| The sovereign debt crisis is exercising everyone at the moment and I have found it virtually impossible to get any real information about what this is about. Everything I read seems to take certain things for granted: and I am increasingly persuaded that this is not much to do with anything objective. There seems to be a few things at work: speculative attacks on one country after another for no reason other than private profit: and an ideology which is using the problem to ruthlessly further an agenda and to consolidate the power of corporations while undermining democracy. The shocked reaction to the proposal to hold a referendum in Greece is telling, IMO.
In order to try to follow this I have been having a look at Italy. Italy is the country currently under attack and I have been wondering why. There are a few facts which seem to be agreed:
1. Italy's government debt is 118% of GDP
2. Italy's economic growth is low compared to that in other european countries
3. Italy's current account is not in deficit
4. Italy has relatively high inflation
5. Italy only has to borrow at all in order to service its existing debt.
On the face of it there is no problem. Italy has had a high debt for a long time and nothing bad has happened: things are not much different now.
When a country has debt to service there are a number of ways of doing that. Inflation is one way: economic growth is another: diverting tax revenue from the provision of services into debt repayment is a third: raising tax income is a fourth: borrowing more money is a fifth. I am not sure if there are other ways of doing this so these are the only things I can consider. There is also printing more money, but that seems to not be allowed in the eurozone.
All countries get the money to do what they need to do from tax, in the first place. The group agrees to donate a proportion of the money they make to the state, so that the state can do some things which are seen to be for the benefit of all. What the government should do, and how much the proportion paid in tax ought to be, is a political decision: not an economic one. In a democracy it is the result of a complex compromise between competing groups with different interests and the aim is to arrive at a balance everybody can live with: though nobody is going to be entirely happy. From time to time different groups gain ascendancy, and the balance shifts in one direction or another. But on the whole, the matter is internal, and in fact that is what a sovereign state is: it is a group of people who sort out how they will allocate their resources for themselves.
Let us say that there is a country of 100,000 people. Between them those people make goods and services and the money (gdp) that generates is £1,000,000. They now have a fight (election).
Some of them want to have an army, which would cost £25000 and a system of justice, which would also cost £25000, and nothing else. So they would like to pay tax of 5%.
Another group of people don't want to have an army: but they do want the system of justice (£25,000) and they want to make sure that people who cannot work are ok, which would cost £100,000; and they would like some education for everybody, costing £75,000; and also a health care system estimated at £100,000. They would therefore like to pay tax of 30%.
After some negotiation they all decide they will have a system of justice they all agree on at £25,000; and they will have an army, though not as good as the first group want, so it will only cost £15,000; they will make do with employment insurance of only £75,000; and the same £75,000 for health care: and they will spent £50,000 on education.
So they will pay 24% in tax and everybody will be unhappy, but only a bit unhappy.
The government therefore has £240,000 to spend on these things and they dutifully set about buying them. The money is not enough to get the best of services for anything except criminal justice: but that is ok. What is not ok is that nobody has thought about roads during all this. And none of the other things can work without roads. The country needs £50,000 worth of roads, and this is realised after a month or two.
They can do a number of things: they can not build any roads this year because there is no money for it: but that means that people wont get to work and wont generate so much money next year. They calculate that income (gdp) will fall by £100,000 if the roads are not built.
They can ask the people to pay a special extra tax to pay for the roads: but the people have likely committed their money and wont be very happy about that:and the costs of collecting it would make it more expensive as well.
They can print some more money. That will devalue the currency somewhat and they are against inflation so that does not appeal
They can borrow the money to build the roads. That will cost more than £50,000 as well: but they should still be able to repay it over time: because they calculate that building the roads will mean folk can work and trade better so it they will have more GDP next year.
So that is what they decide to do.
When governments borrow, what they do is issue a bond. The bond agrees to pay interest twice yearly, and at the end of a fixed period the government repays the principle. So this government issues a bond for £52,000,because it has to pay interest, too, and it finds that private investors will buy that bond if it pays interest at 4% a year. The government thinks that it can repay out of next year's tax, so it says it will repay the whole sum at the end of 12 months.
This Government now has a debt of £52,000 on total income of £240,000: a debt to income ratio of about 21%. They pay one interest installment in year and are left with £51,000 debt. They have built the roads and paid for all the services agreed to.
At the end of the year the people are not especially happy with this. They like fine that they have roads: but they do not especially like the debt. Some of them think the government should have cut something else: but they don't agree what should have been cut. Some think they should have been consulted and insist they would have been perfectly happy to pay a special tax. Some think " I don't use roads and I never agreed to that". Most are disgruntled one way or another. But the deed is done.
This year there are still 100,000 people. The roads and other factors have led to increased growth of 2%: and there is inflation of 1% so they now generate £1,030,000 gdp. There is no election this year so if tax is still 24% the government gets £247,200 to pay for everything. That is unfortunate because the rate of economic growth + inflation is less than the debt+ interest: it had to be at least equal to it if the debt was to be repaid on schedule and all the other things were to be paid for.
They think they will raise tax: but there is an outcry about that. Then they think they will cut everything across the board: and there is an outcry about that too. The want to print some money, but they are part of the EU and that is not allowed. So they decide to take another loan.
This year the government would have to spend £242,400 to keep services as they were last year, because there is 1% inflation. But they also have to maintain the roads they built and which were not factored in: so they need another £10000 for that. Since they did not raise tax they have income of £247,200. and they need to pay £252,400 for services: and they need to pay £51,000 in debt and interest. The shortfall is therefore £56,200. They need to borrow £58,448 to cover that and interest. Around 24% of income.
It is clear that things are getting worse: but it is also clear that if inflation and growth were better that would not be happening. So I now understand how those things interact with government debt. That was probably obvious to you: but it wasn't to me.
But the other thing which is obvious is that the lenders have a lot of power here. One of the things which is happening to Italy is that the lenders in year 2 will not lend at 4%: now they want 6%. This is said to be due to increased risk: but the risk is not demonstrated: it is merely asserted. Italy has run a high sovereign debt since 1991 and nobody was all that worried. Italy is not actually running a deficit as the country in my example is: that is it is not raising less than it is spending on the current account. The shortfall in Italy is almost wholly due to the servicing of the debt. So an increase in the interest is creating the situation it purports to be responding to.
If the lenders are worried about default then the last thing they should do is charge usurious rates of interest. And if Italy was borrowing from a central bank which actually had an interest in solving the problem that would not happen. But that is not the situation.
The lenders are banks and financial institutions. They do not care about anything except profit. They assume that no matter what they do they will not be allowed to fail. And they assume that the politicians will bail out a sovereign country rather than let the euro collapse. One of the things that seems obvious to me is that they have been prevented from making just this kind of profit wrt Ireland and Portugal and Greece, which they were doing before. The bail outs of those countries paid off some of the loans, and so the high interest is not coming in on the bonds. I think they are in the business of income maintenance and so they are increasing their income from the next country down the line: if Italy is bailed out they will turn to Spain or the UK or France and do the same thing. If they actually feared default they would lend at lower rates, not higher: I infer that they don't. I think that explains the shock at the prospect of a referendum in Greece: it makes the possibility of default real: and that was not within their calculations.
Edited by FionaK - 2/11/2011, 19:18
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