As I was driving to work yesterday, I heard the news that French President Sarkozy was departing for Berlin to meet with Chancellor Merkel to see if they might come to an agreement about what to do about Greece’s debt. Meanwhile in the US, the House, the Senate and the President were still involved in debates about what to do about America’s debt. Conventional wisdom on both sides of the Atlantic is that an immediate failure to address the liquidity problems faced by both Athens and Washington will plunge the world into a new era of darkness.
Conventional wisdom, as it so often is, is wrong. The problem is not illiquidity; it is insolvency, and it is a problem shared to some degree by not just the governments of Greece and the US, but by most Western nations around the globe. While it is true that the failure to address the liquidity problems in both nations might cause worldwide economic hardship, it is true that addressing liquidity without fixing solvency guarantees that the Western world will face eventual worldwide economic catastrophe on a scale unimaginable to anyone who didn’t live through the 1930s.
First Greece. It is flat out insolvent. The size of Greece’s debt is about one-and-a-half times the size of its economy. It can’t hope to ever pay back that amount of debt. Banks know this, that’s why interest rates are well over 20%. Greece pays what amounts to Visa/MasterCard interest rate levels for the exact same reason. In both cases creditors offer unsecured debt to borrowers, knowing that a good percentage of those loans will never pay off.
The United States is insolvent too. Then again, it’s not. That’s because US debt to actual creditors is currently at a level that doesn’t push the country into insolvency. Total US obligations, however, will never be met. Let me explain the difference.
The total debt held by the public is about 60% of GDP. That’s significantly less than the $14.3 trillion number you often hear–and that is currently the subject of pending legislation in Washington.
The difference is the debt that the government owes to itself. Remember Al Gore’s “lock box”? It never existed and it never will. It is an accounting myth that treats money that the government “borrows” from social security taxes as a tangible asset. It isn’t.
Instead, think of it as something like this: Imagine that my wife and I both work and that she sets aside 15% of her income for retirement and gives that 15% to me. I go through the years spending all of my income, plus all of the 15% that she gives me, plus a little bit more. Eventually, my wife starts to ask questions about her retirement fund. “Relax,” I tell her. “You’ve been ‘earning’ 5% interest on that money.” And I hand her a nice little official looking annual accounting statement to that effect. Unbeknownst to her, I’m only adding that 5% interest to that amount that I “owe” her. In truth, I’ll never pay her that money. It doesn’t exist. It’s already spent, and I don’t have the income earning potential to ever repay it. But–and this is the key point–that amount I owe my wife is not a debt in the legal sense. Sure, I still have other debts; remember, I’ve been spending all of my income, plus 15% of hers, plus a little bit more. That “little bit more” is money that I owe to outside creditors. And I will have to pay them back or they will make my life miserable. When my wife finds out that there is no money for her, my life will be miserable too. But that’s a different kind of misery–one that will lead to a bitter and nasty divorce.
This is why I say that the United States is insolvent, but it’s not. The US can conceivably pay back its external creditors, but it can not afford to pay back its “wife,” in this case, its citizens, who were taxed in exchange for a non-legally-binding promise. However, the US government is borrowing from its external creditors at such a high rate that in just a few years (before the end of this decade) it will have borrowed more in legal external debts than it can ever conceivably pay back.
Returning to Greece, it is very possible that a Greek default could plunge the world back into recession. That’s because, although Greece is a tiny economy–only about 3% of Europe–its debt is owned by banks around the world. And due to Bretton Woods rules, its debt, like all sovereign debt, is treated extra specially. It is considered to be “safe.” in truth, this is ludicrous. Historically, sovereign debt has always been a huge risk, since from the pharoahs to Robert Byrd, kings and senators have forever been prone to bankrupting their countries to build monuments to themselves. But the Bretton Woods rules giving sovereign debt special treatment weren’t enacted to stabilize economies, but to stabilize governing classes. The fear among governing classes is that when Greece cracks the dam, governments downstream in Lisbon, Dublin, Rome, Madrid, and beyond will likewise be flooded too.
Here’s the rub, if creditors charged governments interest rates commensurate with their actual risk, those huge interest rates (probably at Visa/Master Card levels) would cripple all Western governments’ ability to continue to spend at extravagant levels. And that would be the end of those governing classes. You see, it’s not about protecting you, the citizen. It is, and always has been, about protecting “them” from being like you.
Now let us return to the husband and wife analogy. If my wife was ten years away from retirement, would she be better off learning the truth of her financial situation now, or waiting another ten years? Obviously the former. A divorce, while nasty and bitter, is inevitable anyway, but if it were now instead of later, she would have ten years to actually do something positive toward providing for her own retirement. I, on the other hand, am much better off the longer she doesn’t know the truth.
The situation in both Athens and Washington (and, as mentioned, around much of the Western World) is similar. The money isn’t there. In the case of Greece, default is a mathematical certainty. In the US, while it’s not certain yet, what is certain is that America’s citizens will not get the full value of its government’s future promises, and also certain is that if America doesn’t stop borrowing from its creditors immediately, it will find itself very shortly in the same situation as Greece.
In other words, the nasty truth is that the citizens of most Western nations find themselves in the same situation as my hypothetical spouse: There is no money set aside for them. And the governments find themselves in the same situation as hypothetical me: If my wife divorces me, I’ll be out of money and out on my ass.