The Debt Obsession

Thu Nov 3rd, 2011 at 07:07:34 AM EST Originally Published 

We are living a debt crisis in Europe; some states are presently unable to finance themselves on the regular credit markets. This state of things has provide fertile ground to question the Social State and force on these ailing states a new socio-economic paradigm. This has been achieved by masking the real problems Europe is living and falsely characterizing the economic difficulties of the weakest states. Some days ago I was sent a link to an article by Der Spiegel on Portugal that oincluded this paragraph:

On the way there, a two-lane bike path hugs the coastline for several kilometers between Cascais and Guincho. Special streetlights spaced only 50 meters apart illuminate the brownish-red special asphalt at night. But cyclists are rarely to be found along this route, even during the day, because the wind is simply too strong.

In this log entry I’ll deal with these and other misconceptions about Portugal: structural funds, football stadia, highways. None of it is good, but none of it is the cause of today’s problems. Debt has become an obsession that is holding back the move forward.

front-paged by afew

Skimming the surfaceThe road from Lisbon to Guincho is about 40 km, first alongside the Tagus river, passing its outlet and then along the Atlantic coast, towards the West. We call it the Marginal, for following the margin between land and water. When I lived in Portugal I used to ride that road almost every week; especially during the Fall/Winter when clear skies make it one of the sunniest and pleasant paths to do when its cold. I used to take the ferry or the train from the south margin with some friends, meet a few other riders across the river and then off we’d go towards Guincho, passing through Caxias, Carcavelos, Parede, Cascais; from there start the climbs into the luxurious mountains of Sintra. This road has two lanes each way making it safer for groups of riders; its relative flatness also makes it a perfect path for resistance training. It is the busiest cycling path in Portugal, where you can find most athletes of the region in the disciplines of Triathlon, Duathlon, Mountain Biking and of course Road Cycling. During Winter you can easily cross paths with the likes of Sérgio Paulinho. Some of my biking buds do this road almost every day. The only thing true on Der Spiegel is the wind from Cascais to Guincho, always strong and from the West; but you can easily find a group where you can protect yourself.Maybe the journalist from Der Spiegel went to Cascais during the night, or maybe during a stormy day. This is in essence the problem with the debt obsession, its just skimming the surface without getting to know the underlying issues that brought on the present difficulties. Those obsessed with Debt see it as something evil or immoral, in what is almost a religious stance, taking debt has something bad by itself. That naturally happens for they don’t go further into the biophysical and institutional details that can turn sovereign debt into a burden.

Not the same as your debt

Before going on into the misconceptions laid out by Der Spiegel, it is important to understand what is sovereign debt. The debt contracted by a state is not the same thing as the debt contracted by a household or a company. A state goes into debt denominated on a currency whose value it controls, thus it has further options to pay it back and comply with the respective interest. It almost sounds like a con, so why do investors lend money to states? This a very important question which has a simple answer: because it is a risk free investment, the interest may be low but in theory the state never defaults, if needed be the value of the corrency can be adjusted to commit with outstanding obligations. Sovereign debt is thus a low return, low risk, high liquidity investment that fits in the portfolio of every investor. It is a very important instrument in modern economies, it produces an additional flow of capital to the state budget, guaranteeing that money keeps circulating, theoretically directing resources into strategic state investments, either be it Social programmes, Infrastructural upgrades or Institutional reforms, things that in the long run increase the state’s economic resilience.

But a state can’t go on expanding its outstanding debt for ever. For starters there is a limit imposed by the savings of its citizens and institutions, if that limit is breached then capital has to be lent from foreign investors. This debt outstanding to the exterior represents a continuous flow of money to outside the economy that slowly drains internal investment. If the indebted state is experiencing healthy growth this can be handled to some extent, otherwise it becomes unsustainable. The end result is either an open default or a serious monetary devaluation, the aftermath of which can not only be very painful (with a rapid impoverishment of citizens) but can even lead to state institutions loosing control of the situation (e.g hyperinflation, bank runs).

Those obsessed with debt think it is exactly a scenario like this that is unfolding in Portugal (and the remaining PIIGS). Only at the surface, there are much deeper processes in motion. Following, I’ll deal with some misconceptions about Portugal spelled out by Der Spiegel and later move on to the real causes of the present crisis.

Portugal has been living beyond its means for decades

This is very easy to verify looking at a long term graph of sovereign debt as percentage of GDP:

Portugal’s sovereign debt since 1850. Source: My Guide to your Galaxy.

Sovereign debt in Portugal remained below 70% of GDP from its access to the EU in 1985 up to 2008. There were a few years during which Portugal broke the Stability and Growth Pact around the turn of the century and again in 2004. In both occasions the budget deficit was brought back down below 3% of GDP, avoiding the dreaded expansion of sovereign debt.

The sovereign debt crisis in Portugal is something very new, with the first jump up in 2009. This is true pretty much for all the PIIGS, though Greece effectively had problems from the past. Thus this crisis is not due to decades of bad budget management, but to other problems, much more serious, that I’ll tackle ahead.

Portugal received a boatload of structural funds during the past decades

That is very true, but it is also important to understand to what purpose where those funds used. In a nutshell they where employed to destroy Portugal’s Primary Sector: subsidies to decommission the fishing fleet, subsidies to reduce agriculture production, to plant unprofitable crops, to simply leave arable land vacant. Today the Primary Sector represents no more than 1/3 of what it was in 1985, when Portugal joined the Union. I’m not going to focus too much on the responsibility of this tragedy, for certain state leaders lacked the vision to administer these funds differently and equally responsible was the lack of steering and oversight from EU institutions. These funds opened and sustained an artificial trade deficit that now wants to close rapidly.

And while I’m at this, it is also important to note that during the same period the Secondary Sector halved. This had mostly to due with the opening of the internal market to Asia, where industries operating in the same sectors as those in Portugal (e.g. Shipbuilding, Clothing, Shoe-making) benefited from a huge salary advantage. Either this opening was too fast or ill prepared, the fact is that certain transformation industries simply vanished.

I don’t know if there ever was a clear intention to transform Portugal into a service economy, possibly underpinned on high education jobs. Either intended or not, that process has failed rotundly, with the Tertiary Sector today not being able to generate enough wealth to compensate that lost in the other sectors. There can be several reasons for this, but to me it seems difficult to have an economy based on knowledge and low wages at the same time. High educated people can easily find better working conditions abroad, just like it happened with me.

This is why Portugal is ailing today: a wide trade deficit due to a de-structured economy. The thing is that Portugal is part of something much wider called the Eurozone, which on a whole has no trade issues at all, by the contrary.

Highways and Football Stadia

These are two other tenants of the sloppy budget management discourse. While they are good examples of the lack of vision in internal policies, blaming these particular infrastructural projects for the present levels of sovereign debt is once again throwing sand to the eyes.

To host the Euro 2004 Football Cup there where 10 stadia either built anew or deeply renovated. The five larger of these where built by the major football clubs: two in Lisbon and three others in Oporto, Braga and Guimarães. These projects where financed by private debt and advertising deals, not by the state budget; so far these five stadia have continued to generate revenues that seem to support themselves, featuring regularly in the big EUFA competitions. Of the other five smaller stadia, two where built by clubs that collapsed in the meantime (in Oporto and Aveiro), another in Leiria has proved to be to big an infrastructure for the hosting city, and two others in Coimbra and the Algarve are unattached to football clubs. As a whole these ten stadia amounted to an investment just over 660 M€ (0.4% of GDP) of which 100 M€ where put up by the state.

Highways are very interesting things in Portugal, they are not primarily financed by the state but commissioned to private companies for 20 to 30 year periods during which they must built and maintained. Costs are paid by users who face the heaviest tools in Europe, eventually transferring to these companies 2 to 3 times the actual construction costs. There were some exceptions to this scheme, with tool-free highways in less developed regions, but since 2009 all those exceptions where scraped.

Certainly Portugal would do much better with a proper rail network than its countless highways, and likewise 10 stadia for the Euro 2004 were a megalomania, but these are not the culprits for today’s unbearable sovereign debt.

The debt crisis, as it happened

So what did happen to Portugal’s sovereign debt? As I referred before, Portugal broke several times the Growth and Stability Pact before 2009, always for no longer than one year, with small figures and never really expanding the debt to GDP ratio. During the last months of Barroso’s office, some pundits were even pointing to the possibility of excessive liquidity that the Government should tackle (Barroso’s successor took care of it in excess).

The first point to make on this is that Portugal was one of the states most affected by the expansionist policies started in the US by George W. Bush’s office after the 2001 recession, that had to be replicated by most of the OECD (not to be picky here, this is just an important point). The result was the overheating of the Civil Construction market, which on the one side came as balsam to an economy that was loosing its Secondary Sector, but on the other hand rapidly expanded household debt. Due to ill thought legislation that has prevailed since the Fascist regime, there was no real house rental market in Portugal; the law is so penalizing on landlords that makes renting a very risky business (e.g. a renter that defaults on payment has 6 months for free before being effectively thrown out). This means that most families in Portugal are indebted to banks with figures that equal several decades of salaries.

This all turned around when Central Banks started increasing interest rates on the wake of a rise in energy prices first, and then minerals and food. They took these price rises as a direct consequence of their policy in previous years, misunderstanding the physical mechanisms at work. Household debt servicing went up, but the prices of energy, food and many other goods kept creeping up all the same; household budgets were rapidly squeezed and defaults spread. This eventually resulted in the 2008 credit stoppage and the ensuing support programmes to the banking industry. 2009 was a rough year, with the explosion of unemployment and a serious contraction of GDP. States like Portugal faced at the same time a reduction of income due to the recession and an increase in expenses with both social aid programmes and the sorting out of ailing banks. The budget deficit in Portugal sky-rocketed to unheard levels of 10% of GDP, with Parliament elections later that year preventing prompt action to curb non essential expenses. But this scenario started changing in 2010 with most economies recovering; by the midst of that year Portugal was the fastest growing economy in the Eurozone.

During the summer of 2010 events took a complete U-turn, with rating agencies starting their thorough downgrading of Portugal’s (and other Eurozone states) sovereign debt. To complicate things further a stalemate around the 2011 budget formed in August at Parliament, with the minority Socialist government unable to find the support to its intended cuts. This soap opera dragged up to the end of October, when the largest member of the EPP in Portugal finally agreed on the budget. In the meantime interest rates on Portuguese 5 year bonds went nigh on 7%/a, despite the intervention of the ECB in the secondary market; looking back this was effectively the end game. During the Parliamentary session that debated and approved the budget, EPP members made it clear that they would overthrow the government before 2011 was out. So they did, through an agonising process that I previously accounted for, ending up with the aid request to the EU and the IMF. This was effectively a form of sovereign default.

Apart from the pathetic internal politics, the road to this default was set mostly by the rating agencies. In effect, from the summer of 2010 to May of 2011 Portugal lived a fast regression by which a good part of its debt transformed from internal to external debt. In a matter of months the money lent from banks in other Eurozone states became a burden, with ever increasing interest rates undermining any attempts to equilibrate the state budget. And it is important to note that the major fault of this regression has been of the EU itself, not of the rating agencies directly. These are private, foreign institutions that exist with the sole purpose of creating profits for their shareholders and partners. They had perfectly showed during 2008 that such is their way of operating, Europe can only blame itself for relying on such institutions. We end up with the awkward situation of a Dutch bank having to ask an American private company if it should lend money to Portugal, another Eurozone state.

The interest Portugal has to pay on its sovereign debt as percentage of GDP. Source: Desmitos.

This could have all been avoided if the proper mechanisms had been enacted in time. When the Eurozone bank aid programme was announced in 2008, it was already clear that some states where exposing themselves too much. Something like an European Treasury, an Eurozone backed sovereign debt emitting entity was needed and would have spared many of the ordeals lived today. This debt market regression has been left unchecked for so long that now not only infra-structurally weak states have been affected, even larger states with small trade deficits and high savings rates like France are going under stress. While the Eurozone debt market isn’t restored, with state A lending money from a bank in state B as if it was an internal bank, without foreign interference, there is no end to this crisis.

The present answer

So far the actions taken by the Eurozone to deal with the crisis have done little to nothing to deal with this regression. An aid package is agreed on to help some ailing state, the rating agencies come and downgrade another state, which leaves a few banks in trouble, these banks get themselves downgraded and put in check their states of origin and further sovereign downgrades ensue; a series of emergency Councils follow, new aid packages are agreed upon and the process restarts.

What is more, these aid packages come with such austerity measures that are guaranteeing that the supposedly aided state doesn’t close it’s budget deficit. In Portugal a public worker that received 14 000 € in 2010 will be getting only 11 000 € in 2012, a reduction of 25%; at the same time the working schedule has increased from 40 to 42.5 hours per week. The government expects a reduction of GDP in 2012 of some 3%, though in effect it doesn’t has a clue of how deep the recession will be, such austerity send numerical economics models into uncharted territory: how much will unemployment increase? how many households will be forced to default on their debt? what will be the impact on tax revenue? what happens to tax evasion? The budget gap becomes a moving target, the government aims at some nominal value but it can only wild guess at what percentage of a fast contracting GDP will it correspond.

Unfortunately some of the strings attached to these austerity recipes are aimed at deriding the Social State. This debt obsession has been very useful to the Liberals, that have sized the moment to spawn their ideals of reduced solidarity and economic laissez faire. I believe this is one of the reasons why decisive action hasn’t been taken by the European Council yet. But the clock is ticking and one of these days it could be one of those Liberal powers to get downgraded.

Looking ahead

By the end of September an unthoughtful swing of the French Senate to the Left became the latest and most visible pronounce of the political change operating in Europe as a consequence of the failed austerity and lessaiz faire strategy. Days later the Commission President made use of the State of the Union address at the European Parliament to clearly demarcate himself from his own party’s strategy, acknowledging the failure of these policies obsessed with debt. Perhaps with the end of his term in sight, Barroso simply doesn’t want his name attached to the most deficient generation of politicians the European Union has met in its yet short history.

In 2012 elections determining the executive offices in France, Italy and Spain shall take place; in 2013 it will be Germany’s turn, if the coalition based on a party that simply disappeared from polls can reach that far. In about one year a whole new generation of political leaders shall be heading the European Council; most of them will be Socialists, but what’s important is that they will be much more willing to finally re-start the European Integration process.

Until then, and in spite of the new agreements on the EFSF, perils remain in the way, like a bank run prompted by an ill programmed debt “hair-cut”. Rating agencies can at any time decide to hit one of the largest states of the Union; in such case decisive and swift measures towards further integration must be taken. Can present leaders cope?

What really matters

But what is most dangerous about this short-sighted obsession is that it is masking the true reasons for the present crisis: long lasting trade deficits associated to over reliance on foreign energy. Slowly the austerity relegated commodity prices to the background, Oil for instance has been over 110 $ per barrel for many months without anyone noticing it. It has delayed, or completely eliminated, projects that would mitigate the dependence on Oil; in Portugal the TGV plans were fully scrapped and several tram lines are now menaced, those existing to stop functioning, the planned to never be built. In Spain feed-in tariffs to Wind power are under political pressure, as so  those for Solar in Germany. The debt obsession is a process of self destruction.

When the renovation of the political leaders roster in Europe is done with, this ill obsession will have its days numbered. New proposals shall certainly come on the table to deal with the debt stress, but will the new leaders be able to tackle the real source of these problems? Will they understand the full reach of the situation they’ll be facing? I hope so, for there may not be space for another failed political generation.

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