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Greece has a sovereign debt problem. The bonds
of the Greek government have been downgraded by a major rating service. Their
prices have fallen sharply in the market. This means that the risk is high
that the government will default on its sovereign debt.
The interest rates that the Greek government
must pay in order to borrow have risen sharply. This is worsening the
government’s solvency and budget problems.
The government faces default. The
government’s various spending cutbacks haven’t solved the
problem.
They cannot solve the problem. It’s
apparently too late. The government would have to restructure its debt by
renegotiating with its multiple lenders. That’s a difficult and time-consuming
process. It would have to work out repayment while simultaneously altering
government policies so that the country’s private market economy could
expand. This involves knotty political and economic issues that take years to
resolve. The government doesn’t have this time.
The problem traces back to the earlier fact
that for some years the government was able to borrow heavily at low interest
rates. This means that it was able to sell its bonds at high prices. The
problem arose because these market prices were too high.
The sovereign debt of Greece became overvalued
due to central bank/banking system money inflation. This inflation, it should
be strongly emphasized, originated in the fiat dollar system of the United
States and the Federal Reserve.
The central banks of the world and the world
money supply are heavily influenced by what the Federal Reserve does through
a kind of multiplier effect, because foreign central banks respond to Fed
inflation with inflation of their own. Ronald I. McKinnon explained this
important process in his June 1982 article in the American Economic Review.
We see it happening today when foreign banks have to inflate in reaction to
QE2 in order to prevent their currencies from strengthening too much against
the depreciating dollar.
The high bond prices encouraged the Greek
government to borrow too heavily and to raise
government spending. But since its spending was not productive, it
didn’t produce high enough tax revenues to service the debt. In time
the government faced the problem it now has, which is not enough tax cash
flows or income to service the debt.
Monetary inflation, in other words, causes
overvalued sovereign debt. This sets in motion larger government spending,
higher debt loads, and an eventual fiscal crisis when tax revenues fall short
of what is required to maintain government spending and service the debt.
This process goes on in addition to the
business cycle effects, well-known in Austrian economics,
that inflation produces. In keeping with the analogous finance
literature on overvalued equity, I identify this process as one that involves
agency costs of overvalued sovereign debt.
This process is only made worse when major
lenders, such as large banks, have reason to believe that they occupy a
privileged position and that their bond positions will be paid off by
political means if necessary. These lenders then all the more become willing
to buy overvalued sovereign debt.
This effect of inflation is important because
of its broad applicability in an age of inflation. In particular, a number of
other countries including the U.S. have followed the Greek path.
Michael C. Jensen was the first to analyze the
agency costs of overvalued equity. Everything that he says about the dire effects on
a company’s behavior from having an overpriced stock find
a parallel when a government issues overpriced debt. The parallels are not
perfect, of course. In fact, every bit of analysis suggests that the problem
will be worse for overvalued sovereign debt.
Intuition can be a misleading guide in these
matters. We are taught that a high stock price is a good thing, and it is
a good thing when it accurately reflects value creation in the enterprise.
But not all high stock prices arise from value creation. Central bank money
inflation fosters speculation. Speculation leads to asset price bubbles. Rising prices attract naive investors.
We have twice seen in recent memory how
government/central bank inflation-produced speculation leads to a breakdown
in critically important internal market practices and institutions. First we
had overvalued stocks break down in 2000 amid hundreds of cases of overstated
earnings. Accompanying this were accounting and auditing scandals as well as
law firm and investment banking misbehavior. Second, starting in 2006 and
continuing to the present, we have the real estate bubble. We have seen
similar scandalous behavior pervading the mortgage and real estate
businesses. This has included all the major banks, all major investment
bankers, the government agencies like Fannie Mae, legislatures, law firms,
bond rating agencies, insurance companies, and auditors. The scandal went
even more deeply into the U.S. government and the Federal Reserve through
their multiple bailout activities.
This breakdown in institutions that are
supposed to act as professional agents finds its root cause in government
that goes way beyond its appropriate bounds.
In the case of overvalued equity, Jensen
points to "earnings management" that becomes lying about earnings
as one means by which management becomes corrupted in order to come through
with earnings numbers that justify its overvalued equity. The analogue is for
governments to lie about the beneficial effects of the programs and
activities that they are promoting and funding with their excessive debts. We
hear politicians today justify huge sales of overpriced government debt as
worthwhile because they are fighting recession, producing jobs and green shoots,
kick-starting the economy, and providing national security. Like phony
accounting numbers for earnings, these are all myths and lies. We hear
Federal Reserve officials peddling similar misinformation to justify their
bond purchases that are helping to keep sovereign debt overpriced.
Jensen suggests that "manning the helm of
an overvalued company feels great at first." Among other things, the
management bonuses rise steeply. Politicians likewise score among voters and
secure campaign contributions when inflation stimulates some economic
activity initially. They can point to housing projects going up or a falling
unemployment rate or the numbers of people who are first-time homeowners. The
financial and housing industries shower money on them. The Federal Reserve
can build up its image by broadcasting how it prevented the financial system
from collapsing.
But, when there is overvalued equity, Jensen
says "massive pain lies ahead". A company cannot produce real
earnings to justify its overpriced stock. It turns to earnings manipulation
and fraud. It turns to wasteful acquisitions. Nortel acquired 19 companies
between 1997 and 2001.When Nortel stock fell by 95 percent, not only was its
value destroyed but also that of these acquisitions. Companies seek out unworkable
products and build up unusable capacity.
The same massive pain goes for governments
that overextend themselves with excessive borrowing at then-low rates of
interest. This is evident in Greece. It threatens to become evident
elsewhere, including the U.S. When the nation does not produce enough income
to service the government debt, some manner of default is bound to occur.
The U.S. is finding it extremely difficult to
find a way out of the looming pain that its overvalued sovereign debt has
caused. The U.S. has over-issued debt. Its "acquisitions" lie in
every area of government spending, in particular, popular social spending
programs and a huge military establishment. Huge numbers of Americans have
been "acquired" and linked into programs like food stamps.
Huge numbers of Americans expect a future
retirement safety net courtesy of Uncle Sam. This is looking less and less
likely as time passes. As in the case of overvalued equity that eventually
crashes and burns up phantom value, U.S. sovereign debt will crash and burn
as the private market economy increasingly cannot produce sufficient revenues
to pay the taxes required to service the debts.
The proximate cause of this likelihood is
agency costs of overvalued sovereign debt.
That itself traces back to a faulty political
system that has destroyed proper constraints on the funding of government and
therefore on government size. This has three main aspects. (1) The central
bank is able to enter the sovereign debt market at will and keep the price
overvalued. (2) The government is able to impose a wide range of taxes in
order to fund its programs and debts.(3) There are
no limits to government spending and the demand for such spending is
infinite.
Let’s look at each of these briefly.
The constraint on money creation has
disappeared Government no longer competes with markets for
privately-produced and costly money in the form of gold and silver. When
government debt promised and paid gold, government had no recourse but to tax
its citizens in gold. Without that constraint, government can pay off debt by
issuing more debt and more promises to pay off in paper.
The debt is supported in price by
government’s powers to tax. As long as the people are able to
produce enough income to pay these taxes and are willing to pay them,
the system of debt expansion goes on because debts are serviced. The system
is dynamically unstable, however. The larger that government becomes, the
lower the ability of the private sector to produce real income becomes
because government spending is unproductive and prevents capital formation
This undermines the ability of people to pay the required taxes. Debt grows
but economic growth falls short of debt growth due to low growth in capital
formation. Taxes then fall short of spending and deficits rise. The
government and the country’s economy then get into an untenable
position.
The third aspect is that the U.S.
Constitution, as interpreted by the Supreme Court, does not limit government
spending or government activities and size, and this lack of limitation is
combined with an infinite demand for receipt of government funds among the
population. In other words, almost everyone stands ready to rob his neighbor
via government taxes and get the proceeds for himself through redistribution
in government spending; and there are no limits on how large this thievery
can become.
This system is dynamically unstable too. It
eventually must run into a wall or limit because the parasitic activities
will overwhelm the productive activities. This limit is now in view. The
government’s unfunded liabilities ($200 trillion by some estimates)
vastly exceed its capacity to tax at current levels. Only by outright
expropriation of wealth in the form of saved assets (seizing pensions) or by
high levels of taxation that sap human wealth can the promises be kept. Those routes spell massive
pain.
If a society does not impose limits on its own
parasitic activities, it will eventually destroy itself. If it crushes its
productive activities, it will destroy itself. If the society’s people
do not impose the proper limits on their own behavior, individually and
collectively, then they are setting a course for massive pain.
At this time, Greece does look like the future
of America. Is it too late for America? Just about. When I see this society
impose some limits on its parasitic behavior and encourage productive
behavior, I will become more optimistic. However, I’ve been waiting for
that for 40 years and I’ve yet to see it.
Michael S. Rozeff
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