Europe should share burden of debt
Today, the world is threatened with a repeat of the 2008 financial meltdown but on an even more cataclysmic scale. This time, the epicenter is in Europe, rather than the United States. And this time, the financial mechanisms involved are not highly complex structured financial products, but one of the oldest financial instruments in the world: government bonds.
While governments and central banks race frantically to find a solution, there is a profound psychological dynamic at work that stands in the way of an orderly debt workout: our aversion to recognizing obligations to strangers.
The impulse simply to cut the Gordian Knot of debt by defaulting on it is much stronger when creditors are remote and unknown. In 2007-2008, it was homeowners who could not keep up with payments; now it is governments. But, in both cases, the lender was distant and anonymous. US mortgages were no longer held at the local bank, but were repackaged in esoteric financial instruments and sold around the world; likewise, Greek government debt is in large part owed to foreigners.
Despite assumptions that national temperament somehow imbues countries with a proclivity to default, a key determinant of debt sustainability should not be ignored: the identity of the state's creditor.
This variable makes an enormous difference in terms of whether debt will be regularly and promptly serviced. The frequent and spectacular early modern bankruptcies of the French and Spanish monarchies concerned for the most part debt owed to foreigners. The sixteenth-century Habsburgs borrowed at very high interest rates from Florentine, Genovese, and Augsburg merchants. Ancien Rgime France developed a similar pattern, borrowing in Amsterdam or Geneva in order to fight wars against Spain in the 16th and 17th centuries, and against Britain in the 18th.
The Netherlands and Britain, however followed a different path. They depended much less on foreign creditors than on domestic lenders. The Dutch model was exported to Britain in 1688, along with the political revolution that deposed the Catholic James II and put the Dutch Protestant William of Orange on the English throne.
Indeed, the Glorious Revolution enabled a revolution in finance. In particular, recognition of the rights of parliament of a representative assembly ensured that the agents of the creditor classes would have permanent control of the budgetary process. They could thus guarantee also on behalf of other creditors that the state's finances were solid, and that debts would be repaid.
Constitutional monarchy limited the scope for wasteful spending on luxurious court life, as well as on military adventures the hallmark of early modern autocratic monarchy.
In short, the financial revolution of the modern world was built on a political order which anteceded a full transition to universal democracy in which the creditors formed the political class. That model was transferred to many other countries, and became the bedrock on which modern financial stability was built.
In the post-1945 period, government finance in rich industrial countries was also overwhelmingly national at first, and the assumptions of 1688 still held. Then something happened. With the liberalization of global financial markets that began in the 1970s, foreign sources of credit became available. In the mid-1980s, the US became a net debtor, relying increasingly on foreigners to finance its debt.
Europeans, too, followed this path. Part of the promise of the new push to European integration in the 1980s was that it would make borrowing easier. In the 1990s, the main attraction of monetary union for Italian and Spanish politicians was that the new currency would bring down interest rates and make foreign money available for cheap financing of government debt.
Until the late 1990s and the advent of monetary union, most government debt in the European Union was domestically held: in 1998, foreigners held only one-fifth of sovereign debt. That share climbed rapidly in the aftermath of the euro's introduction. In 2008, on the eve of the financial crisis, three-quarters of Portuguese debt, half of Spanish and Greek debt, and more than 40 percent of Italian debt was held by foreigners.
When the foreign share of debt grows, so do the political incentives to impose the costs of that debt on foreigners. In the 1930s, during and after the Great Depression, a strong feeling that the creditors were illegitimate and unethical bloodsuckers accompanied widespread default. The economists' commonplace that a monetary union demands a fiscal union is only part of a much deeper truth about debt and obligation: debt is rarely sustainable if there is not some sense of communal or collective responsibility. That is the mechanism that reduces the incentives to expropriate the creditor, and makes debt secure and cheap.
At the end of the day, a collective, burden-sharing Europe is the only way out of the current crisis. But that requires substantially greater centralization of political accountability and control than Europeans seem able to achieve today. And that is why many of them could be paying much more for credit tomorrow.
The author is professor of History and International Affairs at Princeton University and Professor of History at the European University Institute, Florence.
Project Syndicate.
