The Great Debate UK

By Laurence Copeland

Oh no! Sluggish growth, a declining population, earthquake and tsunami…. and now this: “Dating Agency Downgrades Japan” screams the FT front page.

That’s what happens when you scan the headlines too quickly.

On a closer look, it seems that all those elegant Tokyo office ladies are OK after all. It’s just that one of the rating agencies has put Japan on downgrade watch, only a few days after the USA got the same treatment. The fact that all the main markets other than gold appear to have taken the announcement about the U.S. in their stride should not be taken as evidence that all is well, however.

In this table I show the latest credit default swap rates (the cost in basis points of insuring 5-year Government debt against default) for nine countries. Alongside the CDS spreads, I give two key indicators of the country’s solvency: its national debt (i.e. its accumulated Government debt) and its Government budget deficit, sometimes called its Public Sector Borrowing Requirement, which is the annual addition to its national debt, both measured as proportions of national income (or GDP).

Start with Greece. You have to pay more than 13 percent to insure against a default by the Greek Government at some point within the next five years. In this situation, Greece can hardly borrow on the open market, since it would have to compensate lenders for the cost of insurance – hence, the desperate need for soft loans from the EU. Nonetheless, since its debt is already 144 percent of GDP, a figure which grew by 10 percent in 2010, and its electorate seems unable to stomach further austerity measures, you don’t need the Delphic oracle to foresee what is euphemistically known as a restructuring.

The Greek predicament is made worse by the fact that it has also allowed special interest groups – truckers, taxi drivers, lawyers etc – to wreck its international competitiveness. In domestic political terms, this means its beleaguered government faces war on two fronts – to reduce its fiscal deficit (higher taxes, spending cuts, improved tax revenues), and to open its protected services industries to competition, in the teeth of opposition determined to preserve the status quo.

Portugal is in a far less disastrous position, with debts of only 83 percent of GDP and CDS rates of “only” 659 points, but its problems are qualitatively similar to those of Greece – slow growth, uncompetitive industry and fiscal irresponsibility.

That is not all they have in common, however. As I have pointed out in previous blogs, in both cases much of their debt is owed to banks in northern Europe – especially Germany, but also France and Britain, so that the generous handouts to Greece and Portugal are actually just another round of bank bailouts. (Broadly speaking, while banks in UK, USA and Ireland were lending incontinently to housebuyers, their counterparts in France and Germany did the same for ClubMed Governments).

By contrast, Ireland has an enviable record of economic growth thanks to a low-tax, low-spending, relatively unbureaucratic regime that preserved competitiveness inspite of suffering in the pre-crisis years from the low interest policy pursued by the ECB. The result was rapid credit expansion, an unsustainable house-price boom and disaster for Ireland’s banks when the global crash arrived.

Having made the original blunder of entering the Eurozone, the Irish Government then made its second – this time, fatal – mistake, in responding to the 2008-9 crisis by guaranteeing almost all of the debts of its irresponsible commercial banks, at a cost which turned out to be crippling – maybe a third of GDP or more – hence the ballooning Government deficit, the enforced austerity and the understandable bitterness over their predicament as they find themselves in the same class as feckless ClubMed countries. Irish bitterness is even sharper when the EU – ever vigilant in its battle to keep Europe in long term decline – exploits Ireland’s current weakness to try to force it to raise corporate tax, which is one of the factors giving it a competitive edge and some hope of growing out of its current predicament.

Finally, consider France, which has a similar debt-to-GDP ratio to Germany, but with a CDS rate nearly double, a difference explained (I suspect) by two factors. First, Germany is perceived, quite rightly, as having a far more competitive economy than France. Secondly, France’s public sector is currently borrowing 8 percent of GDP, which is a serious problem, given that the French are already highly taxed, and cutting spending will involve confronting the notoriously aggressive French unions – and with a presidential election on the horizon too.

So much for the euro zone.

Now look at UK and USA. Both are borrowing around 10 percent of their national income every year, and America’s Federal debt is approaching 100 percent of GDP. So how can their CDS rates be so low? How can the cost of insuring U.S. Government debt be the same as that of Germany, which has a lower national debt and a deficit of only 3 percent of GDP?

While the Americans have only begun to talk seriously about cutting their deficit in the last week or two, the British Government claims, with some justification, that we are reaping the benefits of having made a start on the long job of putting our house in order. But this is by no means the whole story. At least as important is the fact that, unlike the euro zone member countries, Britain and America can take the dishonest escape route of inflation – printing money so as to repay our debts with devalued pounds.

Since default-by-deflation is not covered by CDS insurance, it is not reflected in the UK and U.S. CDS rates in the table, which are therefore much lower than for euro zone countries. Essentially, the CDS rates for non-euro zone countries reflect only the (remote?) prospect of massive political upheaval. (Can anyone imagine a deadlock in the U.S. Congress so serious that no majority could be found to sanction repaying Treasury bond holders?)

You may wonder why, in the face of QE1 and QE2, both countries are still able to borrow for 5 years at only a little over two percent. My guess is that, as long as the market can see that most of the new money is simply being used to restore bank reserves rather than to expanding credit, the demand for medium- and long-term debt will be strong enough to keep yields low. (In any case, there is something of a disconnect between the bond markets and the currency exchanges, where the dollar has on balance been weak ever since the crisis).

Now consider Japan, which is different again, since it has a debt-to-GDP ratio of 225 percent, a figure which was growing by nearly 10 percent per year – before the earthquake struck! In other words, its position is, on the face of it, far worse even than Greece. Yet its debt can be insured for a mere 80 points, more or less the same as France.

The explanation of this apparent anomaly is that, first, the Japanese have been printing money for about a decade while prices have tended to fall rather than rise, thanks to the caution and thrift of their household sector. The market believes that Japan can carry on indefinitely printing money to pay off its debts.

The second factor, however, is that the bulk of Japanese Government bonds are held by its own citizens. In that sense, its taxpayers owe themselves money. Moreover, large as is Japan’s Government debt, it is nonetheless smaller than its citizens’ savings (largely in its post office savings deposits), which the markets probably assume could be mobilised if the worst ever happened. One way of presenting the Japanese situation is to say that the debt overhang is a mechanism for channelling wealth from the young (i.e. taxpaying workers) to the growing generation of old folk, whose savings are in any case rising in value in real terms as prices fall ever lower.

Note that for most of the last decade, Japan has run a balance of payment surplus – not a deficit, like UK and USA. In other words, as a country, Japan has been net saving, building up its net asset position vis-a-vis the rest of the world. Whereas in Britain and America the household sector and Government share the blame for the overspending reflected in their ballooning balance of payments deficits, in Japan, by contrast, Government profligacy was more than offset by private sector thrift – indeed, the country’s expansionary fiscal and monetary policies were intended to neutralise the contractionary effect of low levels of household consumption.

No wonder the price of gold is rising. Ultimately, the world’s major currencies – dollar, euro, pound, yen – look like the Four Ugly Sisters. For the sake of comparison, look at Norway – stable, democratic, and with vast oil and gas revenues, far more than its Government can spend, leaving a large surplus to be siphoned off into its sovereign wealth fund.

No wonder it costs only 18 b.p. to insure against a Norwegian default! What’s not to like (except the climate)?

Laurence Copeland is a professor of finance at Cardiff University Business School. The opinions expressed are his own.