically flat, and this was during a period where the US population and GDP rose dramatically.

Now this is extremely misleading. In fairness, Sumner is tackling the claim of whether there was an inflationary boom in "the 1920s," and so he understandably looked at the start and end dates for the decade. Yet look at the actual chart of the monetary base during the period:

Figure 1

By picking January 1920 as his start date, Sumner was in the midst of the huge inflationary boom during World War I (when the Fed was partially monetizing the massive debt issued by the federal government). To curb the rampant consumer price inflation (exceeding 20 percent on a year-over-year basis), the Fed jacked up rates and crashed the monetary base, ushering in the depression of 1920–1921.

Then, as the chart above clearly indicates, the Fed slammed on the gas again in early 1922. After this set in motion another unsustainable boom and inevitable bust, the Fed once again stepped on the gas in the early 1930s in a vain effort to inflate to prosperity. (See my book on the Depression, or Murray Rothbard's classic, to see the massive government distortions that made the post-1929 depression qualitatively worse than earlier ones, and prevented the smooth transition into another boom.)

To be sure, the above chart by itself doesn't clinch the Austrian story. My point is that Sumner's analysis would have you believe that the monetary base was flat throughout the 1920s, when in fact it moved at least qualitatively in the way we would expect from an Austrian perspective.

However, if Sumner's handling of the monetary base during the 1920s was a bit misleading, his treatment of other monetary aggregates might cause one's head to explode:

The broader monetary aggregates rose significantly [during the 1920s], but the government didn't even keep data on M1 and M2 until fairly recently. No one in the 1920s thought the Fed should be targeting aggregates that didn't even exist.

Let's make sure we understand the metaphysical magnificence of Sumner's argument here. In the comments he elaborated,

I've shown there was no inflation as the term was defined at the time. I've shown that there was no alternative non-inflationary policy as understood by policymakers at the time, including those in the 1920s who claimed the Fed was too inflationary. It makes no sense to argue things were inflationary because M2 went up, if M2 didn't exist. There are no policy implications. M2 was an idea invented much later.

Thus, to dispose of the "internet Austrian" claim that a rapid increase in the money stock — such as M2 — could have fueled an unsustainable boom, Sumner points out that nobody at the Fed during the 1920s even knew what "M2" was, so the things that currently comprise this measure (checking account balances, short-term deposits, etc.) couldn't possibly be at fault. I wonder how Sumner explains the massive deaths during the bubonic plague? Did doctors even know what bacteria were back then?

Unfortunately, online databases such as the St. Louis Fed don't have monetary aggregate data (such as M1, M2, etc.) going back far enough to be able to quickly generate charts. But we have this explanation from an interview with Joe Salerno, regarding the inflationary 1920s:

Including [the surrender cash value in permanent] life-insurance policies, the increase in Rothbard's money aggregate between mid-1921 and the end of 1928 totaled about 61%, yielding an annual rate of monetary inflation of 6.5%, compounded annually. Leave them out, and we get 55% over the period, or 6.0% per annum. For comparison, in the highly inflationary 1970s, the money stock grew at an average annual rate of 6.35%, including the double-digit Carter years.

Turning back to Sumner, let's look at his consideration of gold:

5. The price of gold: Lots of modern internet Austrians focus on soaring gold prices as an indicator of inflation. If we are going to use gold prices as a proxy, then here are the inflation rates for each year of the 1920s: 0%, 0%, 0%, 0%, 0%, 0%, 0%, 0%, 0%, and 0%.

This is cute, but of course hardly relevant since the United States was still on a gold standard at the time. Other asset prices did soar (as Sumner acknowledges). Regarding gold, however, we have this famous testimony in 1931 from A.C. Miller, whom Lionel Robbins called "the most experienced member of the Federal Reserve Board":

In the year 1927 … you will note the pronounced increase in [Federal Reserve] holdings [of US government securities] in the second half of the year. Coupled with the heavy purchases of acceptances it was the greatest and boldest operation ever undertaken by the Federal Reserve System, and, in my judgment, resulted in one of the most costly errors committed by it or any other banking system in the last 75 years!…

What was the object of Federal Reserve Policy in 1927? It was to bring down money rates, the call rate [the interest rate on loans to "margin buyers" who buy securities with borrowed capital — RPM] among them, because of the international importance the call rate had come to acquire. The purpose was to start an outflow of gold — to reverse the previous inflow of gold into this country.

The story is too long to recount here; the interested reader should consult my book. The short version is that following World War I, Great Britain tried to go back on the gold standard at the prewar parity, but this was an unrealistic goal given how much money they had printed during the war. The pound was hence overvalued, and gold was flowing out from the Bank of England and into the Federal Reserve. Thus, according to A.C. Miller and other evidence (such as statements by Benjamin Strong), the Fed deliberately eased its own stance in order to take pressure off of Great Britain.


Sumner will have to go back to the drawing board in his attempt to deny that there was any type of inflation during the 1920s. Using either the monetary base or broader aggregates, there was significant inflation after the 1920–1921 depression. Furthermore, we know that in 1927 the Fed deliberately adopted an "easy" policy with the aim of pushing down the very interest rate that governed stock speculation. The facts are entirely consistent with the Austrian explanation of the 1920s boom and crash.


Rodrigo González Fernández
Diplomado en "Responsabilidad Social Empresarial" de la ONU
Diplomado en "Gestión del Conocimiento" de la ONU
Diplomado en Gerencia en Administracion Publica ONU
Diplomado en Coaching Ejecutivo ONU( 
 CEL: 93934521
Santiago- Chile
Soliciten nuestros cursos de capacitación  y consultoría en GERENCIA ADMINISTRACION PUBLICA -LIDERAZGO -  GESTION DEL CONOCIMIENTO - RESPONSABILIDAD SOCIAL EMPRESARIAL – LOBBY – COACHING EMPRESARIAL-ENERGIAS RENOVABLES   ,  asesorías a nivel nacional e  internacional y están disponibles  para OTEC Y OTIC en Chile