… Many governments had the imprudence of piling up debt upon debt over the last thirty years, but especially over the last ten years. There are four main causes for such a public binge of debt in many countries:
- First, in Europe, the creation of the Euro Zone in 1999 induced some imprudent member countries to go deep into debt by taking advantage of the credibility of the euro and by issuing bonds in euros at favorable interest rates. There was, indeed, a widely held belief on the part of lenders and borrowers alike that the new monetary union provided an implicit guarantee of stability to the safety of the loans.
- Secondly, lenders were induced to lend large sums at low interest rates because borrowers could avail themselves of a newly created financial instrument, the Credit Default Swaps (CDS) that allowed them to take a low cost insurance against an eventual default on their bonds. (By the way, the financial crises on both sides of the Atlantic are closely linked due to the fact that some large U.S. banks are heavily exposed to the European sovereign debt crisis as sellers of credit default swaps.)
- Thirdly, the persistent large trade imbalances in the world meant that some countries, such as mainland China (which joined the World Trade Organization in December 2001), piled up tremendous external trade surpluses and their excess funds became available to foreign borrowers. Indeed, large international banks found it most profitable to channel these newly created funds to willing sovereign borrowers around the world.
- Fourthly, some central banks, especially the American Greenspan Fed, thought they were obliged to provide an environment of easy money after the events of September 11, 2001, in the U.S., and they kept interest rates unduly low for too long, thus providing an additional inducement to eager borrowers to go deeper into debt. Indeed, the housing bubble in the United States that led to the subprime mortgage crisis was a creation of the Greenspan Fed with the encouragement of the Bush-Cheney administration.
A first conclusion, therefore, is that many institutional factors and policies contributed into encouraging some governments (and also some consumers and investors) to take on more debt than was prudent, often to finance unproductive spending such as military spending. Today, for example, there are dozens of countries whose gross general government debt stands above 100 percent of their gross domestic product (GDP). Moreover, when a high proportion of this debt is foreign-owned, money to service such debt flows out and this, of course, creates a drag on the domestic economy. Servicing an unproductive foreign debt is one of the financial “black holes” I have in mind here.
But what’s even more important, the financial and banking systems have evolved in such a way over the last ten years or so that it has become very difficult, if not technically impossible, to solve a sovereign debt crisis through the traditional means used in the past.
How come? Because debt restructuring (a fancy term for reducing the capital owed by a debtor through debt write-downs that reflect actual market values and/or the extension of a debt’s maturity and/or a lowering of interest rates) has been made most difficult by the fact that banks and other lenders have been “insured” against a debt default and are thus expecting to receive 100 percent of a loan and interest, no matter how risky their loans have turn out to be and how low their current value … (full long text).