The 2010’s are characterized by the very high levels of debt that imped countries’ policies all across the world. Prof. Viral Acharya (NYU Stern School of Business) explains why and how governments have led us here.
When is it advisable for a country to default?
To understand the reasons why the sovereign debt crisis has engulfed the western economies, it is important to go back, and see where the economics and finance literatures stand, and how they can help us understand exactly what the root causes of sovereign default might be. Is it just strategic for a sovereign state to want to walk away from certain foreign creditors? Or is it for a more solvency-based reason, in the sense that sovereign states have actually built up unsustainable levels of debt on their balance sheets?
What the sovereign debt crisis showed is that many countries may have been on a path of unsustainable fiscal expansion, so that the adverse growth shock since the fall of 2008 seems to have particularly brought the solvency of sovereign balance sheets into question.
Another reason, and one that is particularly relevant to the current European situation, is related to the nexus between the sovereign and the financial sectors. It would appear that a banking crisis is very often followed by a sovereign crisis, and vice-versa. The deterioration in the solvency of a sovereign state can affect its own banking sector, or even the whole currency union it belongs to, as shown significantly by the case of the Eurozone.
The third and final reason, which is the primary innovation in our research with Pr. Rajan, concerns government incentives. Because the sovereign fund crisis raises some important questions: Is there a governance problem? Why are governments able to carry on year after year with such high levels of debt? Are there incentives encouraging them to build up such huge levels of debt? Or did they in fact merely build up reasonable levels of debt but were adversely affected by the financial crisis?
In our work, we focus on the two primary financial instruments available to elected governments: tax policy and debt policy. Our intuition is that since governments have an incentive to be re-elected, the decisions they make in terms of tax and debt levels could easily be driven by this incentive. One must understand that in a democracy, reelection is generally about pleasing the median voter rather than maximizing the outcome for society as a whole. This can create different kinds of perverse incentives.
For instance, it might induce a government to continue spending on a program, even though they know the program to be inefficient. Why would they do that? Because cutting back on expenditure would be equivalent to admitting failure, sending a signal that would say “Our program, our plan, is not working well”. And this would probably have a negative impact on voter opinion.
The second problem is an intergenerational one. The current government may be tempted to lower taxes and increase the amount of debt, because that debt will only have to be repaid much further down the road, by future generations who do not constitute a demographic that they need to taken into account today.
And the third problem is that debt and tax policies may be used to favor certain constituencies, certain sectors of industry, because there may be a nexus linking the government with parts of the private sector. The general idea is that in the process of getting itself re-elected, some conflicts of interests may arise, when the government is more interested in pleasing part of the current generation than future ones.
Consequences on society
This conflict of interests has two main effects that are detrimental to society. The first and perhaps most obvious is that it induces government to issue debt until it reaches an unsustainable level. For a government with the ambition of being reelected, issuing debt is a particularly attractive course of action, since it allows higher spending – or at least enables it to avoid spending cuts – without increasing taxation. From the government perspective, it is an easy way to please enough voters to get reelected. The main problem is that the objective of getting reelected is a short-term one, beneficial mostly to the policy-makers but with long-term adverse consequences for the nation. A government with a genuinely long-term vision would internalize the fact that continuing spending is going to result in much higher taxes in the future, and that it may result in a lower growth rate and a reduction in private sector investment, possibly leading to a sovereign debt crisis, because of the nexus with the financial sector. Therefore, a long-term government would have less incentive to raise the level of debt and would be more likely to default if it was in the country’s future best interest.
The second effect is very perverse. When the debt level is already high, lenders are reluctant to buy more debt. If the government still wishes to raise more debt, it must give guarantees to new lenders, it must create a situation such that future governments will have a strong incentive to repay the debt instead of defaulting. And this can be achieved by entangling the country’s financial sector with the country’s debt. Having a part of the national debt owned by the country’s firms makes default much more unlikely because such a decision would badly hurt the financial sector, thus precipitating a banking crisis in the country or in the currency zone. It can be seen as pledging collateral, as giving credibility to the market that the government will collect taxes at almost any price, even if it is very disruptive for the economy’s growth, because defaulting would be even worse. In a currency zone, it might give investors the confidence that other countries, whose banks may be entangled with the debt of an insolvent country, will come forward and bail out the country in question, as has happened in the Eurozone. And as we have seen, the fact that the banking and financial sectors were tightly integrated led to a very serious sovereign debt crisis.
So governments may have incentives not only to build up high levels of debt but also to show the market that they mean business by entangling their own financial sectors.
Technocrats and the debt-ceiling mechanism
However, there are some interesting solutions available for overcoming this conflict of interest. First, the appointment of a non-elected technocratic government may be a temporary solution. Such a government would probably be driven by fewer short-term interests because appointed technocrats are less likely to run in the next election race. They can therefore more easily make unpopular decisions that, although costly in the short term, will yield benefits in the future, such as raising taxes or cutting spending. As we have seen in Europe, in Italy for instance, the appointment of technocrats can be an answer to the failure of an elected government to deal with the crisis and fix the sovereign debt problem. Whether or not we agree with the policy of Italian Prime Minister Monti, he was at least able to put the right issues on the table – which his predecessors did not do – and talk about the necessity of finding a more sustainable fiscal path.
But of course, in a democracy, appointing an unelected government can only be an exceptional and temporary solution. This shows the importance of having strong and independent central banks and regulators. In Europe, all important decisions made to deal with the crisis have been taken by unelected European officials.
A debt ceiling mechanism is another solution to this problem. Although it has been widely criticized in the US recently, it brought the question of debt sustainability into the open at an early stage. The issue was actually put on the table before the markets had expressed any concerns about the US debt, and while the cost of borrowing was still very low, which I view as a very good thing. It does not solve all the problems but it is a first step towards finding a solution. In Europe, it was only after the markets had raised their concerns and started to increase the cost of funding for Spain or Italy to very significant levels that the situation was discussed. This is probably one of the reasons why the crisis is so severe in the Eurozone, and this demonstrates, if need be, the importance of having at the very least a signaling mechanism to avoid being caught off guard by a sovereign debt crisis.
Rimefi benefited from sponsoring by the Toulouse Business School for editing and releasing this interview.
Pr. Viral Acharya (NYU Stern School of Business)
Viral V. Acharya joined New York University Stern School of Business as a Professor of Finance in September 2008. Prior to joining NYU Stern, Professor Acharya was a Professor of Finance and Academic Director of the Private Equity Institute at the London Business School, a Research Affiliate of the Center for Economic Policy Research and an Academic Advisor to the Bank of England. He was appointed Senior Houblon-Normal Research Fellow at the Bank of England to conduct research on efficiency of the inter-bank lending markets for the summer of 2008.
Professor Acharya’s research interests are in the regulation of banks and financial institutions, corporate finance, credit risk and valuation of corporate debt, and asset pricing with a focus on the effects of liquidity risk. He has published articles in the Journal of Finance, Journal of Financial Economics, Review of Financial Studies, Journal of Business, Rand Journal of Economics, Journal of Financial Intermediation, Journal of Money, Credit and Banking, and Financial Analysts Journal.
Professor Acharya has received numerous awards and recognition for his research. He received the Best Paper Award in Corporate Finance from the Journal of Financial Economics in 2000, Best Paper Award in Equity Trading at the Western Finance Association Meetings in 2003, Outstanding Referee Award for the Review of Financial Studies in 2003, the inaugural Lawrence G. Goldberg Prize for the Best Ph.D. in Financial Intermediation, Best Paper Award in Asset Pricing from the Journal of Financial Economics in 2005, and an inaugural Rising Star in Finance Award in 2008.
Acharya earned a Bachelor of Technology in Computer Science and
Engineering from the Indian Institute of Technology, Mumbai, and a Ph.D.
in Finance from New York University Stern School of Business.
Regulation of banks and financial institutions / Corporate Finance / Credit risk and valuation of corporate debt / Asset pricing with a focus on the effects of liquidity risk / International Finance
New-York University Stern School of Business / National Bureau of Economic Research / Centre for Economic Policy Research /European Corporate Governance Institute
Sovereign Debt, Government Myopia and the Financial Sector
V. Acharya and R. Rajan, 2013, the Review of Financial Studies, 26(6), 1526-1560.