Some consolatory reading for the Greek… Irish… and Portuguese finance ministers on Friday. Citigroup chief economist Willem Buiter has taken a long hard look at other developed sovereigns — and has used the opportunity to remind that no sovereign is safe.
It’s billed as a response to a recent IMF paper arguing that default (in the eurozone in particular) would be ‘unnecessary, undesirable and unlikely’.
Taking issue with the paper’s use of the average characteristics of fiscal challenges facing advanced economies, for example, Buiter says that’s the wrong way to look at it, because each sovereign default is an outlier event, depending on a government’s unique debt profile and the market for that debt.
However — the problem with an appreciation for nuance is that it makes even the previously certain, well, uncertain. As Buiter writes (emphasis ours):
…even the fiscally best-positioned G7 countries, Germany and Canada, face major fiscal challenges. Germany would not be able to join the Euro Area today if it were not a member already, because it fails to meet the deficit criterion (no more than 3% of GDP) and the debt criterion (no more than 60% of GDP) – in the case of the public debt to GDP ratio, by a significant and growing margin. Indeed, the aggregate Euro Area fails both criteria by wide margins, and of the 16 individual member states, only Luxembourg and Finland qualify on both criteria…
Canada’s fiscal position may be enviable from a US perspective, but a gross general government debt in excess of 80% of GDP at the end of 2009 ought not to be a particular source of fiscal pride.
We conclude that no sovereign debt can and should be considered completely safe. We still consider it unlikely that there will be a sovereign default during the next five years by more than a couple of advanced economies.
That’s because you just have to look at what Buiter calls country-specific conditions before judging default risk (instead of the IMF’s approach). It also helps to read some history (links added):
Historically, before the 19th century, the norm everywhere (including in the countries that we now characterize as advanced economies) was that sovereign risk tended to be worse than the credit risk of leading merchants or private bankers…
The poor credit rating and performance of sovereigns in Western Europe before the 19th century should not come as a surprise, as prior to the modern age of broad-based income taxes and indirect taxes, the sovereign’s revenue sources were limited: seigniorage (revenue from coinage), a range of in-kind or corvée (labour supplied without pay) taxes, import and export duties and their local equivalent, tolls, Scutage, Tallage, Aids, Danegeld, Carucage, assorted excises, transactions and transfer taxes, a range of property taxes and poll taxes, including inheritance taxes and death duties, the sale of monopolies, fines, confiscation of wealth and plunder. Although the taxes were many, the revenues were low.
Modern income and indirect taxes have helped, but they (along with the centralised state) are comparatively recent innovations. Buiter says that public spending has increasingly outpaced them — and, not only that, but globalisation itself will make tax avoidance easier, building on declining norms of compliance:
Tax enforcement is costly. It is effective only if tax compliance is both a social norm and an internalised objective of most citizens, enforced by the law (and informed random auditing), by social disapproval for evasion and avoidance and by the small voice of individual conscience. Such an equilibrium is vulnerable to defection. If a sufficient number of taxpayers default from the ‘pay what you owe’ equilibrium, others will wonder why they should pay both their own taxes and a share of the taxes of those who avoid and evade their fair contributions. If enough defect, there can be a tipping point after which only the foolish and the unlucky pay their taxes in full.
Well — OK, Buiter; but you haven’t explained why default is any sort of response to this. Watching their sovereign cop out of its obligations won’t really discourage citizens from doing the same in future. Nor is it so clear that this is just a problem for advanced economies.
One can imagine Asia’s rising middle classes demanding better welfare states — but without the tax compliance norms to support them, given democracy’s weakness in the region, for example. Especially as China’s population ages faster than expected, say.
Then there are other wild cards which might make default risk more manageable for advanced economies in the future. Buiter himself has already noted greater supranational support for monetising debt away, including the ECB’s bond buying, for instance. Governments may face problems from pensions and so on — but they sure do retain control of printing presses.
Uniqueness is all, Willem.
_________________________________
At the same time, this particular observation from Buiter is interesting:
We suspect that the capacity to tax has been eroded in a number of advanced economies to the point that we may well see a higher incidence of private entities from the advanced economies ‘trading through the sovereign’, returning us to the way the world was before the broad-based income taxes and sales taxes became part of the normal economic landscape. We expect this to occur first for internationally operating companies and multinationals domiciled in one of the fiscally challenged Euro Area member states…
We would not be surprised, for instance, to see leading Spanish banks trading through the Spanish sovereign and we have already observed instances in which Italian or Greek companies had CDS spreads that were below those of the sovereign…
Well, it would be wondrous indeed if yields on Spanish bank bonds saw off both banks’ exposure to sovereign debt and their funding needs ahead of Basel III. We aren’t wholly convinced.
Then again, it’s easier to imagine Standard Chartered trading through the UK given its emerging market exposure. That might build on signs of revived equity interest in European corporates who are less reliant on fundamentals at home.
At any rate — it’s something to watch.
Related links:
Corporates won’t trade through Treasuries – Felix Salmon
What AAA corporate yields tell us – FT Alphaville
Ask now whether governments will default, but how – FT Alphaville