31 May 2019

"The euro crisis had its own dynamics"

At a conference at Goethe University, academics discussed the phenomenon of public debt from an economic-historical perspective

More than ten years after the beginning of the financial crisis, the situation of the public budgets has hardly improved: many countries worldwide are still heavily indebted; according to the International Monetary Fund, Japan is the country with the highest level of debt at almost 240 percent of gross domestic product. In mid-May, theoretical and historical perspectives of public debt were the focus of a research conference at Goethe University in Frankfurt. It was jointly organized by the House of Finance, the Institute for Banking and Financial History (IBF) and the SAFE Research Center. Altogether, six papers were presented and discussed, including studies on government bonds, public debt and national divisions, case studies on debt in Italy and Germany, a study on the link between public debt and financial stability, and an analysis on government debt over the centuries. The conference was supported by Bankhaus Metzler and the Friedrich Flick Förderungsstifung. Michael Klaus from Bankhaus Metzler opened the conference with a welcoming address in which he underlined the topicality of the issue and pointed to the unsolved debt problem in the US and Europe.

Not a typical debt crisis

Kris Mitchener, Professor at Leavey School of Business at Santa Clara University, held a speech on the long-term prospects of the sovereign debt crisis in the European Union. This crisis, in fact, should not have been a surprise for the markets, he said. After all, insolvent states were no exception historically. "Since 1820 there have been 248 external defaults from 107 states and colonies," Mitchener said. According to him, the markets priced in this risk only slowly and granted European peripheral states such as Greece or Portugal almost the same financing conditions as Germany for a long time. However, spreads had widened with the outbreak of the financial crisis – although not in countries like Germany, France or the United Kingdom, whose credit institutions had a particularly high number of bad US mortgage-backed securities in their books.

For this reason, Mitchener does not see the euro crisis as a typical debt crisis that spread across borders through shared risk exposure. "The euro crisis had its own dynamics," said Mitchener, recalling Greece's accession in 1999. From 2000 onwards, the country had a level of debt similar to that of a non-member country of the Monetary Union, while the financing conditions on the market were similar to those of the other members. At the same time, inflation rates in the Member States of the Monetary Union converged in subsequent years, as did financing rates. "This shows that the markets were assuming that there could implicitly be no default risk on government debt instruments of members of the Monetary Union," Mitchener said.

He outlined several aspects which, in his view, were new or unusual in this crisis. First, it was a debt crisis of developed countries – in the years before the euro crisis, there had been defaults in emerging markets such as Russia and Argentina. Secondly, it was a crisis without default. Greece had not missed any repayment installments or breached any other obligations until 2012, but then demanded new credit conditions.  He also pointed out that the changed financing conditions of the state had an impact on the real economy and led to a decline in output. Greece, for example, has lost 20 percent of its gross domestic product since 2008, he said.

Further, Mitchener described "financialization", i.e. the increasing importance of financial motives of financial markets, financial institutions and their actors for the national and internal economy, as characteristic of the euro crisis. This also applies to the state-bank nexus ("doom loop"), through which the credit institution and the state become interdependent due to high stocks of government debt securities in the banks' books. "It looks as if these issues will accompany us in the next crises," Mitchener said.

Risk shift in the crisis

Claudia Buch, Vice-President of the Deutsche Bundesbank, spoke about the relationship between private and public debt and the implications for financial stability. Financial crises are be preceded by a decoupling of debt from economic fundamentals, she said; moreover, according to Buch, the reduction of debt after the crisis affects production. In her presentation, she showed that the trends in private and public debt are very different internationally. She made clear that recessions after a credit boom are more severe and cause higher social costs than normal recessions.

In a crisis, risks tend to shift from the private to the public sector, Buch said. Implicit government support for credit institutions would then turn explicit. According to Buch, macroprudential policy is the first line of defense against financial instability. "It is particularly important in a monetary union," Buch said, especially if it is characterized by a common currency and national fiscal policy and if it is financially integrated to a high degree. Financial stability can only be achieved through close cross-border cooperation, such as that existing within the framework of the European Systemic Risk Board or the Financial Stability Committee.

Various debt raising goals

Barry Eichengreen looked at the issue of public debt from a historical perspective. The Professor of Economics and Political Science at the University of California, Berkeley, who is this year Visiting Professor of financial history at the House of Finance of Goethe University, presented a research paper together with Asmaa El-Ganainy. The researchers analyze public debt over the past centuries. Before the 19th century, states used debt, in particular, to secure their borders, wage wars and secure their own survival.

Eichengreen said, however, that the 19th century should be seen as a transitional period. Although states had lent money for wars as well, they had also used more debt to invest in infrastructure and education. Eichengreen said that debt finally rose sharply in the 20th century, partly as a result of major wars and partly as a result of development initiatives. Recessions, banking, and financial crises also played a major role for debt during this period. In the late 20th and 21st centuries, the focus shifted again: Now, for the first time, debt has risen for an expansion of social spendings, such as pensions, health care or other social services.

The history of debt management is as long as the one of debt: governments of states have tried with varying success to repay the loans taken out. There are many historical examples of defaults and restructurings, he said. However, examples such as the United Kingdom, France or the US show that it is possible to service the debt over a long period of time and repay large loans. In addition to the political will to achieve budget surpluses over longer periods of time, this also requires luck, namely the absence of crises and wars, Eichengreen said. Even rapid growth, inflation, and financial repression, for example after the Second World War, had historically been a means of reducing public debt.

But the latter instruments are less promising today, said co-author Asmaa El-Ganainy of the International Monetary Fund. A larger share of the national debt is now held by foreign creditors; moreover, such a strategy would endanger financial stability today.

Selected presentations of the conference:

Stephanie Collet

Barry Eichengreen and Asmaa El-Ganainy

Rui Esteves and Marc Flandreau

Thomas Kleinlein

Kris Mitchener