Sovereign Debt and Crises

This time is different

There are four words that, in the history of finance, have preceded almost every catastrophe, spoken with sincere conviction by intelligent people just as they were setting out toward ruin: “this time is different”. It is the phrase with which, in every age, the protagonists of a boom have explained to themselves and to others why the old rules no longer applied, why the surge in prices or the accumulation of debt they were living through was not a bubble destined to burst like all the others, but the fruit of a new era, of an unprecedented situation to which the lessons of the past did not apply. A new technology that changes everything, a new way of managing risk that has eliminated it, a new economy that no longer knows the old crises: every generation finds its own reasons to believe it has escaped the laws that had governed all the previous generations. And every time, with impressive punctuality, history undertakes to recall that those laws had by no means been abolished, and that this time was not different at all.

This phrase, and the illusion it expresses, are the guiding thread of this chapter, which addresses one of the most important and most topical themes in the whole history of money: financial and debt crises. We have already met individual episodes of crisis throughout the book — the bubbles of the eighteenth century, the bankruptcies of Renaissance sovereigns, the collapse of the gold standard. Now it is a matter of looking at them together, of grasping their recurring character, of understanding that crises are not exceptional and unforeseeable accidents that now and then disturb an otherwise stable system, but a structural and recurring feature of financial capitalism, which returns, with disconcerting regularity and in ever new forms, whenever certain conditions occur. To study the crises of the past — from 1929 to 2008, and back for centuries — means to discover a pattern that repeats itself, and with it an uncomfortable truth: that the trust on which money rests is not only the source of its power, but also the root of its fragility, because what swells with trust can deflate, suddenly, when trust evaporates.

It is worth saying at once where much of what we know today about this regularity of crises comes from. A now-famous quantitative study examined the financial history of many countries across centuries, gathering data on crises, defaults and inflations, and showed that debt crises are a recurring and almost universal phenomenon, that states default far more often than is usually believed, and that the conviction of being immune to them — the “this time is different” — is itself one of the most reliable signals that a crisis is approaching [Reinhart & Rogoff 2009]. On this basis, and on that of the great studies on the anatomy of crises we have already met, we can reconstruct the recurring pattern and apply it to the two great traumas of the twentieth and twenty-first centuries: the Great Depression begun in 1929 and the global financial crisis of 2008.

States default

Let us begin with a truth that surprises many, because it contradicts the image of the state as a debtor that is solid and reliable by definition: states default, and they have always done so. We have already seen, in the chapter on the Renaissance bankers, the Spanish crown declare bankruptcy repeatedly despite the gold of the Americas, and the Medici and the Fugger ruined by loans to sovereigns who did not pay. But those cases were not exceptions: they were episodes of a phenomenon that runs through all history. States have defaulted on their own debt — that is, they have stopped paying, or have imposed on creditors losses, restructurings, deferments — in every age and on every continent, in recurring waves, with a frequency that those who have not studied financial history struggle to believe. Sovereign default is not a pathological rarity, but a periodic, almost physiological event in the life of indebted states.

Why do states default so often? The underlying reason we have already met when speaking of the relationship between finance and power: the state is a particular debtor, because it has sovereign force on its side and there exists no superior authority that can compel it to pay. When the burden of debt becomes unsustainable, or when paying costs politically more than not paying, the state can always choose not to honour its commitments, and creditors have scant remedies. But there is more: states tend to borrow too much precisely because they can, because credit is easy so long as trust holds, and because every generation of rulers is tempted to defer to the future the cost of its own spending by accumulating debt. And here the illusion of “this time is different” intervenes: in periods of tranquillity, when debt grows but trust still holds, both governments and creditors convince themselves that the debt is sustainable, that growth will repay it, that the situation is under control — until the moment in which something cracks the trust, the creditors take fright, stop lending or demand prohibitive rates, and the castle of debt collapses, revealing an insolvency that had been there for some time but that no one had wished to see.

History shows that these episodes are not random but occur in waves, often tied to the great cycles of international credit. In periods in which capital is abundant and seeks outlets, it flows toward countries and governments that offer attractive returns, swelling their debt; when the cycle reverses, capital flows out, credit dries up, and the countries that had gone into debt in the easy years find themselves suddenly unable to refinance, and fall into default in a chain. Recent history offers abundant examples of this rhythm, worth recalling so as not to believe that debt crises belong only to the remote past. Over the last decades, waves of debt crises have repeatedly struck emerging countries: Latin America experienced a severe debt crisis in the 1980s, when many of its states, having gone into debt in the previous decade when credit flowed easily, found themselves suddenly unable to pay; Asia was overwhelmed by a violent financial crisis in the late 1990s, when the capital that had flowed in en masse flowed out suddenly, bringing economies that until shortly before were celebrated as miracles to their knees; Russia defaulted on its debt at the end of that same decade; and other countries followed, at different times and in different ways. Every time the pattern was similar: abundant capital that flows in during the easy years, debt that swells, trust that at a certain point cracks, capital that flows out suddenly, and crisis. And every time, before the fall, some version of the conviction had been heard: this time was different, that country or that region had found the way to endless growth. It is a rhythm that has repeated itself for centuries, and that ties sovereign-debt crises to the global movements of capital and trust [Reinhart & Rogoff 2009].

The anatomy of the disaster

Before looking at the two great cases of 1929 and 2008, it is worth fixing the recurring pattern that crises follow, because it is surprisingly constant across centuries and forms. We had already outlined, speaking of the bubbles of the eighteenth century, the three phases of mania, distress and panic; now we can enrich that picture with the intuition of a twentieth-century economist, Hyman Minsky, who grasped the deepest paradox of financial crises: that they are born, in a certain sense, precisely from stability.

Minsky’s now-famous idea is that economic tranquillity prepares its own end. When the economy has gone well for a long time, when crises seem a distant memory and prices rise and debts are regularly repaid, financial actors progressively lower their guard. The long absence of crises convinces them that risk is low, and so they go into debt more and more, lend to ever less reliable borrowers, take on ever more reckless positions, because everything seems to be going well and whoever is bolder earns more. Stability, paradoxically, generates the imprudence that will lead to instability: the longer the calm lasts, the more debts and fragilities accumulate, the more the system becomes vulnerable to a shock. Until the moment in which something goes wrong — an important debtor that does not pay, a price that stops rising, a piece of news that frightens — and the whole scaffolding of debts accumulated in the season of trust begins to crumble. That moment, in which trust reverses abruptly into fear and the castle of debt begins to collapse, has been called the Minsky moment, and it is the heart of every financial crisis.

At this point the most fearsome mechanism intervenes, the one that turns a localised difficulty into a general catastrophe: contagion. Finance is a dense network of credit and debt relations: every bank, every firm, every participant is at once creditor of some and debtor of others, in a chain of obligations that binds the whole system. So long as everyone pays, the network holds and strengthens; but when an important node breaks — a great bank that fails, a great debtor that does not pay — its collapse propagates along the network, because whoever had lent to it finds themselves in turn in difficulty, and in turn cannot pay their own creditors, and so on, in a chain reaction that can bring down the whole system. It is systemic risk, the risk that trust, evaporating in one point, dissolves everywhere, because in a network of mutual debts mistrust is as contagious as trust had been. A systemic crisis is the moment in which everyone, suddenly, stops trusting everyone, credit seizes up, and the whole machine of money created by credit — which we had seen to be the heart of the modern economy — jams, dragging the real economy down with it.

The crash of 1929

The first great case, the one that inaugurated the century of modern crises, was the Great Depression, triggered by the crash of the American stock market in October 1929. In the twenties, the United States had lived a long boom, accompanied by a feverish stock speculation: the prices of shares had risen for years, fed by enthusiasm and, above all, by credit, because very many bought shares by going into debt, convinced — according to the eternal script — that prices could only keep rising. It was a classic bubble, swollen by leverage, according to the pattern we know. And like every bubble, it burst: in October 1929 prices began to collapse, panic spread, and those who had bought on debt were forced to sell to repay the loans, feeding further falls in a ruinous spiral. The stock crash, in itself, was dramatic, but it would not have sufficed to provoke the catastrophe that followed if it had not propagated to the banking system and the real economy.

And here the mechanism of contagion and bank panic we had studied in the chapter on central banks entered the scene. The financial crash overwhelmed the banks, many of which had lent for the speculation or were exposed to ruined debtors; the depositors, frightened, ran to withdraw their money; and a chain of bank failures propagated through the country, destroying credit, savings, trust. The banks that failed dragged with them the firms that depended on them; the firms that failed laid off workers, swelling mass unemployment; unemployment and fear depressed consumption, aggravating the business crisis, in a downward spiral that dragged the American economy, and then the world economy, into the gravest depression in the history of capitalism. And here was grafted, as we had seen, the error of the gold standard: the gold constraint prevented the authorities from reacting with the necessary energy, forcing them to restrictive policies precisely when they should have loosened, and thus amplifying the catastrophe. The Great Depression was the product of a deadly combination: a speculative bubble swollen by credit, a bank panic not stemmed, and a rigid monetary system that prevented the cure. It was, in a certain sense, the demonstration of everything that can go wrong together in the financial system.

The Great Depression left a deep legacy, because it taught the world lessons that would shape economic policy for generations. It was understood that the lender of last resort had to intervene decisively to stem bank panics, instead of letting them burn unchecked; that it was necessary to protect depositors to break the mechanism of runs on the banks, and deposit-insurance systems were created for this; that the rigidity of the gold standard was incompatible with stability, and it had to be abandoned; and that the state had a role in sustaining the economy in crises, according to the ideas Keynes was elaborating precisely in those years. For decades, these lessons made the financial system more stable, and one could believe that the risk of another Great Depression had been neutralised forever. But lessons, in time, are forgotten, and the defences erected after a crisis are dismantled when the crisis has become a distant memory and it seems that “this time is different”. It was exactly what happened, in the decades that preceded the second great trauma [Kindleberger & Aliber 2005].

The chain of 2008

The global financial crisis of 2008 was, for our time, what the Great Depression had been for the previous generation: the great trauma that reminded the world, in the most brutal way, that crises had not been abolished. It is worth reconstructing its mechanics carefully, because it is recent, complex, and still the object of heated political controversies, and it is important to understand it in its mechanisms without reducing it to a moral fable of culprits and victims. The crisis of 2008 was, in its substance, another variation on the pattern we know — a bubble swollen by credit, a stability that had generated imprudence, a Minsky moment, a systemic contagion — but with new characteristics linked to the sophisticated finance of our time.

At the centre of the crisis there was a housing bubble, above all in the United States: for years house prices had risen, fed by easy and abundant credit, and very many had bought a house by going into debt, even people with modest incomes and scant guarantees, the so-called subprime mortgages. So long as house prices rose, everything seemed to work: whoever could not pay the mortgage could sell the house, now more expensive, and repay the debt. But on this fragile base a financial pyramid of extraordinary complexity had been built. The mortgages, instead of remaining in the balance sheets of the banks that had granted them, were packaged together with thousands of others and transformed into securities, through a procedure called securitisation, and sold to investors all over the world. The idea, in theory, was to disperse the risk, distributing it among many instead of concentrating it on a few banks. In practice, something different and perverse happened: the risk was dispersed in a way so opaque and complicated that no one knew any longer with exactness where it was, who held it, how big it was. Securities built on risky mortgages were rated as safe, and spread throughout the world financial system, creating a network of mutual exposures whose true extent no one knew. Rating agencies, the companies whose business is to judge the reliability of securities and debtors by assigning the grades that investors use to orient themselves, helped foster this illusion of safety. Those agencies gave their highest ratings, reserved for the safest securities, to financial products built on mortgages that were in reality risky, helping to spread them throughout the system as if they were safe. The reasons for this failure have been much discussed, and among them was a structural conflict of interest: the agencies were paid by the very issuers of the securities they had to judge, which certainly did not encourage severity. Without wishing to reduce a complex affair to a single cause, it is clear that the seal of safety affixed by the agencies to securities that were not safe was one of the gears that allowed the risk to spread unnoticed throughout the whole system, preparing the contagion.

Then house prices stopped rising, and began to fall. It was the Minsky moment: whoever had a mortgage they could not pay could no longer save themselves by selling the house, because it was now worth less than the debt; defaults multiplied; and the securities built on those mortgages began to lose value. And here contagion was triggered, amplified precisely by that complexity that should have dispersed the risk. Since no one knew with exactness who held the toxic securities and how exposed they were, the banks stopped trusting one another: each suspected that the others might be insolvent, and therefore no one wished to lend to anyone any longer. The interbank credit market — the system through which banks lend money to one another, and which is the blood of the financial system — seized up suddenly. It was a panic, but a new panic: not lines of depositors at the counters, but banks that refused to lend money to one another in the darkness of mutual uncertainty. When Lehman Brothers, a large American investment bank, failed in September 2008, the panic reached its peak, and for a few weeks the world financial system was on the brink of total collapse, of a general blockage of credit that would have dragged the world economy into a catastrophe comparable to that of 1929 [Ferguson 2008].

The central-bank backstop

What prevented 2008 from becoming a second Great Depression was, in large measure, having learned the lesson of 1929. The central banks and the governments, this time, did not stand by watching while the system collapsed: they intervened with an unprecedented force and rapidity, doing exactly what the doctrine of the lender of last resort, formulated a century and a half before, prescribed. The central banks injected liquidity into the system in enormous quantities, lending freely to prevent the paralysis of interbank credit from suffocating the economy; the governments intervened to save the largest banks, those whose failure would have propagated the contagion to the whole system, considered “too big to fail”. These were colossal interventions, which engaged immense public resources and broke many taboos on the role of the state in the economy. But they achieved their immediate aim: the total collapse was avoided, the financial system was kept on its feet, and the crisis, though severe and followed by a heavy recession, did not degenerate into the catastrophe of 1929. The lesson of the Great Depression, learned at a high price, had worked.

But those interventions raised, and still raise, profound controversies, which it is right to set out without claiming to resolve them, because they touch questions of justice on which opinions legitimately diverge. On the one hand, saving the banks was necessary to avoid the collapse of the system, which would have struck everyone, and first of all the weakest: to let everything fail in the name of abstract justice would have provoked a general economic catastrophe. On the other hand, those rescues appeared to many profoundly unjust: with public money the very banks were saved that, with their imprudence and their greed, had provoked the crisis, while ordinary citizens paid its consequences in terms of recession, unemployment, austerity. There was talk of “privatisation of profits and socialisation of losses”: the bankers had pocketed the gains in the good times, and now the community took on the losses in the bad times. And the problem of moral hazard arose: if the banks know they are too big to fail, and that the state will save them anyway, are they not perhaps encouraged to behave in an even more reckless way, sure that the gains will be theirs and the losses everyone’s? This dilemma — between the necessity of saving the system and the injustice of saving those responsible, between immediate stability and long-term moral hazard — is one of the unresolved knots that the crisis of 2008 has left as a legacy, and on which the debate is still open and bitter.

The debt that remains

The crisis of 2008 had a long tail, which intertwined the theme of the financial crisis with that, ancient, of sovereign debt, and which carried the problem to the heart of Europe. To save the banks and sustain the economies in recession, states had spent enormous quantities of money, and their public debt had grown considerably. The private crisis of the banks had thus turned, in part, into a crisis of public debt: the states that had borrowed to save the system found themselves now with a much heavier burden of debt. And in some countries, above all in the euro area, this burden became unsustainable, unleashing a crisis of sovereign debt that threatened the European single currency itself.

The European sovereign debt crisis, which unfolded above all at the beginning of the decade following 2008, revived, in a new form, the ancient drama of states that can no longer pay their debts. Some countries of the eurozone, burdened by high debts and deprived of the possibility of devaluing their own currency — because they had abandoned it by adopting the euro — found themselves caught in a vice: the markets, having lost trust in their capacity to pay, demanded ever higher interest rates to continue lending to them, which made the debt even more unsustainable, in a spiral that threatened default and exit from the euro. To avoid it, a hard programme of austerity was imposed on those countries — cuts to public spending, increases in taxes — in exchange for the aid necessary to avoid default. And here a painful dilemma opened, which divided Europe and which is still today the object of controversy: the dilemma between austerity and solidarity. On the one hand, those who maintained that the indebted countries should balance their public accounts with sacrifices, to regain the trust of the markets and not offload their debts onto others. On the other hand, those who objected that austerity imposed in full recession aggravated the crisis instead of curing it — further depressing the economy, as we had seen the deflation of the gold standard do — and that solidarity among the countries of the monetary union would have required sharing the burden, not offloading it onto the weakest. This conflict between discipline and solidarity, between the responsibility of each and mutual support, has not found a definitive solution, and remains one of the great open questions of Europe and of every union of states that share a currency but not a budget [Eichengreen 2008].

It is worth, at this point, pausing to consider in what ways, historically, states have reduced their excessive debts, because this illuminates the choices that still arise today. There are essentially five paths. The first is growth: if the economy grows fast enough, the debt, though remaining high in absolute value, becomes lighter relative to the wealth produced, and therefore more sustainable. It is the most painless way, but also the hardest to obtain on command. The second is austerity: to cut spending and raise taxes to repay the debt, with the social costs and the recessionary risks we have seen. The third is inflation: since the debt is fixed in nominal terms, a sustained inflation erodes its real value, lightening the burden for the debtor state at the expense of the creditors — it is the mechanism we had met in the previous chapter, inflation as a hidden tax that strikes those who hold the debt. The fourth is outright default: to stop paying, or to impose on the creditors a restructuring that reduces the value of what is owed. The fifth, more subtle, is what scholars call financial repression: to keep interest rates artificially low, perhaps by obliging in various ways savers and banks to hold the public debt at returns lower than inflation, so that the debt erodes slowly over time at the expense, once again, of those who hold it. Each of these ways has winners and losers, and the choice among them is never purely technical, but profoundly political, because it decides who will pay the bill of the accumulated debt: the taxpayers through austerity, the creditors through inflation or default, the savers through financial repression. Behind the apparent neutrality of debt questions there always hides, as behind every monetary question, a conflict over distribution, over who must bear the burden.

At this point a clarification is needed, because it touches an episode significant for intellectual honesty. The study on the history of debt crises that we have cited several times, and whose underlying historical thesis — that debt crises are recurring and that states default often — is solid and precious, also had a controversial aspect. A part of it, which sought to identify a precise threshold of the ratio between debt and output beyond which economic growth would slow, was used in the political debate to justify the policies of austerity; but that specific quantitative analysis later proved marred by errors, among them a banal error in a spreadsheet, and the precise threshold value it proposed did not hold up to verification. It is important to distinguish: the general historical thesis on the recurrence of debt crises remains valid and well documented; the specific and more fragile claim of a precise numerical threshold, used in the debate on austerity, was instead rightly criticised. The affair is instructive because it shows how delicate the passage from historical analysis to political prescription is, and how important it is not to make the data say more than they can really demonstrate.

The lesson of crises

Let us draw the lessons from this history of crises, because they are among the most important that money can teach, and among the most topical. The first lesson is that financial crises are not exceptional accidents, but a recurring and almost structural feature of capitalism founded on credit. They follow a pattern that repeats itself across the centuries, in ever different forms but with a constant logic: a long period of stability and trust encourages the accumulation of debt and risk; stability generates the imprudence that undermines it; at a certain point trust reverses into fear, and the accumulated debt collapses in a contagion that propagates along the network of financial relations. The “Minsky moment” and systemic risk are not pathological exceptions, but the normal way in which a system founded on trust and credit periodically enters into crisis. And the illusion of “this time is different” — the conviction of every generation of having escaped the old laws — is itself part of the pattern, the recurring signal that precedes the fall.

The second lesson concerns the deep nature of money, and it is the thread that ties this chapter to the whole book. Crises reveal, in the most dramatic way, that money and credit rest on trust, and that trust is a network. We had seen, since the first chapter, that money is a promise, a social convention, a fact of shared trust. Crises show the reverse of this truth: that what is built on trust can collapse when trust evaporates, and that, in a densely interconnected network of mutual debts, mistrust propagates with the same rapidity with which trust had propagated. Money created by credit — the “value from nothing” that we have followed throughout the book — is a marvellous machine for creating wealth, but it is also a machine intrinsically unstable, because what has been created by trust can be destroyed by its lack. Crises are the price we pay for the power of credit: they are the moment in which the value created from nothing returns, at least in part, to the nothing from which it had come.

The third lesson is the most practical, and concerns the public debt of our time, which remains a great open question. The crises of the twentieth and twenty-first centuries have left as a legacy, in many countries, historically high levels of public debt, accumulated to save the financial systems, to sustain the economies in recessions, and to finance growing spending. How sustainable this debt is, to what point it can grow without unleashing a crisis, how it can be reduced without suffocating the economy, are questions to which there exists no certain answer, and that divide profoundly economists and governments. The history we have told warns us not to fall into the illusion that “this time is different”, that debt can grow indefinitely without consequences; but it also warns us not to confuse analysis with propaganda, not to claim numerical certainties that the data cannot give, to recognise the real complexity of the problem. Contemporary public debt is one of the great unknowns of the future of money, and it is also one of the themes on which the wisdom — or the imprudence — of the generations to come will be measured. On this future, and on the new forms that money is assuming precisely while these ancient questions remain unresolved, the last chapters of the book concentrate, beginning with the one that tells the most radical of recent innovations: the birth of a money that claims to do without states and banks, and that drew precisely from the crisis of 2008 its origin and its reason for being.