Sovereign Debt: A Modern Greek Tragedy - The Moral of the Tragedy

May 07, 2012

The ability to borrow to finance current spending can be very beneficial. U.S. examples include funding World War II and building the interstate highway system, Waller says. However, borrowing is also seductive; its rewards are felt immediately and the pain is postponed until the future. It is very tempting to borrow for short-term gains while downplaying the pain to come. As a result, debt burdens can rise to unsustainable levels, leading to crisis and austerity. This is the tragedy of sovereign debt, Waller says.

Presentation (PDF)


Christopher Waller: All right, I guess this is a first quiz, for me. I think I missed one maybe somewhere. Get your clickers out. This is in the headlines right now. So we're going to ask you: What do you think the long-run fate of the European Monetary Union is going to be? Here we go. So about almost 2/3 of you think it will still exist with fewer members. About a quarter of you are absolute pessimists that it's going to implode. And there's always somebody that thinks, ah, maybe it won't change, and there may actually be more members in the future.

Here's the second thing. So now I'm going to start leading into a little bit about the U.S. I've talked about Europe, so let me think about it. How concerned are you about the level of the U.S. debt? I told you it's about 14 to 15 trillion dollars. Are you concerned? Ooh, there's a lot more people excited about this one. It's like when you teach class there's always somebody, you know, their head is down, they wake up, they start answering. Very concerned, 62 percent; somewhat concerned 31; not concerned at all, just a few of you.

All right. Here's the tricky question. You're all concerned, you're U.S. citizens, you get to elect people this year, they get to do one of these things for you. Take your pick. Well, 8 percent said just raise taxes, 27 percent said decrease spending, and 2/3 of you say you're going to have to do some of both.

Now let's go from there. So in the U.S., total deficit spending right before the start of the financial crisis went from 1.2 percent of GDP to 8.7. I mean, it exploded, in part because GDP went down and spending went up. Our federal debt—now, again, this number I'm going to show you, this excludes debt held by the Social Security Administration—so it's 68 percent of GDP in 2011, and it will go to a projected peak of 76 percent in 2013. And as I kind of hinted, if I don't exclude anybody and just say, take the total amount of debt that's been issued by the U.S. government no matter who holds it, our debt is over that 90 percent threshold. It's actually 100 percent now. We've hit triple digits.

So these deficits that I'm talking about are the result of both lower tax revenues and higher outlays. So I'll give you some simple numbers. For about the last 40 years—this is a rough rule-of-thumb—government spending or government outlays, federal, is about 20 percent of GDP; tax revenues about 18 percent of GDP. So there's about a 2 percent deficit for the U.S. over the last roughly four years. Now, it moves around and bounces around, but it's a pretty reasonable number to pick. Currently government spending or outlays is about 24 percent of GDP, and taxes are about 15 percent of GDP. So tax revenue fell 3 percentage points, government spending went up 4 percentage points. So both things happened. It wasn't one thing or the other, it was both. So those of you who said you've got to do some of both since both things are contributing to the problem, yeah, it's maybe not a bad answer that both things have to happen.

Now, here's that fascinating thing with always the U.S. Despite the large increase in our U.S. debt in the last few years and our deficit spending, our bond yields have hit near record lows. People are flocking to buy this stuff. This sounds crazy. You're running up these numbers that we're screaming at Italy and Greece, and people can't buy enough U.S. debt. Well, there's a simple explanation for this. As everything else in the world got bad, well, we still look at the U.S., it's not great, but it's sure better than everything else. So people poured out of mortgages, poured out of risky sovereign debt, and the demand for U.S. Treasuries has soared. So they bid up the price of these things and the yields have plummeted to the point where 10-year Treasury bill is paying under 2 percentage points. If you net out inflation, that's close to a negative real return. People seem to be happy around the world to get that.

I mean, I'll just make it fun. If you go ever read the Reinhart and Rogoff book, every time a country has a major financial crisis, one of the things that happens is their currency just depreciates massively because everybody is trying to dump that currency and get out. During our financial crisis the dollar went up. Everybody wanted the dollar. This is a weird thing. Here's a country in the middle of a massive, once in a hundred year kind of crisis, well, maybe twice in a hundred years, and everybody wants to hold your currency. But this shouldn't be something to say, oh, that's no problem then. Everybody wants our stuff. We can borrow as much as we want. Because I'll just tell you, look at Italy, they sat there with 100 percent of debt-to-GDP for 20 years. Nobody was worried. And then one day, bang, just like that people got spooked. And that's what can happen to us. There's nothing to say the U.S. is so special that this would never happen to us.

So what's the moral of this tragedy? Well, the moral is the following. As I tried to stress early on, the ability to borrow to finance current spending can be very beneficial for society. Borrowing is not a bad thing. And we have many examples of where we've done some things that I will argue at least personally that these were good things. We borrowed tremendously—I showed you—to finance World War II which led to the end of Nazism and Fascism, set the stage for 60, 70 years of democracy around the world. I personally think that's a pretty good thing. We built civil works projects like the interstate highway system that was incurred by borrowing, financing these projects and providing something that is a great civil project. And we also during the Great Depression, we enacted the New Deal with a lot of construction projects—various dams, various things that people think have had social value.

But this is the tragedy of this story, which is borrowing by its very nature is seductive. You get the rewards immediately. You get to borrow, you get these funds, you get to have a nice time, you get to enjoy all this immediately, and the pain of repayment is delayed until later. So it's very tempting to kind of borrow for the short-term gains and kind of kick the pain down the road. As a result, you can borrow too much. This is also what we saw with households in the first financial crisis on mortgage debt. We've seen it with governments. And suddenly you wake up one day and your debt burden is unsustainable, leads to a crisis and periods of austerity and pain and suffering. That's the tragedy of sovereign debt.

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