Creditors, Society, and Risk

The investment bubbles of the past decade and the recent financial crisis have generated situations in which numerous countries have seen their budgetary deficits and total debt levels rise considerably. The situation is particularly severe in the Eurozone where the common currency deprives debt-laden countries from relatively painless responses to limiting their debt burden. 

There is a fundamental question that arises whenever debtors and creditors find themselves in difficult circumstances: how should the pain of recovery from overpowering debt be shared? It seems that the current dominance of those who favor austerity measures above all else indicates that the pain should not be shared at all.

Paul Krugman makes this observation in his book End This Depression Now!:

"If you look at what Austerians want—fiscal policy that focuses on deficits rather than job creation, monetary policy that obsessively fights even the hint of inflation and raises interest rates even in the face of mass unemployment—all of it in effect serves the interests of creditors, of those who lend as opposed to those who borrow and/or work for a living. Lenders want governments to make honoring their debts the highest priority; and they oppose any action on the monetary side that either deprives bankers of returns by keeping rates low or erodes the value of claims through inflation."

Abraham Newman pondered the same issues as Krugman and arrived at a more pointed observation. His article appeared in Foreign Affairs under the title: Austerity and the End of the European Model: How Neoliberals Captured the Continent.

"Austerity politics in Europe is not simply a short-term fight between the surplus countries in the center and the deficit countries on the periphery. It is a long-term political agenda that privileges lenders over debtors and capital over labor and, as such, should be seen through the lens of partisan politics. Center-right governments in Germany, the Netherlands, and Spain have been among the most vocal proponents of austerity."

A related debtor-creditor confrontation is occurring in Stockton, California. The city is in dire financial straits from over-committing itself during the housing boom, and from a drop in revenue following the housing crash. Stockton is planning to follow the path of municipal bankruptcy. The issues involved in such an approach are complex. Articles here and here provide some background.

Stockton city officials argue that they have cut costs as much as possible while still maintaining a functioning city. As a result they feel the need to balance their budget by a partial default on payments owed bond holders. In a sense this is what one would expect from a bankruptcy: everyone would share in the loss.

Debt holders have countered by pointing out that Stockton has not done everything they it could to cut costs because it is still paying funds into the retirement system that covers current and future retirees. This situation is made more complex because Stockton can claim that the California constitution and state court decisions prohibit it from cutting pension benefits.

Of interest here is the notion that the interests of debt holders take precedence over workers and retirees. Why should creditors be first in line for available funds?

The problems in Stockton, and in Europe, can be traced in part to the accumulation of debt at low cost. A creditor who decided to loan money to a city or to a country will claim that they have assessed the risk to their funds and are charging a rate of interest that is commensurate with the possibility that they might lose their investment. If these organizations are doing their job properly, they should be recognizing a risky investment by demanding a high rate of return. This would be issuing a warning to the borrower that it might wish to reconsider its plan of action.

If the creditor feels that there is no threat to its investment, then why worry about the integrity of the loan? It becomes in its interest then to loan as much money as possible if there is certainty of compensation. Isn’t this a classic example of moral hazard?

It would seem that the only way bond markets can work efficiently is if there actually is risk involved. An economy where a class of creditors is shielded from loss has already been demonstrated to be hazardous (think sub-prime mortgage lenders).

The city of Stockton made unwise decisions and now has to pay the price; the creditors of Stockton also made unwise decisions and they should also have to pay a price. Replace Stockton by Spain and the same statement holds.

Share the pain.