Opinions - 06.08.2014 - 00:00 

“Saving in order to invest”

Argentina’s payment default again raises the question as to how much sovereign debt is sustainable. There would be little gain for future generations if they inherited a lower sovereign debt but at the same time a less efficient economy, writes HSG professor Christian Keuschnigg.
Source: HSG Newsroom


5 July 2014. In the eurozone, sovereign debt amounted to an average of over 90% of the GDP in 2013. Besides competitiveness drifting apart and a lack of stability on the part of the banks, excessive sovereign debt was a driver of the euro crisis, which annihilated huge of assets and caused great losses in income and unemployment.

There is no simple limit to sovereign debt. For a strong country with robust growth, a debt of 90% is no problem, but for an economically weak country it is too much. The limits to indebtedness are revealed on the capital market when government bonds become due and must be refinanced.

As in a check on creditworthiness, investors ask themselves whether the newly issued bonds would still be serviced when they become due. Investors must assess the extent of a country’s growth potential, how far the sources of taxation can still be exhausted, which other indispensable government expenditure has priority and whether there will be enough left to service the debt safely.

If this check has a negative result, government bonds that become due cannot be refinanced and there will be a payment default. Cautious debt management will fix the terms and structures of sovereign debt in such a way that the due dates of bonds will not conglomerate in one year and that the country will not have to make excessive use of the capital markets.

Incurring debts is attractive to politicians

A low sovereign debt is in the national interest. For a start, increasing sovereign debt is tantamount to relieving the present generations of a burden to the detriment of future generations. If families and companies save and invest money in order to boost children’s economic prospects, then it cannot be in the national interest if the government does the opposite with new debts. Secondly, it is one of the government’s core functions to stabilise economic conditions in order to protect citizens against avoidable income risks. This, however, cannot be done if a country goes into recession owing to excessive sovereign debt and because it is unable to finance the transitional deficits. Thirdly, low sovereign debt secures low interest rates thanks to undoubted creditworthiness, which turns the country into a safe haven for investors.

When the interest load is low, less money must be diverted from taxation to service interest payments, which means that more is left for productive government functions. Excessive debt, however, turns a country into a risk for investors, who have to be compensated for this risk by means of higher interest rates. The country becomes vulnerable to a sudden loss of confidence.

The fear of high income losses is apt to trigger a flight from government bonds, which leads to strong price losses and soaring interest rates, thus bringing about national bankruptcy as in a self-fulfilling prophecy. Such a scenario can only occur, however, if the debt is too high in the first place and its sustainability is doubtful. Unfortunately, political competition encourages a certain amount of short-sightedness and often makes sovereign debt attractive to decision-makers.

The risk of a currency union

The advantages of low taxes and generous government expenditure can be recognised immediately and are politically palpable, whereas the disadvantages of a higher sovereign debt are less clear-cut and will only bite years later – possibly after one’s own term of office. For the same reason, generous social spending and subsidies can be felt at once and are politically attractive, whereas spending on education, research and public investments first call for a sacrifice and will also only bring about success years later.

However, this expenditure is important for safeguarding the sustainability of sovereign debt. In a currency union, there is the further moral hazard that a country is able to incur a great amount of debt and to foist off at least part of this encumbrance on other member countries in the case of threatening insolvency. The latter will have to come to the rescue in order to prevent a spread of the crisis and to guarantee the continued existence of the union. Ultimately, it is possible to escape the obligation to service the sovereign debt by means of a haircut, thus foisting off the encumbrance on investors who are anonymous or enjoy little political popularity – with consequences that are costly in the long term. The country’s failure to perform contracts and a lack of legal security damage investment security and hamper growth.

The moral hazard of excessive debt funding can be countered. One important brake is capital market discipline. A country with increasingly dubious sustainability of sovereign debt must pay higher interest rates in order to compensate investors for the higher risk and, in an extreme case, is barred from the capital market. Secondly, institutional rules are required such as the brake on debt in Switzerland and the fiscal pact in the Eurozone. These rules narrow the politicians’ decision-making scope and are more effective if they are enshrined in the constitution. And thirdly, independent institutions like the International Monetary Fund (IMF) and the European Stability Mechanism (ESM) play a central part.

They provide stricken countries with refinancing, though strictly against the satisfaction of severe reform precepts that aim to restore the sustainability of sovereign debt. Besides fiscal consolidation, these precepts include severe structural reforms serving to strengthen growth forces. The emergency loans granted by the IMF and the ESM go hand in hand with a substantial loss of sovereignty and thus also have a preventive and deterrent effect. If the sovereign debt cannot even be made sustainable with strict reform precepts, then an intervention by the IMF and the ESM must be preceded by a haircut to such a level as will make the remaining debt sustainable.

Primarily reduce consumption spending and transfers
With or without IMF or ESM intervention, the question arises as to how the debt can be reduced: whether by means of higher taxation or lower expenditure. This is quite fundamentally about the extent of government activities. Since the economic costs of taxation increase progressively with the level of taxation, countries with a high public spending ratio will find their situation more sustainable if they cut expenditure. A raise in taxation would quickly generate more revenue, but then growth-impeding effects would begin to bite and people would put up resistance against taxation. This would erode tax efficiency, programme the next tax raise and hamper the growth forces yet again.

Cutting expenditure avoids this vicious circle and has more durable effects. However, any growth-relevant expenditure on education and research must be maintained or even extended. Non-investment spending, such as subsidies, social security and administration, must be cut all the more.

Saving means foregoing some things in order to invest. Both should take place at the same time for the country to be able to grow out of debt more easily. There would be little gain for future generations if they inherited a smaller sovereign debt but at the same time a less efficient economy.

This op-ed first appeared in Finanz und Wirtschaft on 6 August 2014.

Photo: Photocase / uni_com