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Articles & Essays

The Sovereign Debt Problem
George Soros- October 05, 2010 World Leaders Forum at Columbia University As you know I have written several books which serve to explain the crash of 2008. Two years have elapsed since then ± it is time to bring the story up to date. That is what I propose to do today. The theory I shall use is the same as in my previous books, so I shall not repeat it here. The main points to remember are, first, that rational human beings do not base their decisions on reality but on their understanding of reality and the two are never the same ± although the extent of the divergence does vary from person to person and from time to time ± and it is the variance that matters. This is the principle of fallibility. Second, the participants¶ misconceptions, as expressed in market prices, affect the so-called fundamentals which market prices are supposed to reflect. This is the principle of reflexivity. The two of them together assure that both market participants and regulators have to make their decisions in conditions of uncertainty. This is the human uncertainty principle. It implies that outcomes are unlikely to correspond to expectations and markets are unable to assure the optimum allocation of resources. These implications are in direct contradiction to the theory of rational expectations and the efficient market hypothesis. The extent and degree of uncertainty is itself uncertain and variable. Conditions may range from near-equilibrium to far from equilibrium. Again, it is the variance that matters. In practice markets have a tendency to move towards one of these extremes rather than to hover near a historical or theoretical midpoint between them. In evolutionary systems theory these extremes are called ³strange attractors´. My contention is that financial markets tend towards these strange attractors, not to equilibrium. So much for theory. Now for the actual course of events. *** In the crash of 2008 the uncertainties reached such an extreme that the markets actually collapsed. But that was a short lived phenomenon. The authorities intervened and managed to keep the markets functioning by putting them on artificial life support. In retrospect, the momentary collapse may seem like a bad dream, but it was real enough and two years later we still suffer from its consequences. Let me explain why.

This meant that they had to do in the short term the exact opposite of what would be needed in the long term. If governments are now forced to pursue fiscal discipline and tighten monetary and fiscal policy too soon there is a danger that the recovery will stall. In addition. with Germany in the surplus position. Then the fiscal conservatives led by Andrew Mellon and Irving Fisher were confronted by rebels led by John Maynard Keynes. The clash of views has led to a drama which is unfolding differently in different parts of the world. That is because the imbalances that have accumulated over a quarter of a century have not yet been corrected. The deleveraging of the private sector is underway. Only when you have regained control can you correct the direction of the car. I shall briefly review how the credibility of sovereign credit came to be questioned in various parts of the world and then I shall address the question ± how much debt is too much? *** . The remarkable unanimity that prevailed in the first phase of the crisis and culminated in the one trillion dollar rescue package that was put together for the London meeting of the G20 in April 2009 has dissipated and political and ideological differences have arisen. the division of opinion is more along national lines. Before the economy has recovered and unemployment has fallen. Financial markets are functioning more or less normally with toxic credit instruments replaced or guaranteed by sovereign credit.When a car is skidding you have to turn the wheel in the direction of the skid to prevent the car from crashing. The underlying cause of the crash was the excessive use of credit and leverage. That is how the financial authorities had to deal with the crash. Because the global imbalances which were at the root of the financial crisis still remain to be corrected. Misconceptions are rampant. Only after financial markets resumed functioning could they hope to reverse course and reduce the outstanding credit and leverage. The US still consumes too much and China is still running an unsustainable export surplus vis-àvis the US. the credibility of sovereign credit has come into question. A similar imbalance prevails within the eurozone. But the second phase is running into difficulties. The discussion is eerily reminiscent of the 1930s. The only way to do it was to replace the private credit that lost credibility with the credit of the state which still commanded respect. corporations and households alike. but it is far from complete. In Europe it is heavily concentrated in the banking sector. the housing and commercial real estate bubbles in the US have not yet been fully deflated and in the eurozone the banks have not yet been properly recapitalized. The first phase of this delicate maneuver has now been successfully completed. the question arises: How much government debt is too much? That is one of the central questions confronting policymakers today. To prevent a catastrophe they had to avoid a sharp contraction of credit. In the US it applies to banks. Now. The center of fiscal conservatism is Germany. They complicate matters enormously because it would require global cooperation to correct the global imbalances. while those who have rediscovered Keynes are located mainly in the United States.

But what appeared to be a currency crisis was in reality more a banking crisis and a clash of economic philosophies. The first clear reminder that the euro lacked a common treasury came after the bankruptcy of Lehman Brothers. these countries grew faster and developed trade deficits within the eurozone. European banks hold more than a trillion euros of Spanish debt of which more than half is held by German and French banks. became more competitive and developed a chronic trade surplus. Instead of the convergence prescribed by the Maastricht Treaty.Doubts concerning sovereign credit first reached a crisis point in Europe and they revolved around the euro. It led to a radical narrowing of interest rate differentials and that. in turn. Greece and Ireland. But Angela Merkel opposed a joint Europe-wide guarantee. when it comes to sovereign credit they are on their own. the financial markets were so impressed by the guarantee that they hardly noticed the difference. this fact was obscured until recently by the willingness of the European Central Bank to accept the sovereign debt of all member countries on equal terms at its discount window. The euro was an incomplete currency to start with. Unfortunately. notably Hungary and the Baltic States into difficulties. while Germany reigned in its labor costs. depriving them of the capacity to add to their positions. Capital fled from the countries which were not in a position to offer similar guarantees pushing the countries of Eastern Europe. generated real estate bubbles in countries like Spain. But interest rate differentials within the eurozone remained minimal. This allowed the member countries to borrow at practically the same interest rate as Germany and the banks were happy to earn a few extra pennies on supposedly risk-free assets by loading up their balance sheets with the government debt of the weaker countries. The finance ministers of the European Union promised that no other financial institution whose failure could endanger the system would be allowed to default. For instance. Greece started the process when the newly elected government revealed that the previous government had lied and the deficit for 2009 was much larger than indicated. The discount facility of the ECB allowed the deficit countries to continue borrowing at practically the same rates as Germany. The large positions came to endanger the creditworthiness of the European banking system. At first. but it was the introduction of the euro and ECB¶s willingness to refinance sovereign debt that got the banks weighed down with these large positions in the first place. So even though member countries share a common currency. The euro boasted a common central bank but it lacked a common treasury. each country had to take care of its own banks. relieving them of any pressure to correct their excesses. So the introduction of the euro was indirectly responsible for the development of internal imbalances within the eurozone. . Although it was the inability of the banks to continue accumulating the government debt of the heavily indebted countries that precipitated the crisis. It was only this year that financial markets started to worry about the accumulation of sovereign debt within the eurozone. The Maastricht Treaty established a monetary union without a political union.

Markets panicked and interest rate differentials widened dramatically. it was unwilling to act. which had been traumatized by two episodes of runaway inflation. As a result. was adamantly opposed to any bailout. It is this clause that has made the crisis so difficult to deal with. when practically all member countries are in violation of the Maastricht criteria. but it is a step in that direction. But the European authorities were slow to react because member countries held radically different views. ¼500 billion from the member states and ¼250 billion from the IMF. and nothing could be done without Germany. So the Greek crisis festered and spread. And deflation renders the burden of accumulated debt even heavier. Germany is not only insisting on strict fiscal discipline for the weaker countries but is also reducing its own fiscal deficit. So. France was more willing to show its solidarity. This brings me to the gravest defect in the euro¶s design. Now these countries are expected to return to the Maastricht criteria in short order. And now. there is neither an adjustment mechanism nor an exit mechanism. What is worse. So the crisis has passed its high water mark and the euro is here to stay. tax receipts. When Germany agreed to substitute the euro for Deutschmark it insisted on strong safeguards to maintain the value of the currency. Moreover. creating deflation. When the authorities finally got their act together they had to offer a much larger rescue package than would have been necessary if they had acted earlier. in the absence of exchange rate depreciation. in order to reassure the markets. But it is far too early to celebrate because the emerging common fiscal policy is dictated by Germany and Germany is wedded to a false doctrine of macro-economic stability which recognizes only the threat of inflation and ignores the possibility of deflation. In the meantime. the ECB was given an asymmetric directive. the authorities had to put together a ¼750 billion European Financial Stabilization Fund. It is liable to push Europe into a period of . Since Germany was heading for elections. This misconception is incorporated in the constitution of the euro. Germany. It expects member states to abide by the Maastricht criteria without establishing an adequate enforcement mechanism. the lack of a common treasury. The turning point came when China re-entered the market and bought Spanish bonds and the euro. and consumption reinforce each other and are not offset by exports. the euro has begun to remedy its main shortcoming. they need to cut wages and prices. it is difficult to see how the weaker countries could regain their competitiveness vis-à-vis Germany and start growing again because. When both creditor and debtor countries are reducing deficits at a time of high unemployment they set in motion a deflationary spiral in debtor countries. the Maastricht Treaty contains a clause that expressly prohibits bailouts and the ban has been reaffirmed by the German Constitutional Court. Reductions in employment. it does not allow for error. raising the prospect that deficit reduction targets will not be met and further reductions will be required. doubts about the creditworthiness of sovereign debt spread to the other deficit countries and. Deficit reduction by a creditor country such as Germany is in direct contradiction of the lessons learnt from the Great Depression of the 1930s. Member countries are now a little bit pregnant and they will be obliged to take additional steps if necessary. And even if budgetary targets were met. The Stabilization Fund is very far from a unified fiscal policy. under duress.

The Republican opposition has succeeded in blaming the Crash of 2008 and the subsequent recession and persistent high unemployment on the ineptitude of government and in claiming that the stimulus package was largely wasted. Canada. This favored Germany against its main competitor. European debtor countries have to pay hefty premiums over the price at which Germany can borrow. but at the meeting the US yielded to the majority and agreed that budget deficits should be cut in half by 2013. Prior to the meeting President Obama publicly appealed to Chancellor Angela Merkel to change her ways. Angela Merkel went into the recent G20 meeting in the minority and ± with the help of the host country. It has no desire to impose its will on Europe. As a result Germany objectively determines the financial and macroeconomic policies of the Eurozone without being subjectively aware of it. Japan. So the euro. all it wants to do is to maintain its competitiveness and avoid becoming the deep pocket to the rest of Europe. But people in Germany are unlikely to recognize this because they are doing much better than the others and the difficulties of the others can be blamed on structural rigidities. since the unpopular policies are imposed from the outside. produce social unrest and. And the euro-crisis brought about a decline in the value of the euro. That may. and the newly elected Conservative British Prime Minister. And the policies it is imposing on the eurozone are liable to send the eurozone into a deflationary spiral. Germany is the shining star in the economic firmament. in turn. turn public opinion against the European Union. Germany believes it is doing the right thing. As I explained earlier. The US is not under the same pressure from the bond markets as the heavily indebted states of Europe. The policies of the Obama administration are dictated not by financial necessity but by political considerations. This may be the right policy but it comes at the wrong time. interest rates on US government bonds have been falling and are near record lows. It dealt with the burden of reunification by reducing its labor costs becoming more competitive and developing a chronic trade surplus. The Crash of 2008 was primarily a market failure and the fault of the regulators was that they failed to regulate. In the second quarter of 2010 the GDP jumped by 9% annualized. with its asymmetric directive. The public is deeply troubled by the accumulation of public debt. the government was obliged to do in the short run the exact opposite of . The German commitment to fiscal rectitude is also gaining the upper hand in the rest of the world. It is true that the stimulus was largely wasted but that was because most of it went to sustain consumption and did not correct the underlying imbalances. Germany is unlikely to realize that it is following the wrong macroeconomic policy because that policy is actually working to its advantage. may endanger the social and political cohesion of Europe. By contrast. Without a bailout the financial system would have stayed paralyzed and the subsequent recession would have been much deeper and longer. There is an element of truth in this narrative but it is far too one sided. Unfortunately. David Cameron ± came out as the winner.prolonged stagnation or worse. This means that financial markets anticipate deflation not inflation. The pressure is entirely political. But as the strongest and most creditworthy country it is in the driver¶s seat.

the administration had deployed the so± called ³confidence multiplier´ to restore confidence and that turned to disappointment when unemployment failed to fall. It is the Obama administration that has failed to make a convincing case. Quantitative easing is more likely to stimulate corporations to devour each other than to create employment. But that seems unattainable in the current political environment. I believe there is a strong case for further stimulus. I do not believe that monetary policy can be successfully substituted for fiscal policy. consumption cannot be sustained indefinitely by running up the national debt. The imbalance between consumption and investment needs to be corrected. But to cut back on government spending at a time of largescale unemployment would ignore all the lessons learned from the Great Depression. The administration feels that it has to pay lip service to fiscal rectitude even if it recognizes that the timing may be premature. The Republicans are campaigning against any further stimulus and they seem to be winning the argument. But the Obama administration considered that politically unacceptable because it would amounted to nationalizing the banks and it would have been called socialism. was in the way it bailed out the banking system: it helped the banks earn their way out of a hole by supplying them with cheap money and relieving them of some of their bad assets. Corporations operate very profitably. Again. Perhaps a Republican victory will give them more confidence. in my opinion. on a strictly economic calculation it would have been more effective to inject new equity into the balance sheets of the banks. they are building up their liquidity. That was the source of the resentment that the Tea Party exploited so successfully.what is needed in the long run. The Obama administration has in fact been very friendly to business. The obvious solution is to draw a distinction in the budget between investments and current consumption and increase the former while reducing the latter. Admittedly. this belief is not without justification: a quarter of a century of agitation calling the government bad has resulted in bad government. That political decision backfired and caused a serious political backlash. I disagree. but in its absence investment and employment needs to be stimulated by the government. A large majority of the population is convinced that the government is incapable of efficiently managing an investment program aimed at improving the physical and human infrastructure. but instead of investing their profits. . But this was an entirely political decision. In addition. Where the Obama administration did go wrong. We shall soon find out. There are times like the present when we cannot count on the private sector to employ the available resources. Now consumption still needs to fall as a percentage of the GDP and fiscal and monetary stimulus are still needed to keep the GDP from falling and to prevent a deflationary spiral. The public saw the banks earning bumper profits and paying large bonuses while they were badly squeezed by their credit card charges jumping from 8% to nearly 30%. The Administration is now on the defensive. But the argument that stimulus spending is inevitably wasted is patently false: the New Deal produced the Tennessee Valley Authority and the Triborough Bridge.

on the contrary. The right policy is to reduce the imbalances as fast as possible while keeping the increase in the debt burden to a minimum. There are a number of variables involved. the real return on such instruments is considered attractive by the Japanese. That is not to say that it would be sound policy for the US to maintain interest rates at zero and preserve the current imbalances by issuing government debt indefinitely. choking off the recovery. That is because the question does not have a hard and fast answer.This brings us to the question I raised earlier. . the prevailing rate of deficit financing becomes unsustainable and needs to be reigned in. the debt burden is not an absolute amount but a ratio between the debt and the GDP. But premature fiscal tightening may choke off the recovery prematurely. interest rates on US government bonds may well be heading in the same direction. The higher the GDP the smaller the burden represented by a given amount of debt. Yet ten year bonds yield little more than 1%. The real reason why Japanese interest rates are so low is that the private sector ± individuals. This can be done in a number of ways but cutting the budget deficit in half by 2013 while the economy operating far below capacity is not one of them. So does engineering a moderate rate of inflation by depreciating the dollar against the renminbi. What stands in the way are misconceptions about budget deficits exploited for partisan and ideological purposes. Once the economy starts growing again interest rates will rise and if the accumulated debt is too big it may rise precipitously. The other important variable is the interest rate: the higher the interest rate the heavier the debt burden. But that is not such a big difference as long as China does not allow its currency to appreciate because that policy obliges China to finance the deficit one way or another. How much room does the government have for fiscal stimulus? How much public debt is too much? This is not the only unresolved question but it is at the center of political debate and the debate is riddled with misconceptions. one of the highest in the world. Exactly where the tipping point is located remains uncertain because it is dependent on prevailing attitudes. Admittedly. There is a real danger that the premature pursuit of fiscal rectitude may wreck the recovery. To start with. I am making an important assertion. In this context the risk premium attached to the interest rate is particularly important: once it starts rising. banks and corporations ± have little appetite for investing abroad and prefer ten year government bonds at a 1% to cash at zero percent. In saying this I am not being evasive. The big difference is that Japan has a trade surplus and the US a deficit. The tolerance for public debt is highly dependent on the participants¶ perceptions and misconceptions. Take the case of Japan: its debt ratio is approaching 200%. With the price level falling and the population aging. As long as US banks can borrow at near zero and buy government bonds without having to commit equity and the dollar is not allowed to depreciate against the renminbi. Investing in infrastructure and education makes more sense. In other words it is reflexive. Japan used to have a high savings rate but it has an ageing and shrinking population and its current savings rate is about the same as the US.

6) To deal with the other major problem .the inability of some governments to borrow at reasonable interest rates . The creditor countries can indirectly impose discipline on Italy by controlling how much Rome can borrow in this way. All this enables countries such as Italy to borrow short-term at very low cost while the ECB is not lending to the governments and not printing money. This will re-establish co-operation between the ECB and eurozone governments and allow a meaningful voluntary reduction in the Greek debt with EFSF participation. This removes one of the main sources of the current credit crunch and reassures financial markets. This is in accordance with the German position and more helpful to France than immediate recapitalisation.the ECB lowers the discount rate. the EFSF to accept the solvency risks. Recapitalisation is postponed but it will still be on a national basis when it occurs.the ECB to provide liquidity. Any ECB purchases are sterilised by the ECB issuing its own bills. Those who refuse are denied access to the discount window of the ECB. Banks can be recapitalised and the eurozone member states can agree on a common fiscal policy in a calmer atmosphere . 7) Markets will be impressed by the fact that the authorities are united and have sufficient funds at their disposal. 3) The EFSF is then used to guarantee the banking system. 5) The ECB instructs banks to maintain credit lines and loan portfolios while installing inspectors to control risks banks take for their own account.My seven point plan to save the eurozone George Soros | Financial Times | October 25. 4) In return for the guarantee big banks agree to take instructions from the ECB acting on behalf of governments. not government bonds. They appeal to European Central Bank to co-operate with the European financial stability facility in dealing with the financial crisis in the interim . encourages these governments to issue treasury bills and encourages the banks to keep their liquidity in the form of these bills instead of deposits at the ECB. The solvency risk is guaranteed by the EFSF. the EFSF takes over the Greek bonds held by the ECB and the International Monetary Fund. The ECB stops open market purchases. 2011 1) Member states of the eurozone agree on the need for a new treaty creating a common treasury in due course. 2) Accordingly. Soon Italy will be able to borrow in the market at reasonable rates.