Friday, July 19, 2013

Sovereign Debt - the Conversion of Foreign Debt into Domestic Private Wealth

From 2001-10, Greece's foreign debt increased by 283 BEUR. This debt entered the country essentially in two ways: half of it as new debt of the state and the other half as new debt of the private sector (mostly the banking sector).

When the state borrows, it generally does so because it wants to spend money. Spending on the part of the state represents income on the part of those who receive the state's spending.

The state can spend money domestically and abroad. When it spends money abroad, the state generates income to those foreigners who receive that income (producers of submarines, for example). When the state spends money domestically, it generates wealth for those who receive it.

When the state borrows abroad, it conceptually incurs foreign debt on the part of all citizens (conceptually, all citizens are liable for the state). The state can spend that money on many different things domestically. It can hire new employees and provide good salaries to citizens who may previously have had low salaries (or none at all). It can increase the salaries of existing employees. It can increase pensions. It can increase all other public spending which, in turn, creates wealth on the recipient side.

And here is the key point: as soon as the state spends borrowed money, it increases wealth on the recipient side. That may be towns who suddenly have more money to spend. That may be public sector companies. But that is also the millions of citizens who receive their income from the state.

Put differently, money which enters the country as foreign debt is, to a large extent, converted into new domestic private wealth!

Now, much of that new private wealth may quickly disappear if its 'owners' spend it on consumption. Particularly if they spend it on consuming imported goods, the new domestic private wealth converts into income for foreigners who export to Greece.

However, that part of the new private wealth which is not spent on consumption remains private wealth (i. e. a conversion of sovereign debt into private equity has taken place). That new private wealth might be seen in real estate investments, in cash under mattrasses or in bank deposits abroad or whatever. Whichever way one slices it, it remains private wealth.

The trouble is that the owners of the new private wealth cannot understand that their new wealth is the result of sovereign debt. My brother-in-law has his own small earth-moving business; he is a workaholic and much of his work is close to hard labor; he has reinvested much of what he earned in the last couple of decades into his business; he has no debt; and - he is financially quite comfortable even now. There is no way that he could understand that his financial comfort is the result of sovereign foreign debt (without it, the villages and other important customers of his would not have had the money to place orders with him).

In Argentina during the 1980s, the general rule of thumb was that the financial assets which Argentines held abroad were at least as high as the foreign debt of the state. When applying this formula to today's Greece, it would suggest that the financial assets held by Greeks abroad would be approximately 250 BEUR. I cannot judge that number but even Greek politicians have suggested that the number could be in the ballpark. To that number, one would have to add the new domestic private wealth which was generated by foreign debt and which was not spent on consumption.

And the moral of the story? Money generally does not disappear. It just changes owners and the debt of one party can quickly be converted into private equity of another party.


  1. Some remarks in german to your post:

  2. Totally disagree with that: "part of the new private wealth which is not spent on consumption remains private wealth"
    This is not happening to an extend so as to increase consumption, there are many indications and statistical data which show that still private consumption is negative around 15%.
    How private wealth is invested is accurate, but without convincing that recession is becoming mild, reforms implemented and mainly people start believe in better years.

    Very good observations from Pr Aiginger.
    I have written to you the same.


    1. Suppose a person, in the go-go days, had a net monthly income of 10.000 Euro and his monthly expenses totalled 7.000 Euro. Could you perhaps explain to me what happened to the other 3.000 Euro?

      I referenced the period 2001-10 (and not the period since then). During this period, the state generated enormous amounts of income (financed with foreign borrowings) directly for its employees and pensioners and indirectly for most Greeks. To the extent that this income was not spent by way of expenses, it can only have remained as private wealth (which wealth, if invested in real estate, is worth less today than it was then).

      Answer this question for me, please: what do you think happened to the 80 MEUR+ deposits which were withdrawn from Greek banks in the last 2-3 years? All spent on taxes?

      From 2001-10, 283 BEUR entered the country as new foreign debt and 199 BEUR left the country by way of current account deficit. Please explain to me what happened to the difference!

      The interview with Aiginger is good but, as far as I can tell, has nothing to do with my article.

    2. Always happy to answer Herr Klaus!

      My reference period was from 2010-13.
      The 3000 euro would become consumption or a kind of investment.
      Yes from foreign borrowings generated vast amounts of income, the specific period you mention. The 80 b euro was not of course spent all in taxes or in other obligations but part of it. Foreign borrowings created this private wealth of 80 b euro which explains in a way current account deficit.
      However If the German gov has found a way by imposing a tax to Greeks with the 80 b in local and mainly foreign private wealth ( created by foreign borrowings) so as to help with a new haircut Greek state, it would be something great and fair!
      But also I remember that before 2 years when I was against those who transfer money from Greek banks you tend to give a justification like many other and especially German -Austrian banks!
      Its quite easy for Bank Of Greece to find those transfer or take 80b.

      The interview with Aiginger was irrelevant, but was an attempt to support belief that reducing targeted huge taxation (in diezel prices eg) would improve most Greeks dissapointing view of economics

      Sorry for taking so long to answer.


    3. Picture a Greek who claims ownership of a lake in Northern Greece and values it at 300 MEUR. He goes to a minister and asks him to buy the lake from him. The minister tells him that he is nuts when he thinks that he will pay 300 MEUR for that lake. Then the Greek tells the minister that 50 MEUR out of the 300 MEUR are for his own pocket. The minister no longer thinks the Greek is nuts and closes the deal.

      At the end of the day, Greece has 300 MEUR in new debt and the Greek and the minister have 300 MEUR in private wealth (which they most likely transfer to Switzerland & Co.).

      You get the gist of it?

    4. Herr Klaus, what are you saying is a bit more complicated, everybody however knew a lot before 2010, but in an environment of fake affluence (Greece) everybody was trying to share in, to profit from unfortunately and the truth was hidden, especially from Greek elites.
      However you didn't comment the 80 b € flight. You tend to interprete as a logical result, a consequence not as a part of bad management.
      To remind only that in Argentina 22 b $ left country and after that, few months later the country collapse.


    5. What is so complicated about 300 MEUR of new debt being tranformed into 300 MEUR private wealth the way I described it?

      In Argentina (or in other local currency countries), capital flight in Greek dimensions could never occur. Why? The locals don't want to get potentially worthless local currency out of the country. They want get their Dollars & Co. out of the country. And in times of crisis, a local currency country has no Dollars & Co. What left Argentina, left the country via the Bonex-market, more or less a black market.

      The first thing a local currency has to do when it hits external payment problems is to implement capital controls. All Latin countries are experts at that.

      Greece was totally diffent. The Euro in a Greek bank was the same Euro as in a German bank. EU-treaties do not allow capital controls. Via the ECB, Greek banks had de facto unlimited Euro-supply to fill the hole which deposit flight left. In short, tax payer money was sent to Greek banks so that wealthy Greeks could transfer their Euros out of the country (or put them under mattrasses). Just as simple as that!

    6. Herr Klaus if Tricet do not buy around 60 b euros of Gr bonds in 75%, i am not so sure wthether the euro would have the same "value" as relatively as in Gr today as in Germany, it would be a matter of time for Grexit!Practically speaking! Your example is almost accurate but y tend to see it from one side only. The Greeks took money out of Greece but with tolerance let me say of bureacrats and some elites in Gr AND in eu. The total absence of rules in Greece we are paying!


  3. If Greece had kept the drachma, how much foreign debt would it have?

    Furthermore, how much of drachma-period Greek public debt was internal and how much external?

    This is an important point to make because a lot of people blame the governments since the 80's for the rise in public debt, but without really differentiating between internal and external debt, or possibly without even knowing the difference between the two.

    1. If one knew how much foreign debt Greece would have today if it had kept the Drachma, then one would know exactly how much damage the Euro did to Greece's external accounts. My sense it that the increase in foreign debt would have been substantial but by far not as substantial as it was.

      'Substantial' because financial markets were running berserk and threw money at just about everyone and everything. Take Iceland and Hungary, two non-Euro countries. Bankers had convinced each other that Iceland was going to be the Wall Street of the North Sea. And in Hungary, foreign banks lent the Hungarian banks CHF and Yen so that those banks could make CHF and Yen loans to homebuilders. At the peak, I believe almost all new Hungarian homes were financed with cheap foreign currency. Fortunately, both countries were smart enough to pass laws which made the foreign lenders bleed (and they had a local currency which they could devalue).

      'Not quite as substantial’ because the borrowing rates would have been much higher. Consequenty, too much borrowing would have really exploded the budget and warned lenders (if the books had been kept correctly…).

      I am glad that you raise the issue of external versus internal debt. Since the start of my blog, I have tirelessly argued that THIS is the differentiation which must be made because IT is much more important than the sovereign debt per se.

      The key term is ‘cross-border’. What happens within the borders doesn’t really worry others. If all of Greece debt had been held domestically, I guarantee you that there would have been much less excitement between Paris/Brussels/Frankfurt/Berlin (perhaps none at all).

      When debt is cross-border, foreigners really start worrying what could happen to their loans. They don’t differentiate much between cross-border debt of the state or the banks or individual companies. They start from the premise that ‘Greece might fall into the Aegean’ and then it doesn’t matter who your borrower is. The consequence is that the run is not only against the state but against the entire country. The bankers’ slogan becomes ‘let’s run down our Greek exposure before the country falls into the Aegean’. And the Greeks reasonably start sending their money across the border to keep it safe.

      Once there is a run on the country (in the case of Greece, it began slowly in 2008, accelerated during 2009 and hit the fan in early 2010), all normal solutions cease to work. One has to renegotiate the ENTIRE CROSS-BORDER DEBT of the country (if legally possible, the domestic debt should be separated). In other words, one takes the 404 BEUR of foreign debt which Greece owed at Y/E 2010 (half in the public and half in the private sector) and reschedules that. Part of the negotiation must be that foreign trade credit remains open. The holders of those 404 BEUR know that they won’t see their money for a long time (possibly not even interest for a few years). Where should the money for repayment come from, after all???

      Before the Euro, sovereign debt of most countries could only be issued in foreign currency if the country sought foreign investors. Local currency bonds were typically only bought by national investors. So even before the Euro, countries could go bankrupt if they ran out of foreign currency (see Argentina) because they couldn’t print that.

      What most people overlooked is that the Euro is much more similar in its functioning to what a foreign currency was before the Euro. They treated the Euro like a new local currency and the results can be witnessed all over the Eurozone today. The differentiation between external and internal debt was no longer made because both were in Euros!

  4. "If the books had been kept correctly…"

    Hey, c'mon, this whole story about "Greek statistics" has been pure hyperbole. The deficit shot up not because the previous government was hiding it's true size, but because the effects of private credit contraction became apparent at about the same time that PASOK won the elections.

    Anyway, what I would like to know (and can't find it anywhere) is how much of drachma-period Greek public debt was internal, and how much was external (cross-border if you like).

    This would give us some valuable context on the rise of Greek public debt since the early 80's.

    1. Below are the BoG statistics going back to 2002. If you write to them, I am sure they would give you the statistics for previous Drachma-years.

      I was going to also link you the stats of the Ministry of Finance but for some reason I can't access their homepage (their stats are good!).

      About your c'mon: we were discussing what happened up to 2010 and not what happened thereafter. My argument was that exploding interest expense would have limited FX borrowing had Greece remained with the Drachma.

      But to your argument: the greatest deficit which Greece ever had was in 2009. Despite that, the economy shrunk by over 3% that year. When an economy has a budget deficit of about 15% and a shrinking GDP, you know that there is immense trouble ahead. Private credit contraction is what happens in every economy of the world when banks (and depositors) sense that immense trouble is ahead. This notion that somebody somehow did something to Greece is a fairy tale. Greek banks had essentially unlimited access to ECB funding throughout this time, certainly enough to replenish liquidity caused by 80 BEUR deposit flight and the current account deficit (which remained phenomenally high during the first couple of years). This was not so much a liquidity problem. It was a problem of banks, which were already in deep trouble, not wanting to make loans in the context of an economy going down the drain.

    2. I don't think we'll ever agree on this, Klaus.

      A lot of countries were running big deficits, and yet their GDP shrank during the recession. It's not as if Greece was the only one, even if it was the most prominent.

      In any case, we have governments and central banks for a reason, and that reason is to deal with situations like these. Now, by abolishing it's currency, Greece gave most of that power to Frankfurt, and Frankfurt let us down (and not only us).

      I assure you I don't view this as a fairy-tale. But if it pleases you, I mainly hold responsible the Greek politicians who abolished our currency, and who also refuse to return to it.

      So, how should have the failure of the banking system been addressed?

      There were two options.

      The first option was to use fiscal policy (i.e. even bigger deficits) to counteract private credit contraction. This would have kept the structure of the Greek economy intact, but also that of other European countries as well (i.e. it would retain the European imbalances).

      The second option was to use fiscal policy to actively change the structure of the Greek economy, i.e. build new export sectors. This would also change the structure of the other European countries (i.e. it would reduce their account surpluses).

      Of course, all this directly comes against ECB's mandate, which forbids it from directly financing governments. To this I say, to hell with the ECB's mandate, and to hell with central banks. Central banks are nothing. Countries are everything.

    3. The approach which I had recommended in the early months of my blog was different from your 2 proposals. I started from 2 givens': (a) the public sector must be shrunk significantly, partially starved to death; and (b) total GDP consists of public and private sector. When one is pushed down dramatically, it is mandatory to implement measures that the other one grows and compensates.

      Put differently, parallel to the austerity in the public sector, the EU and Greece should have worked out incentives for initiatives in the private sector. The EURECA project sounded creative to me (20 BEUR new foreign investment). THE EIB could have been gotten involved. A lot of options could have been pursued so that growth in the private sector would have followed.

      I know your argument that in such crises, the private sector can't help itself. I agree with that. That's why I stress 'incentives' on the part of the EU and Greece.

    4. Yes, but we're still going sideways. Why not pursue this further?

      So, in a nutshell, I think that globalization has failed, liberalization has failed, and that (Keynesian) government intervention and protectionism should be reconsidered.

      This is a model which worked brilliantly for the postwar era (the era of full employment), and then it was abandoned through the pretext of the two oil crises in the 70's.

      Why? Well, obviously to favor capital. And look how well that worked out.

    5. 1 of 2
      Ok, so we continue.

      The last time I studied Keynes was at university over 40 years ago, so I am not one of those who can quote Keynes for every particular situation. But I do remember succinctly how one of our professors hammered into us the following: 'Keynes was not for sustained deficit spending. Instead, he said that over the economic cycle, the budget should be balanced. Which means deficit spending in downturns and surpluses in upturns'. Governments have ignored the latter part.

      I agree with you that from the viewpoint of the established and saturated First World, globalization may appear as a failure to many. But I guarantee you that there are many countries in the formerly underdeveloped world who consider globalization as the greatest thing since sliced bread. But even First World consumers have benefited a lot because so many products have become so much cheaper. Something similar can be said about liberalization (generally speaking). Or do you want to return to the days of extremely expensive air travel?

      What has definitely failed is government intervention. A liberal would say that the only way that the free market can work for the benefit of all is when there is a strong state; a state way above interest groups (lobbies). A very strong state which keeps the free market players in check just like a CL-team requires a top referee.

      Just look, as only one example, at the financial sector. How governments and other official institutions could have allowed such a world-threating monster to develop is beyond me. Both, center-left as well as center-right, in Europe as well as in the US, almost pushed the monster to become even more world-threatening.

      I know stealing is bad and illegal, but that alone shouldn't make the department store owner to leave the doors unlocked overnight when there are cleptomaniacs in the area. Governments not only left the doors for speculation unlocked; instead, they OPENED them! I can still see Alan Greenspan testifying before Congress that there was no risk/need to control/supervise derivatives! And today we are talking about a worldwide volume of close to 1.000 trillion!!!

      It would be so easy to contain risks in the financial sector. All governments would have to do is to require financial institutions to increase equity (true equity, that is) to 15-20% of total assets (through a nominal increase in equity and NOT through a reduction of assets like Deusche is doing now; and Deutsche only aims at a percentage of 3%!!!). Until they reached that level, dividend pay-outs should be banned. And it would be very easy for governments to make the derivative market as transparent as other financial markets are.

      Did speculators invent the Euro? The creators of the Euro themselves pointed out in 1995 that the Euro, as it was then designed, would bring along enormous risks (Delors Report). All those risks which we have now seen come true were mentioned in that report. But governments ignored the experts because they felt so much smarter.

      You can't compare the post-WW2 era with today. Those were years of building, of making new products which not everybody already had. Today, large portions of the First World already have everything. So we are very much down to replacement demand.

      Good examples of successful deficit spending were the Nazis during the 1930s and the US during the WW2 (this was explained to me by the Governor of Austria's Central Bank). The Nazis reached full employment rather quickly by printing money. The US financed WW2 via the Fed. However, there was one critical factor in both of these situations: both societies forewent short-term consumption in favor of longer term objectives. Yes, that could have worked for the Nazis if, instead of arms, they had had made products for sale to the rest of the world. Then they could have conquered the world with money (instead of failing with arms). And by foregoing consumption during WW2 for many years, Americans had enormous catch-up demand after the war was over.

    6. 2 of 2
      In many EU countries, the state's share of GDP is already over 50%. How much higher do you want that to go? Just by looking at Germany and Austria, I see governments wanting to control everything in a belief that they can steer the economy. And the Greens are not even satisfied with controlling; they go right into forbidding (even forbidding politically incorrect, or rather gender-specific, language). Do you really think that this is the best way to create wealth for nations?

      Someone, like myself, who is definitely for free trade will also understand that free trade can only achieve desireable objectives for all if it is more or less balanced over time. If the balance gets out of whack, even a free trader like myself would understand that some form of incentives (you call it protectionism) need to be implemented to re-establish balance. But it's got to be incentives and not planning.

      I leave it here for now even though I feel like writing a whole essay about it.