Assessing Sovereign Risk
May 20, 2011
An expert panel turned to history to project some possible future consequences of growing sovereign debt problems. The panel was hosted by the Milton Friedman Institute at Chicago Booth's 2011 Management Conference.
Historically, national debt crises have sometimes been resolved by revolutions, said Thomas J. Sargent, a Distinguished Fellow at the Institute. He cited the second American Revolution of 1789, when Alexander Hamilton and creditors essentially reorganized the nation under a strong central government that assumed the debt of states. Another form of revolution is inflating the debt away, as the Russians and Germans have done, Sargent said.
“Debt loads can’t grow perpetually,” noted Sargent. “The arithmetic of government budget constraints says you’re going to have to do something to service the debt. You’re either going to have to increase taxes, decrease government expenditures, inflate it away, or default.”
Mark Brickell looked to the more recent history of the housing bubble and resulting financial crisis for useful lessons for assessing sovereign debt. “The government policy that promoted home loans inadvertently distorted the data that private sector actors and their regulators were using to measure risk, so home loans appeared to be less risky than they really were,” said Brickell, former Chairman of the International Swaps and Derivatives Association. Implicit subsidies of sovereign debt could lead to similar misjudgments and mismanagement of that debt, he said.
Brickell explained that lenders, security underwriters, rating agencies, and regulators routinely relied on historical data to project house prices and estimate future defaults on home mortgages. Pre-crisis default rates were very low, so mortgages looked like a low-risk investment.
But government policies that lowered capital requirements and loosened lending to underserved borrowers worked as subsidies, inflating the number of loans and pushing up housing prices. “The rate of defaults was artificially suppressed because distressed borrowers had no need to default. As the bubble grew, they were able to sell their home at profit or refinance their mortgage and pay off the old one.
“So we had federal policy that was distorting default data. If you taint that data, you create a problem both for the managers and the regulators.”
Brickell said he found this explanation for the crisis more satisfying than other suggested causes ranging from mania to greed, fraud, regulatory ineptitude, and ignorance. “I think makes it easier to understand why so many got it so wrong and why no investigators on the Financial Crisis Inquiry Commission have found sufficient fraud to cause $1.5 trillion in losses.”
If it’s true that subsidies can have this effect on market information that managers use to evaluate risk, many other subsidized markets could be affected, including sovereign debt markets, Brickell noted. “Where there are subsidies that distort data, they lull us into a false sense of the level of risk. Those coming to the aid of debtor nations may be making bad decisions about making more capital available than they should.
“I think it’s a good thing for regulators to think about as they consider sources of systemic and sovereign risk,” Brickell concluded.
John Cochrane, AQR Capital Management Professor of Finance in the University of Chicago Booth School of Business, pointed out that for investors assessing sovereign debt risk, flawed market data is not the only problem. You also have to forecast the actions of governments backing possible bailouts. “The habit of bailing out adds uncertainty and makes you more prone to crisis,” he said. “If only our problem was assessing the fundamentals of a nation’s financial situation and not the actions of politicians, this could be a lot easier.”
Impact in Europe
Moderator and MFI Director Lars Peter Hansen asked Cochrane to comment on dangers for the Euro and the European Central Bank arising from the debt crisis in Greece, Portugal and Ireland.
“The euro is in trouble,” replied Cochrane. He said that the EU could be operated cleanly as a currency union without a fiscal union, where the Euro was simply a common standard of value. “It would be almost the perfect currency, almost the modern gold standard. The key to that is that if you borrow too much money, you go bankrupt,” Cochrane said. “We have to agree that the way this works is that we’re all using the same currency and now you don’t get to inflate your way out of debt, you have to default your way out of debt.”
“The other way it can work is that we can have a currency union with a fiscal union. We can agree we all use this currency and all of our sovereign debts are guaranteed by the ability to print money to pay them off, but then you need some kind of mechanism to stop Tom over here from racking up the bill and saying, ‘John, you have to pay it off.’”
Instead, Cochrane said, today it’s operated as “a huge mess halfway in between,” where nations rack up the debts, and then the ECB pays them off. “That leads to inflation, which is where we are now. The ECB is buying up Greek, Irish, and Portuguese debt and issuing fresh Euros to do it. You all know where that leads sooner or later.”
Cochrane added that the debt mess in Europe also reveals some hidden dangers. “Why is the EU so anxious to bail out Greece? It turns out a lot of that Greek debt is hidden inside German and French banks. If you let Greece default, you have to explicitly bail out German and French banks, or let them go, which might be even better,” he said. The Greek bailout “is an implicit way of bailing out these banks without the public knowing.”
Moral Hazard
Asked to comment on the moral hazard posed by bailouts in Europe, Sargent again drew a comparison to early American history.
“Our government began as a big bailout of the states,” he said. The American Revolution was financed by 13 states all issuing debt and money; after the war those states were essentially 13 countries with a lot of bad debt. The central government had no power to tax and repay those debts.
“Creditors and people like Alexander Hamilton thought it was important that the U.S. had credit, so they had a revolution. They committed treason, got behind doors, and rewrote the government. They struck a bargain that the federal government would assume all the debt of those 13 states, in exchange for states giving up the most important revenue source—tariffs,” Sargent said.
By the 1830s, states had once again run up huge debts building infrastructure that the federal government refused to fund. Europeans bought state-issued bonds believing they were backed by the federal government. When states began defaulting on these bonds in the 1830s and '40s, Congress refused to bail them out this time. “I would interpret the U.S. in 1830s as a really nice example of moral hazard,” Sargent said. “Because the federal government bailed them out the first time, Europeans thought the U.S. was a good place to invest, and then, surprise!”
Brickell commented, “Moral hazard and market discipline are two sides of same coin. If you don’t have moral hazard, you have more market discipline. We need that in these sovereign debt markets; we get that partly by allowing markets to gather information at lower cost. Credit default swaps help us do that. Being able to short government debt helps us do that.”
Brickell said more public information would help. “I’d love to open the newspaper every day and see a little chart of what the CDS spread for the past 12 months has been. That would show if we have a policy problem that’s leading investors to be more concerned about the quality of our debt.”
But Cochrane objected to the idea that there could be warning signs. “Markets are inherently unpredictable. We cannot avoid risk by planning to sell on the way down when some warning comes. Risk must be held somewhere. The challenge is not to give better warning signs but to set markets up so losses can be born without a run and without chaos.”
Solutions
Asked about ways to mitigate the debt crisis, Cochrane said that one of the biggest problems is that most government debt is very short term, with maturities under one year, so nations are perpetually borrowing to roll over the debt.
“Short-term debt is fuel of financial crisis. One thing I would do if I were in charge of the Eurozone is to say, not only do we talk about limits on the level of debt, but also the kind of debt. You may not issue short-term debt because when you do you are putting a gun to everybody’s head.” He also called for more creativity in structuring debt instruments: “How about long-term debt with coupons that could be adjusted when you get in trouble? Or floating rate perpetuities linked to GDP; there are all sorts of interesting things you could do.”
Cochrane stressed that any tax solution should raise tax revenues, not tax rates. “The governments that have paid off debt in the past have done so by growing, so that reasonable tax rates times growing income paid off the actual debt. The thing that makes our government rake in the money is long-term GDP growth.”
Brickell felt that government responses to the recent financial crisis made the debt problem even worse, as the government bailed out not only individuals but also firms. While struggling with financial distress, families and firms can’t work effectively on making the family income or the company grow. The same is true for nations, he said. "If you go through this chronic cycle where you are teetering on the financial brink…the costs of that financial distress are high, and that makes me more concerned about where we’re headed.”
Still, Brickell saw reasons for optimism politically if not economically, since the Tea Party and the 2010 elections have focused attention on government debt. In Europe, as nations are asked to commit their children’s future taxes to bail out neighboring countries, political opposition may grow.
Sargent wryly agreed with Brickell that government policies worsened the debt picture in the last two or three years, but added, “that actually brought us closer to a solution because the problem is so much worse that the crisis is closer.”