Center for Financial Innovation and Stability

Notes from the Vault

Gerald P. Dwyer
November/December 2011

• The United States has a debt problem, even if it is not as intensely scrutinized as European debt.
• While market prices and markets are much maligned, the prices in markets provide information about underlying problems faced by governments.
• Countries' responses to the sovereign debt crisis in Europe have been quite different, but the most successful ones to date involve radical, wrenching changes over a short period instead of long, drawn-out changes.

For more than two years, the European Union has struggled to address an ongoing crisis over the huge debts of some of its weaker economies like Greece. The Federal Reserve Bank of Atlanta held a conference at the end of November 2011 to explore the origins of the sovereign debt crisis, both in Europe in general and in selected countries. It is impossible to do justice to the talks and the discussion in a few pages. This summary focuses on the presentations related to U.S. and eurozone debt problems, issues surrounding credit default swaps, and the similarities and differences in countries' debt experiences. The discussants provided valuable context and additional thoughts about the topics. The conference proceedings available online provide much more detail about the presentations and include the discussants' contributions.

Debt concerns in the United States
The United States provides a good context for thinking about debt problems and how it has dealt with similar problems in the past. While obviously not directly involved in the sovereign debt crisis in Europe, the difficulties faced by the United States provide a reference point and possibly a warning. Government debt held by the public is increasing rapidly. While the usual measure of the size of debt—total debt relative to gross domestic product (GDP)—suggests that the United States is in reasonably good shape compared to other countries, alternative measures are not so reassuring. For instance, conference participant Thomas R. Saving shows that future U.S. commitments associated with entitlements, especially Medicare, dwarf government debt held by the public. Based on those and other commitments, the United States faces serious budget difficulties in coming years. As a result, the terms of these entitlement programs are likely to change substantially. Moreover, even the current level of debt is large when compared to European countries in some ways.

Saving suggests measuring a government's capacity to pay debt by its debt relative to the government's current tax revenue. This approach measures the resources available to the government given current laws. The more common measure—government debt relative to the size of the economy—measures a revenue base partly available to the government but probably only with substantial changes in laws. Saving's suggested measure indicates the U.S government faces more difficulties than European countries. The ratio of U.S. government debt to tax revenue is quite a bit higher than in European countries, even though the ratio of federal government debt to GDP is lower than in many European countries. These two measures are different because the U.S. federal government collects a noticeably smaller fraction of U.S. GDP in taxes. Given current laws regarding how revenue is raised, the U.S. government is more stretched by its debt than many European countries.

Presenter John J. Wallis has spent a lot of time learning about an earlier situation somewhat similar to Europe now: the United States in the late 1830s and early 1840s. His talk reflected joint research with Richard E. Sylla and Arthur Grinath III on developments and the eventual U.S. reforms. Similar to the European Monetary Union (EMU), the United States is a monetary union of sovereign states all of which use the same currency. U.S. states cannot finance their spending by printing money, any more than European countries in the EMU can. There are no exchange rates across states to adjust to reflect changed economic circumstances because all states use the same money. Any adjustment of relative prices across states must occur through changes in prices of assets, goods, and services.

In the 1830s, several U.S. states ran up substantial debts and subsequently defaulted on them. As in Europe today, this situation raised concerns about effects on other governments in the monetary union and possible increases in future debt. The U.S. solution was a set of balanced-budget amendments to state constitutions, which are enforced at the state level. Superficially similar restrictions are part of one proposal to deal with Europe's problems, although a related proposal calls for the European Union to approve each government's budget.

The eurozone
Thomas D. Willett suggests there are fundamental problems at the base of the issues the eurozone is confronting. The EMU was formed on the premise that monetary integration could proceed gradually, similar to trade and financial integration. The system was set up with no mechanisms for dealing with balance of payment differences between countries or with financial crises. The growth and stability pact to limit government deficits didn't work, and there was a growing loss of competitiveness in Greece and some other countries. Other factors, in particular, false mental models, contributed to the difficulties. Willett suggests the European experiment has been driven by a false "bicycle theory": the European project has to continue to evolve institutionally toward integration or it will fall down, like a stopped bicycle.

Credit default swaps
Financial markets—in particular, markets for credit default swaps (CDSs)—have been blamed for the intensity of the problems in the eurozone (Dwyer 2010; Dwyer and Flavin 2010). In a paper presented at the conference, Sergio Mayordomo and coauthors Óscar Arce and Juan Ignacio Peña examine whether CDSs and government bonds reflect the same information. They find that there are substantial arbitrage profits between CDSs and government bonds since the subprime crisis, with the returns on CDSs typically exceeding those on government bonds. They are able to explain those deviations, especially by liquidity and counterparty risk. They also examine which market reflects information more quickly and find that it's sometimes the bond market and other times the CDS market.

Joshua Aizenman and coauthors Michael Hutchison and Yothin Jinjarak examine a complementary aspect of the market for CDSs, whether the risks priced in CDS spreads seem plausible. They use "fiscal space"—the ratio of government debt or government deficits to current tax revenue—(a measure discussed by Thomas Saving as well) as another measure of governments' difficulties. Whichever measure is used, fiscal space is an important determinant of CDS spreads. Is the size of the effect plausible? They compare the PIIGS CDS spreads—those for Portugal, Ireland, Italy, Greece, and Spain—to those of other middle-income countries. They find little difference in 2008 but higher CDS spreads for the PIIGS countries than for middle-income countries by 2010 given economic conditions in 2010. Their results are consistent with economic conditions in the PIIGS countries expected to worsen in the future compared to the other middle-income countries. It also is possible that CDS spreads simply are too high.

Selected countries
Examining countries' experiences for similarities and differences is one way to begin to learn about the sources of the debt problems, which could suggest possible solutions.

Crises
Greece has been much in the headlines, and conference presenter Georgios P. Kouretas provided context for understanding the difficulties that Greece faces. Greece's participation in the eurozone since its inception was met by decreases in market interest rates for Greece's debt by about 11 percent per year compared to Germany, with differences as low as 0.3 or 0.2 percent per year by the end of 2007. These interest rates reductions did not reflect two serious problems in the Greek economy. First, the Greek government's revenue was falling relative to its GDP at the same time its spending—and therefore deficits—were increasing relative to GDP. Before 2008, these difficulties were masked by the relatively low interest rates paid on the debt. Second, Greece has increasingly lost competitiveness relative to other parts of the eurozone.

In his presentation Colm McCarthy summarized the situation in Ireland, including both a diagnosis of the problem and suggested reforms. Ireland's severe budget difficulties are a direct result of the Irish government's guarantee of all Irish banks' liabilities. The outlays actually borne by taxpayers are about 40 percent of GDP, which is quite substantial and has created difficulties for the Irish government and consequently taxpayers. Combined with a housing downturn and the effects of that downturn on government revenues, Ireland has a clear problem continuing with the current level of debt and interest payments. McCarthy suggested reforms to mitigate future problems. He suggested that centralized bank supervision, resolution procedures, and deposit insurance in the eurozone with no seniority for bank creditors would help ensure other countries do not face the problems Ireland confronts.

In his talk, Santiago Carbó Valverde discussed Spain, which currently has a relatively low ratio of government debt to GDP compared to Greece and Ireland or even countries such as the United States and the United Kingdom. Given its low level of debt, why is there so much concern about Spain? There are two reasons. Spain has been running relatively large deficits since 2010 and there is no end in sight without actions to reduce them. Carbó Valverde argues that reform and restructuring of the Spanish banking system also must be part of any solution of Spain's difficulties.

Different approaches to resolving the crises
Thorvaldur Gylfason focused on Iceland, which provides an interesting contrast to some of the other countries discussed. While there are interesting similarities and differences between Iceland and Ireland (Dwyer 2011), Iceland had an extraordinarily large banking sector in 2008, with bank assets more than nine times annual GDP. Icelandic banks were unable to honor all their promises, and it was impossible for the government to guarantee everything owed by the banks. The government did guarantee its citizens' deposits but not foreigners' deposits. Because Iceland is not a member of the eurozone, the value of Iceland's currency fell substantially. This depreciation helped increase Iceland's exports by making Icelandic products more competitive. Iceland is now in an International Monetary Fund program and beginning to grow. It has applied for European Union membership, although it is worth thinking about how the recovery from the collapse of Iceland's banks might have been different if Iceland had been a member of the eurozone.

Another conference presenter, Anders Ǻslund, has written extensively on Eastern Europe and the Baltic countries, including studies of their responses to the financial crisis and subsequent events. As Ǻslund notes, some of these countries were in the EMU, some had fixed exchange rates, and some had floating exchange rates. The initial effects of the financial crisis appear to be larger in the fixed-exchange-rate countries, but all these countries recovered relatively rapidly. As Ǻslund explains it, fixed exchange rates were sustainable only with decreases in domestic prices and wages. Decreases in the exchange rate were not an option. As a consequence, these countries pursued radical structural adjustment and lowered domestic wages and prices. They also cut government spending to improve their governments' position, and most factors now point to solid growth.

Conclusion
The conference was quite informative in a variety of ways. Countries' responses to the sovereign debt crisis in Europe have been quite different, but the most successful ones to date involve radical, wrenching changes over a short period instead of long, drawn-out reforms. Coming full circle to Greece's problems, these responses suggest it is possible to have a government and other institutions that permit radical adjustment such as Greece is confronting. Unfortunately, institutions change slowly and the problems are pressing.
 
Gerald Dwyer is the director of the Center for Financial Innovation and Stability at the Atlanta Fed. Any errors are the author's responsibility. The views expressed here are the author's and not necessarily those of the other participants in the conference, the Federal Reserve Bank of Atlanta, or the Federal Reserve System.

References
Dwyer, Gerald P. 2010. Financial speculation in credit default swaps. Notes from the Vault March. Available at http://www.frbatlanta.org/cenfis/pubscf/vn_speculation.cfm.

Dwyer, Gerald P., and Thomas Flavin. 2010. Credit default swaps on government debt: Mindless speculation? Notes from the Vault September. Available at http://www.frbatlanta.org/cenfis/pubscf/vn_credit_default_swaps.cfm.

Dwyer, Gerald P. Economic effects of banking crises: A bit of evidence from Iceland and Ireland. Notes from the Vault March. Available at http://www.frbatlanta.org/cenfis/pubscf/nftv_1103.cfm.