Back in August Nic Benton from the Jubilee Debt Campaign argued in Open Democracy that the world needed a way for nations to repudiate their sovereign debt. He suggested that a UN agency or the Permanent Court of Arbitration in The Hague should be empowered to renegotiate unsustainable sovereign debt using Chapter 9 of the US Insolvency Code as a guide. Chapter 9 allows municipalities to receive protection from creditors during periods of financial difficulties by halting repayments while debts are renegotiated and limiting subsequent repayments to levels that are sustainable.
His was not a new argument and it was one receiving virtually no support among the financial establishment. Now however something curious has happened. Support seems to be emerging from the most unlikely quarters. Otmar Issing is one of Germany’s best known economists, President of the Centre for Financial Studies, adviser to Goldman Sachs and former chief economist at the European Central Bank. Writing in the Financial Times “Germany is right: bondholders must pay”, Issing makes many of the same points but from a radically different perspective.
Although Benton mentioned the example of Greece his focus was overwhelmingly on third world debt, Issing's focus is much closer to home: the cost of the European Union bailing out weaker member states. “Why,” he asks, “should taxpayers be taken hostage endlessly by investors who enjoy the benefits of high interest rates and who can rely on being bailed out once an indebted country gets into trouble?”
Both men make two crucial points. First that we need a permanent mechanism for restructuring sovereign debt. Second that we need an acceptance that any debt restructuring must involve losses for private investors. This second point is crucial: government default must be a credible possibility.
The idea of governments defaulting on their financial obligations is supposedly an anathema but why? We are constantly being told that the public sector must act more like the private and private sector defaults are commonplace. It is after all precisely because financial markets consider some companies to be greater risks than others that different corporate bonds have different yields. Interest rates reflect risks. The Irish government must pay higher interest rates than the German because the market believes its bonds are riskier. And yet politicians across Europe appear determined to prove the markets wrong: again why? Companies in financial difficulties renegotiate their obligations, nations should do the same.
We are told that the market for government bonds will collapse if nations can default. Rubbish – the corporate bond market survives the occasional renegotiation, so would the government bond markets. Of course interest rates might rise but that would encourage governments to be more careful before borrowing – just like the private sector.
The real issue is how a Chapter 9 type arbitration mechanism can be designed. The history of sovereign debt default gives some salutary warnings.
Egypt’s financial crises of the 1870s started when naïve Egyptian rulers were sold absurd quantities of credit by unscrupulous Europeans. When it all went wrong the British government were able to buy the the Suez Canal Company for a quarter of its true value and British and French “experts” were installed in key Cabinet posts to ensure that servicing debt took priority over everything else. Effectively the country was taken over by a consortium of European banks and their government patrons.
The Tunisians too borrowed enormous sums from Europe. In 1869 when it became bankrupt Tunisia had debts of 240m piasters but an annual government income of just 20m piasters. As a consequence of its bankruptcy Tunisia’s sovereignty was surrendered to an international financial commission, which proved to be a prelude to a full-scale French invasion and the conquest of the country.
Nobody is suggesting Ireland is about to be invaded by Goldman Sachs' private army but it is worth remembering that, as Eugene Rogan writes in his history of the Arabs in the middle of the nineteenth century, “The single greatest threat to the independence of the Middle East was not the armies of Europe but its banks”. Any debt arbitration mechanism must not become dominated by the lenders.
(As an aside the example of Algeria showed that the key to debt negotiations was not legality but naked power. Far from borrowing money from Europeans the Algerians made the mistake of extending their own credit. When Napoleon started his military adventures in Italy and Egypt he needed food for his troops and their horses. Algeria was the breadbasket of North Africa and the Algerian Dey allowed the French to buy grain on credit. The debts were never repaid. For three decades the Algerians plaintively demanded that the debts be honoured. The French not only refused to pay up but became increasingly intransigent until in 1830 they settled the issue once and for all by invading the country and adding it to the French empire.)
There are remarkable modern parallels with Egypt and Tunisia. The role of the banks is uncannily similar. In Italy, for example, following a three year investigation, four banks have been charged with fraud for their roles in a €1.7bn (£1.52bn) financing package for the city of Milan. It is alleged that the banks, including Deutsche Bank and J P Morgan Chase –– failed to make clear the risks and true costs of the swaps they sold to the municipality.
Greece provides a more high profile example. In 2002 the Greek government was faced with mounting public debt that threatened its Eurozone status. Goldman Sachs suddenly promised to make the problems disappear. An incredibly complicated deal was agreed involving €5bn of off-market cross-currency swaps linked to outstanding Greek debt, under which bonds denominated in yen and dollars were swapped for euros. Because it was treated as a currency trade rather than a loan, it helped Greece to meet European Union deficit limits while pushing repayments far into the future.
The deal had three outstanding features. First was the fact that although technically legal at the time it was clearly contrary to the spirit of the eurozone rules. Second, and possibly for that very reason, both parties agreed to keep the deal secret. Third Greece paid a staggering €200m in fees and charges.
Is it really anathema for European governments to consider defaulting on such deals? And if they do surely that sets a precedent for third world governments drowning in floods of inherited debt.
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