Yet another sovereign debt crisis….Comparing 1920 European debt crisis with 2009 one..

An absorbing historical account on sovereign debts by Alex Pollock of AEI.

In nut shell he says if there is government debt, we will have debt crisis and defaults.  Govts nicely brand their debt securities as risk free (0n which then much of finance is based) but history shows these are anything but risk-free.

 

In the foibles and adventures of lending and borrowing, at least one constant law holds: loans that cannot be repaid will not be repaid, whether they are to governments or to anybody else. History shows us that sovereign governments often default on their loans, particularly in times of war or economic upheaval. Europe finds itself in this situation now and would do well to examine past sovereign debt crises—particularly, the European sovereign debt crisis of the 1920s—for lessons.

Key points in this Outlook:

  • Having believed the myth that governments don’t default, many banks and investors will take huge losses in Europe’s sovereign debt crisis.
  • The historical regularity of government defaults—more than 250 have occurred since 1800—gives the lie to the notion that holding sovereign debt is “risk-free.”
  • The sovereign debt crisis of post–World War I Europe provides highly relevant lessons for today.

 

He looks at the European debt crisis in 1920s:

Among the history now forgotten in the midst of today’s European sovereign debt crisis is the European sovereign debt crisis of the 1920s, which distracted the finances and politics of that time before ending in huge defaults. As former British prime minister David Lloyd George wrote, “The World War, prolonged over four years on a more intense and destructive scale than human imagination had ever previously conceived possible, left all the belligerent nations at its close deeply impoverished, burdened with immense debts.”[6]

Borrowing money to spend on destruction is even worse than borrowing money to buy things at high prices that later collapse. After the Great War, what assets were left to service the debt? This was especially true for the losers, but also true for the winners—except for the United States, which emerged from that war the principal creditor of all the others.

What was happening was that each one owed each other:

Put simply, the theory of the Treaty of Versailles was that Germany would be forced to pay reparations, a form of debt, so that France could pay its debt to Britain and the United States, and Britain could pay its debt to the United States. Of course there was a slight problem: Germany probably could not, and certainly would not, pay the reparations as decreed by the treaty, so no one could pay off their debt. This was the famous “economic consequence of the peace” as predicted by Keynes.[9]

Guess the solution? Us lending to Germany…

By the mid-1920s, it was obvious that repayment was not happening and could not happen. The debt crisis then gave rise to a complex negotiation and agreement, with restructuring of obligations and new credit for Germany, in what was considered at the time a landmark success. The similarities to the fevered negotiations in today’s Europe are apparent.

The 1920s negotiation was carried out by the inter-national Dawes Committee and resulted in the contemporaneously celebrated Dawes Plan of 1924. This complicated and politically charged effort was chaired by Charles Dawes, who was elected later that year as vice president of the United States and awarded the Nobel Peace Prize in 1925 for the Dawes Plan.

Under the Dawes Plan, German reparation payments were reduced and restructured, and the French military occupation of part of Germany to enforce payments of reparations was to end. Foreign creditors were to have oversight of the Reichsbank, Germany’s central bank, and to have as collateral German customs duties; taxes on tobacco, beer, and sugar; and revenue from alcoholic spirits. But how can you enforce your rights to such collateral against a powerful government that decides not to pay? You cannot.

New loans to Germany from the United States would make Germany’s required payments possible. So in short: since the United States would lend Germany money, it could pay France and Britain so that France and Britain could pay the United States. Stated in this bald fashion, one might think this was not sustainable, which turned out to be exactly the case.

Hmm. This bit about using German custom duties etc as collateral is interesting.

Things were rosy in mid 1920s leading to this time is different and this is new era beliefs:

With investors’ imagination focused on “new era” prosperity, enthusiasm grew for new foreign government bonds in the 1920s, as the leading center of international finance moved to New York City from London. “The Dawes Loan in 1924 opened the eyes of American investors to the romance of buying foreign securities”[20]—a romance investors subsequently regretted, as Winkler observed: “The American investor is now [in 1933] learning what his cousin across the ocean experienced half a century earlier: non-payment.”[21] By 1936, more than 35 percent (by dollar volume) of 1920s sovereign bonds floated in the world’s new financial capital were in default.[22]

As the 1920s progressed, the government debts created by the Great War did not go away. By 1929, renewed conflict over German reparations gave rise to new international negotiations and a new agreement, the Young Plan, which further reduced payments and scheduled them over the next fifty-nine years. 

  And then came the great depression followed by WW II and multiple debt defaults later.

We see the same story of rising debt now. The point is if there is debt there will be crisis.

Finally why do banks invest in G-debt?

We should consider, in conclusion, the important role of banks in lending to sovereigns, especially as today’s European banks face dramatic losses on their loans to governments. Who promotes loans to governments? Governments promote loans to governments. They have an obvious self-interest in promoting loans to themselves and to other governments they wish to help or influence. They may even create a reassuring name for these loans: “risk-free assets.” Banks are extremely vulnerable to pressure and direction from governments—the more regulated they are, the more vulnerable. Bureaucratic government employees will never discourage loans to their political masters.

In addition to promoting their own debt to all possible buyers at all times, governments promoted Great War loans to Allies, loans to Germany in the 1920s, loans to developing countries to “recycle petrodollars” in the 1970s, loans to Fannie Mae and Freddie Mac until they failed, and loans to fellow governments in the European Union up to today.

Herein lies a knotty conflict of interest—one that is, I suspect, impossible to untangle and relevant both to the instructive past and the future. Because governments always promote government debt, future sovereign debt crises are inevitable.

 Superb as always…

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