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The Risk of Sovereign Debt

Mises Daily: Wednesday, December 07, 2011 by 

Collateral debt is in almost all cases collateralized by some asset. A mortgage is backed by the value of the house that it is borrowed against. Student loans are backed against the future earnings ability of the student (or their parents’ income and assets if cosigned). In almost all cases debt is collateralized by the asset that it is used to purchase.

Sovereign debt is slightly different, as no clear asset stands ready to serve as collateral. Instead, borrowing is backed by the future taxing capacity of the state. When investors purchase sovereign debt, they do so knowing that if their plans turn out wrong they will not be receiving some portion of that state’s assets as the consolation prize. They purchase the bond knowing that the ability to repay is conditioned by the future economic health of the country, and also by its future taxing power. As there is a general negative relationship between tax rates and economic health there is an upper bound on how much tax revenue can be raised in the future to pay off debts incurred today.

When we say that sovereign debt is “risk free,” we mean that there is no credit risk. A state is forever able to pay off its nominal liabilities in one of two ways: either it increases its taxes to raise more revenue (through direct taxes), or it monetizes its debt by increasing the money supply (an inflation tax).

Central banks are, by and large, granted some degree of operational independence in order to avoid the second circumstance. The inflation tax is an extremely attractive way for a state to pay for its liabilities. No one pays it directly, and hence there is a reduced chance for “taxpayers” to see the wealth appropriation. A government given direct control of the printing press has an incentive to give higher rates of inflation than the public desires, if only to pay off the debts it incurs. Central-bank independence removes this option.

Sovereign debt is not risk free; the real payoff may differ from the nominal promise. For domestic-debt holders, this arises when inflation occurs. For foreign-debt holders, this risk mainly arises through foreign-exchange risk. In either case the source is the same — inflation reduces the purchasing power of the currency of denomination and thus reduces the real value of the future payment.

Interest rates are set on sovereign debt with these risks in mind. Importantly, if direct default risk is minimized through the state’s future taxing capabilities, the lone risk remaining is through inflation or an adverse exchange-rate movement.

The advent of the European Monetary Union brought about an interesting change to the way that investors calculated these risks.

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Filed under economics economy politics sovereign debt risk collateral assets economic health tax rates tax revenue inflation central banks taxpayers currency interest rates European Monetary Union eurozone crisis

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Statement on the Fed’s Continued Euro Bailout

by Ron Paul                                                                                                     December 01, 2011  

    

The Fed’s latest actions in cooperating with foreign central banks to undertake liquidity swaps of dollars for foreign currencies is another reason why Congress needs enhanced power to oversee and audit the Fed.  Under current law Congress cannot examine these types of agreements.  Those who would argue that auditing the Fed or these agreements with central banks harms the Fed’s independence should reevaluate the Fed’s supposed independence when the Fed bails out Europe so soon after President Obama promised US assistance in resolving the Euro crisis.

Rather than calming markets, these arrangements should indicate just how frightened governments around the world are about the European financial crisis.  Central banks are grasping at straws, hoping that flooding the world with money created out of thin air will somehow resolve a crisis caused by uncontrolled government spending and irresponsible debt issuance.  Congress should not permit this type of open-ended commitment on the part of the Fed, a commitment which could easily run into the trillions of dollars.  These dollar swaps are purely inflationary and will harm American consumers as much as any form of quantitative easing. 

The Fed is behaving much as it did during the 2008 financial crisis, only this time instead of bailing out politically well-connected too-big-to-fail firms it is bailing out profligate government spending. Citizens the world over deserve better than this. They deserve sound money that cannot be manipulated and created out of thin air by central planners who promise printed prosperity. Fiat money caused this European crisis and the financial crisis before it.  More fiat money is not the cure. The global fiat currency system has proven itself a failure, we need real monetary reform. We need sound money.

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Filed under Ron Paul politics economy economics news eurozone crisis Federal Reserve central banks inflation fiat money sound money

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HOW’S THIS FOR SOCIAL UNREST?

by SIMON BLACK October 18, 2011

Phnom Penh, Cambodia

In his seminal work The Rise and Fall of the Third Reich, William Shirer recounts how the struggling Weimar Republic printed its way out of reparation debt from World War I. Out-of-control printing caused the German mark to fall from 75 per dollar in 1921, to more than 4 billion just 3-years later.

Talk about chaos. After a brief period of credit-fueled economic respite, the onset of the global depression in 1929 had people in the streets clamoring for change. Hitler’s National Socialism promised the world… and under such economic distress, people believed him.

There are two important lessons here. First is that hyperinflation comes very quickly. Confidence languishes for months, even years… until one day the currency begins to slide, slowly at first, then exponentially.

The second is what followed. Economic disaster begets social unrest, the two are inextricably linked. Populist rebellions and roving gangs became a constant presence in the republic.

It’s at this point, when people are really hurting, they’re the most impressionable. They’re looking for somebody, anybody, to lead them out of the turmoil. What they got was a charismatic leader with a grand plan.

Here in Cambodia, a similar story unfolded in the 1970s.

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Filed under economy economics politics commentary social unrest inflation hyperinflation Weimar republic