Public debt difficulties


The answer to public debt difficulties is mainly presented as an economic problematic. Individuals and companies can deal with those complications through bankruptcy. It is a legal tool that protects a person under law in order to deal with a solvability problem, namely the incapacity to reimburse outstanding debts. But for states, declaring bankruptcy is sensibly more difficult. The idea that states can be bankrupt seems to be improbable because it looks unmanageable to oblige a state to sell off its assets since they are public assets. States are therefore facing a dilemma when they have to find a solution to public debts.

This subject is particularly relevant nowadays. Many countries have expended their public debts and there is a lot of uncertainty on how this will evolve in the future. This research takes the most recent public debt crisis and defines it in the lens of politics in order to give an example on how debts can affect a country.

The Greek debt crisis is an entanglement of many interests that are defined by the Greece belonging to Europe and the globalized world. In this setting, is the answer to the Greek debt crisis purely economic or does it have political incentives? What kinds of politics are at stake in this case? Answering those questions will allow me to give a different approach to a very recent crisis. Most of the current literature is treating this crisis in economic or political terms. My goal is to find the link between the two and to call to mind what are the most important trends. For that matter, I want to analyze debts within the power structure of the European Monetary Union (EMU) and the world. That way I will show that debts should be taken carefully when a country decides to sell government bonds because it can undermine its sovereign power and has risks for its economy.

Therefore, this paper will first show that debts have an important political angle and in the case of Greece this is greatly dependent on the European political project. The EMU seems to be an economic project but it is actually a political one. I will demonstrate that it was unable to give a valid answer to the 2008 crisis and its consequences on its member-countries. Then, I will show that the negotiations during the crisis are a testimony that the Greek public debt crisis is not only a matter of economic choices; it is a political framework that is discussed and influenced by power structures in order to define the future of the European Union. In the last part of this essay I will bring the Greek case and the European project to a broader perspective by studying the geopolitics at stake. This will allow me to understand international strategies that can influence the political responses to the debt crisis.

I will ultimately argue that we are today writing Europe’s history: this crisis is not only economic it is a political crisis with geopolitics and ideologies at stake.

I. The rise of public debt and its risks:

Initially, public debts used to be a way for states’ sovereigns to deal with emergency situations. Those debts were called sovereign debts; they were issued by kings to bankers or rich merchants and were used to defend their territory. With the industrial revolution and states development, debts were spent more frequently to build infrastructures. In this case, debts were generating an endogenous growth since they were used to expand technological capabilities and public goods, allowing the market to expend. Debts were part of today’s developed-states building. In the 20th century, state loans helped governments to conduct different projects and to reconstruct states after the two World Wars (Reinhart and Rogoff, 2010). Those policies had a Keynesian nature because they were guarantying the debt sustainability by stimulating growth. The reason is that public investments permitted by those loans increased the global revenue and allowed better tax revenue years later in order to reimburse creditors and bring back the debt at a lower level. Moreover, Reinhart and Rogoff, two American economists that studied the impact of debt on growth, observe that the manner in which debt builds up can be central. They argue that:

[…] war debts are less problematic for future growth and inflation than large debts that are accumulated in peacetime. Postwar growth tends to be high as wartime allocation of manpower spending, typically the cause of the debt buildup comes to a natural close as peace returns. In contrast, a peacetime debt explosion often reflects unstable political economy dynamics that can persist for very long periods (2010:574).

With the emergence of financial markets, investments in public debts have exploded since they represent little risks compared to other assets. If debtors believe in the reliability of a country they see a profitable and low danger investment in buying government bonds. Following this logic, the growth of public debts has become the norm in developed countries because developed states have certain credibility and their indebtedness is allowing a better performance of the financial system. The Modern Monetary Theory (MMT) can further explain that “government debt in a sovereign economy is popular in financial markets since it offers a benchmark for pricing risky financial securities, and aids in balancing certain risks (e.g. credit risk, liquidity risk) in investment portfolio” (Sharpe, 2013:712). Wolfrang Streeck (2012) acknowledges that there is also a correlation with the attempt to sustain and restore economic performance in times of low growth in developed countries. Consequently, “Public indebtedness among OECD countries more than doubled in the roughly four decades between the 1970s and 2010 from about 40 percent of GDP to more than 90 percent” (Streeck, 2012:3). However, states’ trustworthiness is hard to quantify for the market because it can depend on different parameters (even for developed countries). It can be because of the economic capability of the country, the reliability of its political and fiscal institutions, its currency or the financial market momentum. Rating agencies such as Standard and Poor’s or Moody’s are in charge of giving reliable indicators to the market. But they notably didn’t expect the last financial crisis.

We can consider that there is a limit for debt sustainability: when it exceeds a certain boundary, debts can become a real burden for the economy. High public debt ratios can decrease the rate of growth for two reasons. First, savings will impede consumption and consequently growth since households will understand that taxes are going to rise. Second public debts can crowd-out private investments from the capital market because increasing its ratio will compete with private debts for the allocation of savings, and “if the resources employed by the State are less efficiently used in comparison with the private sector, there is going to be a loss in output” (Frangakis, 2011:8).

Reinhart and Rogoff find a public debt threshold limit between 65% and 100% of GDP (Sharpe, 2013; Reinhart and Rogoff, 2010). According to the IMF and the OECD, debt accumulation in developed countries must be shortened in order to appease markets and content conditions of fiscal sustainability. Lately, the OECD argued that, “countries should reduce debt levels to around 50% of GDP or lower to provide a safety margin against future adverse shocks” (Sharpe, 2013:708). Indeed, if debts levels are too high, creditors can affect states’ solvency by questioning their real capacities. If a panic movement is created in the market, it might result in an even worst outcome than the financial shock would actually cause (Strange, 1998). It is called the contagion phenomenon. This incident increases greatly during times of crisis because market agents, such as rating agencies, question all investments characteristics. At this point, economically weak states (with important deficit and/or low GDP) will need to find policies in order to regain their reliability and access new loans.

II. The politics of public debt:

Thus, public debt assets are not always risk-free, guarantying state building, the success of an economy or returns on investments for creditors. It depends on how it is contracted and there is always a part of risk for lenders. The way they will deal with a possible default is highly political. In The new world of debt, Susan Strange states, “One basic point in political economy has to be remembered. The phenomenon of borrowing — getting money today in exchange for tomorrow — is economic, but how such transactions are managed is political” (1998:92). Moreover, the borrower-lender relation is much more difficult when the debt is transnational because it involves two states legal systems and authorities. In the past, it often was a matter of hard power and dissuasion. Lord Palmerston, in 1848, proposed:

“the smart policy of leaving open and undecided whether, in a particular case of bad transnational debt, the British government would or would not intervene, possibly with naval force, to recover unsettled claims by British investors. This uncertainty addressed the problem of moral hazard at both ends” (Strange, 1998:93).

Recently, it has become more difficult to threaten states with force in order to reimburse their debts. New bureaucratic practices and international agents such as the IMF and the World Bank have been created in order to provide a transnational answer to the issue. However, there are no formal rules at the international level that help dealing with indebtedness situations (Strange, 1998:93). Thus, public debts are an economic phenomenon and when they turn bad they need a political answer — which is until today, filled with uncertainty.

However, responses to such crisis have been following a certain trend. Since the 1990s, when a crisis aroused abroad, political officers tried to constrain it to avoid the risk of contagion. A good example is the 1994 Mexican and 1997 Asian crisis. The IMF negotiated a rescue package to avoid a default, but this is due to distress as far as economics. Indeed, “the rescue packages do work as antidotes to the virus that could attack the global financial system. They do not necessarily cure the carrier of the virus — the indebted country” (Strange, 1998:104). The nature of the rescue package is generally political reforms in exchange of money with interests. Since the 1990s, the reforms that the IMF has prescribed have been following a trend towards orthodoxy and conformity to liberal economics (Strange, 1998). Most of countries’ Public Debts have a part owned by foreign creditors. When a crisis occurs, we can understand that those creditors will use the IMF in order to regain the most of their investments because, as we have described before, it is one of the only tool they have at their disposal. The IMF will then negotiate with the country’s government to follow its set of policies. Therefore, debts don’t only obey to an economical process because the method to deal with transnational debts has an ideological incentive carried by the supra-national agents decisions.

The main policies required by urgency lenders such as the IMF are austerity measures. Austerity is defined by tightening fiscal policies in order to regain state credibility. Reinhart and Rogoff (2010) claim that the main goal is to reduce risks premium and thus stimulate market investment flows. Because “if a country does not have fiscal credibility, it will have much more difficulty in continuing its fiscal programme because creditors will refuse to continue lending or will demand a higher risk premium (OECD, 2010:5 ; Sharpe, 2013:710). Susan Strange (1988) would also agree that supra-national actors’ set of policies are made to satisfy the financial market, because it is the most powerful agent.

Austerity policies meet many critics. The main one is perfectly described by Wolfrang Streeck. He states that austerity may “encumber economic growth by cutting demand, rather than promoting it by, among other things, creating rational expectations on the part of the real economy for low taxes and higher growth in the future” (2012:16). Blyth (2013) and others (Boyer, 2012) claimed that expansionist austerity doesn’t work in financial crisis because it “may shift an increasing share of a society’s resources from citizens to creditors [and] it may shrink the sum total of available resources” (Streeck, 2012:16). Basically, austerity destroys the confidence in the future because it cuts the real economy demand factor. Keynesian economics best explain this phenomenon.

We now understand the validity of Susan Strange’s argument: economic policies to counter public debt crisis don’t heal the main wound; it is just made to stop the propagation and expects the financial market forces to determine the future sustainability of the country.

In short, I have demonstrated that public debts are an economic phenomenon that has become more important in developed countries from the industrial revolution to the financial markets development. They represent a risk for creditors and for debtors. Theorists and their empirical results debate about the actual debt threshold but they agree that a danger exists for the economy. When debts become unsustainable, a political answer is needed. In the multi state configuration of the world, the political response is confronted to sovereignty rules. Transnational institutions and creditors will try to diminish the sovereign power in order to implement the market power. Therefore, we can consider that debts relationships create an inherent duty from the state to market actors. To understand how this duty is dealt with, I will analyses the Greek debt crisis.

III. Greece and Europe in times of crisis

Today, we are in a crucial period for developed countries because of the global financial crisis of 2008. Debts in the weakest European economies have become problematic. Greece’s current public debt crisis is explicable by numerous factors. I will first enumerate the country’s debt evolution and its specific economic issues, and then I will explain the general economic trends that led to the crisis.

The period 1994-1999 in Greece was characterized by stable public debt to GDP ratio of 110% when the socialist government implemented stabilization policies in order to meet the Maastrich Criteria (Kouretas, 2011). Between 1999 and 2004, the debt to GDP ratio felt with the conservative government since growth was stimulated by the major infrastructure required to host the 2004 Athens Olympic Games and supplementary financial flows transferred from the E.U. Between 2007 and 2009, we have seen an intense increase in borrowing that resulted to a rise of the debt to GDP ratio to 130% (Kouretas, 2011). The Greek debt crisis started in 2010, it “is born out of their creditors’ fear of its ability to pay back its public debt and its accrued interests. It jointly resulted from the world economic crisis and some country-specific factors; high indebtedness (142.8% of GDP in 2010) and a large budget deficit” (Trabelsi, 2012:425). An important point is that the external debt of Greece rose from 94% in 2003 to approximately 200% at the end of 2010, which “implies that the substantial interest payments to foreign holders of Greek financial assets have led to a deterioration of the income account deficit and thus the deficit of current account” (Bank of Greece reports, 2010, 2011; Kouretas, 2011:6).

To save the monetary Union from contagion and gigantic loses for foreign creditors, the Troika (composed of the European Commission, the European Central Bank and the IMF) gave a 110 billion euros bailout package to Greece in May 2010 (Katsimi and Moutos, 2010). But other economic factors made this first bailout package ineffective to restore confidence in the Greek economy.

The Greek economy also suffers from low competitiveness and a weak private sector because it depends extensively on the public sector (Kouretas, 2011; Katsimi and Moutos, 2010). Katsaitis and Doulos (2009) show that the amount of funds transferred from EU to Greece had also adverse effects on private investment because of the weak institutional quality of Greece. The Greek government did not allocate FDI flows in order to assure revenue that will help the Greek economy. This is partly due to the nature of the clientelist state system: Greece is ranked as on of the worst country in Europe for its institutional quality (Cuckovic, 2009; Kouretas, 2011). Therefore, foreign investments were suffering from generalized corruption. Tax evasion is also significant in the Greek economy with a shadow economy as high as 30% of GDP (Schneider, 2010; Kouretas, 2010). Finally, Greek entrepreneurship is confronted to an inefficient bureaucratic system filled with corrupt officials, ranking it at the 109th best place for entrepreneurs among all countries (World Bank; Kouretas, 2011). Therefore, Greece is a small economy with weak institutions and a corrupt state. This brings the necessary question of asking how did investors take Greece as an investment prospect?

The answer seems simple; Greece gained credibility because of the EMU system and the 2000s financial bubble that facilitated blind investments:

Greece promised European leaders it would fix [its] problems if it were allowed into the European Union, and was granted transitional loans that would allow it to undertake the macroeconomic reforms necessary to reduce patrimonial corruption, reform the state administrative capacity, and improve tax collection. Private investors flooded the country with money, believing that reforms would be carried out and that the EU as a whole would take responsibility for any potential problems (Hembruff, 2013: 712).

In details, before 2008 weak economies of Europe called, by unprincipled economists, “PIGS” (for Portugal, Italy, Ireland, Greece, and Spain) enjoyed a decade of low interest rates since the creation of the European Monetary Union (EMU) in 1999. Easy credit provided by banks and governments fuelled debts in households and public sectors. The European Central Bank oversaw a spree of cross-border lending from large EU economies towards minor ones (Kouretas, 2011). Governments with high unemployment and low growth rates depended heavily on low interests bond rates to maintain their welfare system. In parallel, bank loans facilitated a property and consumption boom. The turning point for Greece happened with the preparation of the 2004 Olympic games. Infrastructures financed and constructed by French and German contractors, added to consumption credits from the same countries’ banks made Greek people imagine that they were finally part of the developed-states club while the endogenous flaws articulated above were still existent (Kouretas, 2011).

Furthermore, Timothy P. Sharpe observes that mainstream authors fail to differentiate countries that have access to full monetary-fiscal sovereignty and economies that do not, in order to explain public debts management (2013: 708). Public Debts and States revenues for PIGS in the euro-zone are extensively in the market hands because they have surrendered their currency-issuing control to the European Central Bank (ECB). It has two consequences:

First, they can only finance their spending through taxation and borrowing on the market. But, when the crisis hit the financial market, bad assets contracted to unsolvable households made tax receipts collapse and borrowing impossible because of the lack of confidence (The Economist, 2011).

Second, MMT theorists (Mitchell and Muysken 2008; Wray 1998, 2012; Sharpe, 2013) make the essential difference between a sovereign and non-sovereign economy: “A sovereign economy issues its own […] currency and operates with a flexible exchange rate. A flexible exchange regime allows the Central Bank to pursue independent monetary policy” (Sharpe, 2013:712). It is true that, at the time, devaluating its currency would have been a good policy option for Greece.

Therefore, PIGS are more vulnerable to the pressures of financial investors looking for high risk/high yield securities and “when such investors sense possible default, they embark on a self-fulfilling prophecy” and will quit the market, leading to a financial outburst (Frangakis, 2011:9). Consequently, Eurozone economies have become increasingly reliant on official support from abroad (i.e. IMF, ECB, European Commission, or the Troika) (Sharpe, 2013:712).

Briefly, the EMU permitted low-interest public bonds even in low-income European economies because the EU Institutions and the BCE backed it up. European Banks also developed attractive credits for households, seeing that a whole new consumption market got reachable. All this happened while financial markets were predominant in the European Market. In that matter, it is important to stress that the transnational debt risk that I have described in the first chapter, which makes foreign investors more precocious about their assets, got annihilated because they dealt with a seemingly strong political and monetary Union. We are now forced to note that it was not the case.

Why were European politicians not more precocious whilst the EMU was in a crucial startup phase? To respond to this question we have to recognize the importance of the global financial bubble that preceded the crisis and the general laissez-faire attitude from policy makers.

The pre-crisis naiveté of economic forces can be explained by using the psychology of denial of reality (Laplanche and Pontalis, 1967:115) to understand the financial market behavior. Marc Pilkington claims that the economic agents refused to accept the increase in risks in the five years preceding the outbreak of the financial crisis because they wanted to avoid the worry of the potential consequences. They rather preferred to trust the central banks and the regulatory institutions (Pilkington, 2011:5). Comparing economic theories with psychology might seem far-fetched but Hayek (1993) affirmed that to understand the economy, an economist that is only an economist would be a bad one. Furthermore, Edgar Morin (1999) said that it “would disport the purpose of the single discipline, being merely perceived as an end in itself” (Pilkington, 2011:3). For my study, this psychological approach describes perfectly the denial of responsibility that characterizes the comportment of financial market agents and political actors before 2008, while the EMU was in a crucial period of development. David Harvey (1982) notes, “In the course of a crisis, capitalism is forced to abandon the fictions of finance and to return to the world of cash, to the eternal verities of the monetary basis” (French, 2009:287).

The 2008 crisis was a reality check for the European Monetary system. Europe got hit full force because financial markets were filled with bad assets. The interconnection between the National banking systems made contagion more plausible and, in May 2010, a gigantic rescue package of 750 billions euros was given to the banking system in order to save it from a confidence crisis (Katsimi and Moutos, 2010).

The public bonds market seemed secure until a domino effect began, as The Economist states:

Before the crisis investors assumed no euro-zone government would default on its debt. […] Germany then signaled that defaults could happen and that investors would have to bear a share of the losses — a reasonable demand, but a hard one to introduce in the middle of a crisis. Some investors asked to be rewarded for the extra risk and others, unwilling to start paying for credit research, just walked away. This set off a spiral of falling bond prices, weakening banks and slowing growth (The Economist, 2011).

The German reaction in the worst time possible is a testimony of the lack of political framework in the monetary union. It is also because Germany’s account surplus from its export-led economy had been invested in American subprime mortgages and Greek government debt, making German banks very vulnerable to the crisis (The Economist, 2011). Maria Frangakis claims that the Greek crisis is due to a massive speculative attack on greek government bonds:

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