Author: Stephen Kinsella

The UK’s Chancellor of the Exchequer commended his budget to the House of Commons last week to help create a country that “wants to be prosperous, solvent and free.” Discussing Greece, Germany’s Angela Merkel said “The top priority is to avoid an uncontrolled insolvency, because that wouldn’t just hit Greece, and the danger that it hits everyone, or at least a number of other countries, is very big”

Marc Chandler of Brown Brothers Harriman wrote recently “the less solvent you are, the more sovereignty you have to give up.” In recent years Iceland, Ireland, Greece, Portugal, Spain, Italy, and Cyprus have flirted with national insolvency, been termed ‘insolvent’ by the markets, and many have had to relinquish some of their sovereignty as a result.

You are insolvent when you can’t pay your debts. Households and firms have struggled with insolvency for centuries. Insolvency is usually a balance sheet concept based around the valuation of assets. When the value of your assets is less than the value of your liabilities, you are insolvent. Usually you work out a repayment schedule with your creditors via a restructuring process.

For countries the notion of national insolvency is a newer, and potentially very misleading, idea. Countries aren’t corporations. Technically almost every country would be insolvent if if was asked to pay all of its debt using its available assets. All governments in practice secure their national debts on their abilities to levy taxes. You can’t really repossess a country, in fairness. When a sovereign borrows too much, it either pushes the debt into the future by rolling over its debt, or failing that, defaults on some or all of the debt. The history of sovereign debt is in fact the history of sovereign default. Defaults tend to happen, in bursts, about every 30 years or so. But before the current crisis, very little attention was paid to this idea of national insolvency. There are very few mentions of national insolvency during the East Asian crisis of the late 1990s, for example.

In fact national borrowing on the modern scale really only began around the seventeenth century. Before that in the monarchical era, so-called “court bankers” provided cash-strapped sovereigns with loans and quite often served as royal tax collectors and handled other fiduciary matters for them. Monarchical debts, when they were paid, were usually paid at the people’s expense. For example the land now known as Pennsylvania was given by the Crown to William Penn to repay a 16,000 pound debt. With the passing of the monarchical governance structure, responsibility for a nation’s debt moved from the rulers to the ruled. Henceforth these were the people’s debts, issued by a national bank, the Bank of England — in return for the privilege of producing its own banknotes — on behalf of the people, to their elected rulers.

I believe the analogy between national finances and insolvency is damaging. If politicians and policy makers believe their country is, literally, insolvent, then they behave differently towards their creditors. For politicians of debtor states, suddenly vast privatizations make sense, because of course you’re selling some of your remaining assets. Suddenly the will of the people of the debtor nation becomes secondary to the will of the nation’s creditors. Suddenly democracy is an expensive irrelevance in the face of an overwhelming technocratic desire for a speedy, and market-friendly, solution. There are many examples, but two come easily to mind: Europe’s fury in 2011 when then-Prime Minister of Greece George Papandreou threatened to put his country’s bailout terms to a referendum, and more recently when the Cypriot parliament refused to pass a law which would levy a deposit tax on ordinary citizens with less than 100,000 euros in the bank. When the deal to bailout Cyprus was finally done, the Financial Times reported markets rising as “the plan does not need approval from the Cypriot parliament.” Super.

Creditor countries calling the tune by which debtor countries dance is not a new invention. But using the language of insolvency to do so is new. So when and why did it happen?

The single European currency project, in depriving member states of the ability to issue their own currency, has created the conditions for something close to national insolvency when economies slump. With high debt-to-national output ratios, current account deficits, fiscal deficits, and, putting it mildly, shaky banking systems, the debtor countries of Europe look very much like insolvent firms to the markets. Their sovereign power to issue currency is gone, meaning only painful deflation through the wage channels are possible. Leaving the currency union is very, very costly. The solution is national austerity. Indeed, in some cases, like Cyprus, Ireland, and Italy, the banking systems are so big relative to the rest of the economy as to make the sovereign itself almost vestigial.

The saving of the banking system and the system as a whole is the prime concern of Europe’s policy makers — typically representing the interests of creditor countries — but what will take its place? A more or less autocratic system of coercion is the logical outcome of these policies. They come from using ideas like national insolvency to reduce the grip a people have on their sovereignty.

But there is no asset valuation concept in the founding documents of any nation state; nor should there be.

The euro is the embodiment of an internal inconsistency, the outgrowth of an economic solution to the political problem of repeated, devastating wars. This inconsistency has helped shape and deepen the development of the European Union, but has also caused many of the imbalances within the euro zone, even threatening to tear it apart.

The euro zone’s problems will not be fixed by a banking union without a central deposit insurance scheme, nor will they be fixed by a renewed wave of complex cross-border regulation.

As economist Paul DeGrauwe puts it: “The euro is a currency without a country.” Proponents of increased integration continue to argue that at some point, if the euro is to survive, the ability to directly tax euro zone citizens will become necessary. The problem is that no one, outside of Europe’s elites, particularly wants this outcome — least of all the people living within the euro zone who already identify its institutions as having a deficit of democracy.

Presumably Europe’s elites will want to continue the strategy of incremental integration towards this goal. But that won’t work this time. The debtor and creditor countries are simply too far apart in terms of their domestic political incentive structures to accommodate a solution centered around debt mutualization.

The issue is at once simple and deeply complex. The imbalances can be resolved in short order through transfers from core to peripheral countries. The transfers are required in some volume to right previously extreme imbalances and, in particular, mispriced sovereign debt.

But that is easier said than done. As a friend put the problem from the creditor states’ points of view very succinctly: Would you lend your neighbor, who had just been out partying, your credit card? This transfer from creditor to debtor states amounts, however you break it down, to asking your neighbor for their credit card, because the transfer will be made with future taxpayer’s incomes. Politically, such a transfer is nearly impossible to sell to the electorates inside the creditor states. Indeed, such transfers might actually accentuate the sense of a “democratic deficit” many Europeans feel in relation to the EU.

So: it’s a gridlock, with the people of Europe looking to technocrats because debtor states and creditor states can’t form a cohesive solution.

Enter the ECB. Recent heroic interventions by the European Central Bank, personified by ECB President Mario Draghi, have bolstered confidence that the euro will survive in some shape or form. Yet the key decision makers have only bought themselves time. The moves towards nearly unlimited liquidity for banks, coupled with the rollout of the European Stability Mechanism, has calmed fears of a contagion effect across the Eurozone.

But those actions won’t solve the unsustainable debt buildups across the euro zone. They can’t, as these actions are primarily directed at saving the banking system.

National economies have, to a certain extent, been on their own when it comes to crisis resolution. This makes no sense. Ireland, for example, has an annual output of around 214 billion dollars. Ireland’s banking system has assets and liabilities of more than 550 billion dollars. It’s a bit like asking Hawaii, with an annual output of 69 billion dollars, to bailout Bank of America, worth around 129 billion dollars. Without a federal solution, it just won’t work.

The technocrats at the ECB know this. They understand that a pan-European solution has to be found. And so they are willing to stretch, bend, and sometimes even break the rules to allow euro zone states to recover. The euro zone’s inconsistency in its makeup has to be matched by a credible inconsistency on the part of the ECB — to implement any and all policies that help states succeed in growing again.

The decision to consider a “bail in” for some Spanish banks, the altering of Portugal’s interest rate on its debt in 2012, the recent 25 billion euro promissory note deal for Ireland, and an explicit moment of monetary financing for the Greeks in August 2012 all point to the recognition by the EU authorities that these states are not capable of simultaneously remaining in the euro zone and working their way out of debt.

This presents a problem for Mario Draghi. Central banking is all about the consistent implementation of monetary policy. Now we have the ECB straying dangerously into inconsistent interference in fiscal policy. Hardliners within the euro zone will not be impressed. Yet they will have a euro zone when the crisis passes, and states will be able to borrow on their own and grow at a reasonable pace.

The heart of Europe may still be its inconsistency, but exploiting these inconsistencies may be the only way the ECB can save the euro zone.