We are used to the notion that companies can go bust for want of cash but not governments, since the latter can print money without limit. This may cause high inflation or even hyperinflation (as in Russia under Yeltsin or Germany in the 1920s). But as long as governments can print currency, they can spend and borrow without limit. Right?
Wrong. The panic in financial and stock markets across the globe last week reflected the growing realisation that neither the US nor major European governments can print money without limit to finance government bond issues, and so could default. The US Constitution says both houses of Congress must approve any increase in the government’s borrowing limit (or debt ceiling). If either house says no, the government cannot issue more bonds, and cannot ask the Fed to print money to buy forbidden bonds.
That nearly happened on August 2. Default was staved off by a budget compromise contingent on a Congressional committee finding additional budgetary savings within the next few months. Some Republicans want to force Obama to default by refusing to increase the debt ceiling. In this respect, the US Constitution ties the hands of its government more completely than in most countries. Even when debt ceilings are raised, they may not suffice for even 12 months of budgetary deficits. That creates huge uncertainties.
In Europe, the 17 countries of the eurozone have given up their own currencies and adopted the euro, issued by an independent European Central Bank. Till recently, every European country assumed it could get unlimited euros from the ECB against its sovereign bonds as collateral.
That has been disproved in the case of Greece: it can still get euros but not without limit, and only subject to stringent austerity conditions. Portugal and Ireland are in similar straits. And if Spain and Italy get into similar trouble, not even the ECB will be able to save them without getting huge additional subscriptions from member states and abandoning all pretence of being an inflation fighter.
Now, there have long been exceptions to the rule that governments can print money without limit. In countries with a long history of high inflation, no buyers may be available for bonds denominated in the national currency, obliging governments to issue dollar-denominated bonds.
This has historically been the case in many Latin American countries, notably Brazil and Argentina Again, some countries like Panama have dollarised – adopted the US dollar as their currency – and cannot print dollars. Still other countries have currency boards – their money supply is rigidly linked to their holdings of dollars or some other hard currency – and hence cannot print currency freely.
Yet the vast majority of governments can indeed order their central banks to print money to buy unlimited quantities of governments bonds.
Besides, the major countries of Europe and North America have long been viewed as so fundamentally sound, economically and politically, as to be fully convertible and fit to be used as foreign exchange reserves. These countries are rich democracies, in which voters will not tolerate high inflation.
So, the world has long assumed that sovereign defaults by the US or European members of the G7 are impos-sible. Small, dubious economies like Greece and Portugal could get into trouble. They had low savings rates and were heavily dependent on foreigners to finance their budget deficits. But all major European powers borrowed mainly from their own citizens.
Default by them was considered impossible. This internal confidence persuaded major European countries to give up their currencies and adopt the euro as a common currency, in pursuit of a united Europe that could eventually rival or beat the USA.
This idea was doomed from the start. Martin Feldstein was at the fore of economists arguing that a monetary union without an accompanying fiscal union would fail. Why? Well, if within a country some parts boom and others slump, taxes from the strong areas will automatically finance welfare and retraining in the weaker areas.
That flows from the concept of national unity. But there is no comparable concept of European unity that automatically arranges fiscal transfers from strong to weak countries in the Eurozone. In practice, mixing 17 different fiscal policies with only one monetary policy has been a recipe for disaster.
Greece, for instance, can no longer print currency without limit, for it has abandoned its currency and placed itself at the mercy of the European Central Bank. In theory the ECB is independent, but in a crisis it succumbs to pressures from its key members, Germany and France. These two countries initially opposed any rescues of Greece and others. But later they prodded the ECB into constantly change its norms to prevent open default by the weak countries.
Problem: in the last 12 months, rescues linked to austerity have increased rather than reduced the debt/GDP ratio of Greece and other stragglers. So the markets worry that Spain will go the same way, maybe even Italy. Italian default would bankrupt most European banks, who have large holdings of gilts issued by weaker countries. It is far from clear that Germany and France will authorise the ECB to print enough euros to save everybody.
The inability of rich countries to print their way out of debt is something markets had not reckoned on earlier. That is one reason for last week’s panic.