November 28, 2011 Reading Time: 5 minutes

In recent days, Europe has seen two governments fall: the Prime Ministers from Greece and Italy. New governments where formed. Besides these important changes, the financial markets did not calm down; volatility and uncertainty did not go away as former governments did. This points to the fact that the problems in Europe are not political, but economic, and a change in government does not solve the problem if the economic issues are not properly addressed. Where, then, is the problem?

It cannot be emphasized enough that, even though the financial markets in Europe are under high stress, the financial crisis is a consequence, and not the cause, of the crisis. If one looks at the countries in the Euro area, budget deficits and large amounts of government debt is the norm rather than the exception. It is the governments, not the banks, who are the ones that, due to insolvency, may not be able to pay their debts. We can explore three aspects of this problem: (1) How the problem gets transferred to the financial markets, (2) why European governments do not want to renegotiate their debts and (3) the problem of regime uncertainty.

When European governments spend more than what they collect from taxes (and other sources), they issue treasury or government bonds to finance the budget gap. These bonds are sold in the open market and get into the portfolio of banks and financial institutions. Namely, European savings are used to finance government’s budget deficits. For the banks this is just an investment.  Among the options they face, they can invest in private and public bonds; but the issuance of public bonds has an important effect and an important difference.

The important effect is that they crowd out savings that otherwise would have been invested in the private market and contributing to economic growth rather than financing public spending. In this sense, budget deficits are a drag to economic growth and performance. The important difference is that governments do not respond to prices and markets signals as firms do. Firms and governments react to different incentives and face different constraints. When a firm is facing losses, they need to improve their situation to avoid ultimate bankruptcy. Governments do not try to maximize profit as firms do, but instead political power, and in some cases just spending. In this sense, budget deficits are not interpreted as a problem by policy makers as long as new debt can be issued. To cut spending is usually not the first choice governments like to make. Therefore, governments may be inclined to issue too much debt, especially if the cost of the debt will be paid by future policy makers and not by the politicians in office at the time government spending is increased.

But firms and government do share a common characteristic. Neither of them can issue debt indefinitely. Eventually, the moment comes when governments becomes insolvent and in danger of not being able to honor their debts. When this situation becomes patent, the market price of their issued bonds fall, and the banks holding government bonds in their portfolios have to face a capital loss. Government’s insolvency is extended to the financial market. The financial fragility is a symptom of the underlying budget deficit, the origin of the problem in the first place.

This situation also helps to explain why European governments do not want to default or renegotiate their debts. A default means that the debt issuers transfer all of the cost to the bond issuer. By not honoring the debt, the bond issuer faces a total loss by not being repaid and by not being able to sell the bond in the market at a good price. A renegotiation is something in between. Some of the cost of the debt is transferred to the bond holders through a reduction in the amount of the debt and/or a lengthening of the bond payments. In this case, governments transfer some of the cost of the debt to the bondholders. A renegotiation is, in practice, a default and an issuance of new bonds in compensation is what usually happens simultaneously. The original terms of the contract are not performed.

In either case, then, the bondholders face a capital loss that affects their portfolios. The holders of European bonds are the financial institutions, which are already in a weak situation. To transfer further costs by a renegotiation of the government debt the banks will have to face a further loss in the market value of their portfolios. This will not be the case if the market is already discounting this loss on the price of the bonds. But even if that were the case, bondholders would still be hurt. Even though the prices of government bonds may have fallen, the bond is still paying the original cash-flow. It is this cash-flow that will be reduced in the case of a renegotiation and this affects the banks even if they do not sell the government bonds they have on their portfolios.

When this situation is taken into consideration, it becomes clear why a change of government, as happened in Greece and Italy, does not solve the problem and financial markets remain unstable. A change of government in itself does not solve the problem. Since the underlying problem is the budget situation, this issue has to be addressed directly, clearly, and forcefully. If the markets do not know what is going to happen in the future, namely, if they face a high degree of uncertainty of the regime that will be in place, investments and economic activity do not take off. Is the budget deficit problem going to be addressed by reducing government spending or by increasing taxes? If it is the former, how and when would that happen? What kind of spending will be reduced? If it is the latter, which and by how much will taxes increase? Will it be income taxes, import tariffs, etc? Even more, will the Euro be abandoned? If so, when and how will this happen? Take the example of Greece. What will happen to the firms in Greece if the government decides to abandon the Euro and go back to the Drachma? How will these firms pay their incurred debts in Euros with banks from other countries? How will these firms pay foreign providers? The relevance if this uncertainty holds down investment to the minimum levels until it is clear what regime will be in place in the future, and so investments can be planned accordingly.

There is a lot of concern about the effects of monetary behavior during financial crises and depressions. The Great Depression is seen as a problem of a collapse of the money supply, wrongly charged to the gold standard. Monetary authorities are trying to avoid this problem. Certainly, the monetary aspects are important. But it is not less true or less important how regulations, market interference and regime uncertainty affects the market performance. To see only the monetary aspects of the crisis results in overlooking political aspects that can be just as, or more, damaging than the short run behavior of money supply.

There is something to learn from the Euro crisis. Monetary regimes cannot survive a lack of political will to keep their budgets under control. The role of monetary institutions it is not only to provide monetary stability, but also to control for government spending by not being a lender of last resort to the governments. It is not the Euro in itself that failed, but policy makers and governments by trying to break a simple economic law: no one, including governments, can spend more than their income endlessly.

Nicolas Cachanosky is a doctoral student in economics at Suffolk University, as well as a previous Sound Money Essay Contest winner.

image: Grant Cochrane/ FreeDigitalPhotos.net

Nicolás Cachanosky

Dr. Cachanosky is Associate Professor of Economics and Director of the Center for Free Enterprise at The University of Texas at El Paso Woody L. Hunt College of Business. He is also Fellow of the UCEMA Friedman-Hayek Center for the Study of a Free Society. He served as President of the Association of Private Enterprise Education (APEE, 2021-2022) and in the Board of Directors at the Mont Pelerin Society (MPS, 2018-2022).

He earned a Licentiate in Economics from the Pontificia Universidad Católica Argentina, a M.A. in Economics and Political Sciences from the Escuela Superior de Economía y Administración de Empresas (ESEADE), and his Ph.D. in Economics from Suffolk University, Boston, MA.

Dr. Cachanosky is author of Reflexiones Sobre la Economía Argentina (Instituto Acton Argentina, 2017), Monetary Equilibrium and Nominal Income Targeting (Routledge, 2019), and co-author of Austrian Capital Theory: A Modern Survey of the Essentials (Cambridge University Press, 2019), Capital and Finance: Theory and History (Routledge, 2020), and Dolarización: Una Solución para la Argentina (Editorial Claridad, 2022).

Dr. Cachanosky’s research has been published in outlets such as Journal of Economic Behavior & Organization, Public Choice, Journal of Institutional Economics, Quarterly Review of Economics and Finance, and Journal of the History of Economic Thought among other outlets.

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