Sovereign Debt: A Modern Greek Tragedy

Annual Report 2011This year’s annual report includes an essay on the debt crisis facing many countries around the world. Written by Research Director Christopher J. Waller and Senior Economist Fernando Martin, “Sovereign Debt: A Modern Greek Tragedy” explains in simple terms the roots of the current crisis in Greece and other parts of Europe. In his column, St. Louis Fed President and CEO James Bullard also addresses the crisis, calling it a wake-up call for the U.S. Other features of the report are a message from our new chairman of the board, Ward Klein; lists of other board members, advisers and top managers; and highlights of our work in 2011 and the people who did that work. The Bank’s complete financial statements are also available for review in a separate PDF. (See below)

2011 Annual Report


Video on “Sovereign Debt: A Modern Greek Tragedy”

This 10-minute video captures many of the key points of the essay. Meet the co-authors and see the data that help answer the question “What’s going on?”


Mounting government debt has been in the headlines often over the past several years. On the world stage, the most serious worries seem to relate to Greece and other European countries, most notably Portugal, Ireland, Italy, and Spain-- the countries that have come to be known as the pigs. Their debts have become so staggering that default is often mentioned as a possibility, something that hasn't happened in the industrialized world since 1946. But obviously, the US has its own problems with ever-increasing debt. As a percentage of GDP, debt of the US government is as high as it has been since the end of World War II. What's going on?

Just like individuals, governments sometimes choose to consume more today at the expense of consuming less tomorrow. For individuals, think about mortgages when buying a house. For governments, think about wars. So when a war occurs, typically governments need to increase their expenditure rather suddenly and in large amounts. So rather than increasing taxes, government issued debt. The debt, of course, needs to be repaid over time. So the role of debt is really to smooth out the financing costs over time.

To curtail risk, governments borrow money for varying amounts of time. Short-term borrowing carries lower interest rates than does long-term borrowing. But when a government borrows for short periods of time, it must roll over the debt more often. Rolling over debt is like paying off your Visa card with your Mastercard. And every time a government is rolling over its debt, it is giving the lender the chance to say no, not this time. Why wouldn't creditors roll over debt?

If they think default is likely, they will either demand a higher interest rate or simply flat out refuse to roll over the existing debt. Now governments have a choice. They can either increase taxation or reduce expenditure or they can simply default on the debt.

Although default may seem like a crazy idea, it has been common throughout history, especially in the days of monarchies. In fact, that's where the term sovereign debt comes from. It was the debt of the kings and queens, and today the term refers to the debts of any central government. Is there a threshold of debt that usually triggers default?

Actually, sometimes countries with moderate levels of debt default and oftentimes countries are sustaining large amounts of debt without defaulting. For example, in the 1980s, Brazil and Mexico defaulted with relatively low levels of debt, roughly 50 percentage points of GDP, whereas Japan has been having over 100% of debt since the mid-1990s, and currently debt is over 200% of GDP.

So as Fernando mentioned, many times countries default at relatively low debt burdens. So what we've come to realize, it's not so much the ability to repay the debt as the willingness to repay the debt. And usually the willingness is a problem only because it requires some type of fiscal austerity in the form of higher taxes, cutting social services, public spending, civil servants jobs. And in that process that creates social disruptions at home. Those costs have to be borne by the country under the austerity program.

And naturally, what's going to happen is the cost are not typically borne equally. And people are going to be upset that they shouldn't have to bear the cost or somebody else should bear the cost, and this leads to a lot of political discord and unrest. And that unrest can lead to governments basically being brought down, new governments coming in. And there's a greater incentive to want to then default to avoid the political unrest and the fiscal austerity at home.

So why is this a crisis now?

So in the 1990s, Europe decided to move to a single currency, which later became known as the Euro. In the process of doing that, the countries had to begin a process of convergence with many of their key macroeconomic variables, such as the inflation rate, interest rates, to make sure that when the Euro was formed, they would all look very similar in terms of those variables. Now in addition, at one point they realized they had to also do very similar things with regard to fiscal policy. There were restrictions put on debt to GDP limits, deficits to GDP limits.

Now by 2000, a lot of this convergence had occurred and these countries began to look very similar in many ways, even though their fiscal positions looked very different. So despite the fact that they had very large differences in their debt to GDP, deficits to GDP, the financial markets began to look at these countries as being the same risk of default. And they all were being charged the same interest rate as, say, Germany, which was viewed as a soundest economy in Europe.

So as a result, many of the countries began to accumulate more debt because they were able to borrow at very low interest rates. Now the financial crisis in 2000 kind of woke everybody up to the issue about debt and the ability to repay debts. And by 2008, 2009, they began to look at these countries and say, are these debt levels sustainable? Ireland had run up a lot of debt to bail out their banking system. And a new government in Greece came into power and realized that the fiscal situation was much worse than the previous government had let on. And these two shocks began to open the market's eyes to the fact that these countries are not the same as Germany, that their chances of default were much higher than Germany, and that as a result, interest rates had to be much higher. And in fact, if there was default, they wouldn't get their money back. So a rollover became a problem.

Why have the debt loads in a couple of tiny countries in Europe caused so much havoc and drawn so much attention around the world? After all the combined GDP of Greece and Ireland is less than that for the state of Pennsylvania.

They were just the wake-up call to the bigger countries that had debt problems, namely Italy and Spain. Suddenly all the markets turn their attention to the big borrowers in Europe and began to wonder if they would be able to pay off their debts. And the rollover problem began to hit the very large economies of Italy and Spain. What does all of this mean for the United States?

In response to the recent recession, the federal government has been running deficits of a magnitude we haven't seen since World War II. What's interesting is that the US government has had no problems in issuing this debt in the market. Investors and individuals have been moving away from troubled private securities like mortgages and troubled sovereign debt from countries like Greece, Italy, Spain, et cetera, and have been buying German bonds, Japanese bonds, and American bonds. So the US has been benefiting in that sense by paying a lower interest rate on its own debt.

When a country decides to tackle its debt problems, that usually means taxes are going to be raised or spending is going to be cut or both. But there is another scenario that's been followed by many countries through the ages to help trim the debt load.

When it comes to issues debt in its own currency, one way of financing it is by simply printing money. Now the problem with printing money is that it creates inflation. And inflation, we understand, is costly. On the other hand, it's a way of defaulting a little bit of the debt all the time. So it's less costly than outright default. A good example of this is the Second World War. So the US ran a moderately high inflation of around 10% for three years. And it has been estimated at about 40% worth of GDP has been financed for inflation.

The Fed, the Federal Reserve has been concerned about the fiscal position of the US in terms of the significant increase in the debt and the deficits. Chairman Bernanke has come out several times warning that the Congress and the president need to get the fiscal house in order for the US as well, that what we currently observe is probably not sustainable long run. And the longer it goes on untouched, the more severe the problem becomes in terms of having to adjust later. And that could lead to pretty severe tax increases or spending cuts or the US may find itself in the same position as Europe in the sense that once the flight to quality that Fernando had talked about disappears, suddenly everybody else's debt looks better than ours. And then they may stop rolling over our debt to some extent.

Taking on debt can be a positive experience for an individual, for a country, and for the whole world. Think of what would have happened if the US had not borrowed money to fight World War II. Many people around the world might not be living in a free society today. But the price for borrowing must always be paid. As governments push the limits of borrowing these days, debt burdens are rising to levels that could become unsustainable, leading to further crises and periods of severe austerity. The world has moved into such an era now, and the final act of this modern tragedy is yet to come.


Spanish Translation

Annual Report 2011The annual report essay, “Sovereign Debt: A Modern Greek Tragedy,” is available in Spanish, too.

Essay in Spanish

Financial Statements from the Annual Report

In 2011, the Federal Reserve Board of Governors engaged Deloitte & Touche LLP (D&T) to audit the combined and individual financial statements of the Reserve Banks and those of the consolidated LLC entities. Each LLC will reimburse the Board of Governors for the fees related to the audit of its financial statements from the entity’s available net assets. In 2011, D&T also conducted audits of internal control over financial reporting for each of the Reserve Banks and the consolidated LLC entities. Fees for D&T’s services totaled $8 million, of which $2 million was for the audits of the consolidated LLC entities. To ensure auditor independence, the Board of Governors requires that D&T be independent in all matters relating to the audits. Specifically, D&T may not perform services for the Reserve Banks or others that would place it in a position of auditing its own work, making management decisions on behalf of the Reserve Banks, or in any other way impairing its audit independence. In 2011, the Bank did not engage D&T for any non-audit services.

Financial Statements

Back to Top