Posted by: Dirk | May 5, 2009

European budget deficits 2009/10 – so what?

The FT reports:

Europe’s public finances will be under greater strain next year than at any time since the euro’s launch in 1999, with 13 of the eurozone’s 16 countries expected to have budget deficits of more than 3 per cent of gross domestic product. According to forecasts published last week by Barclays Capital, Germany, France, Italy and Spain – the eurozone’s four largest members – will be burdened with deficits of 6 per cent; 7.1 per cent; 6.1 per cent; and 11.2 per cent respectively in 2010.

So, all these countries are having budget deficits. Let me explain it in a very simple way. European (euro zone) governments are not allowed to take on more debt than an additional 3% of GDP. That’s it.

So, where is the debt coming from, or better, who is the creditor? Well, that’s the people with money. Institutional investors, banks, hedge funds, pension funds and so on, who invest the savings of the whole world. (Yes, almost all important financial markets are global by now, except maybe for China.) The question than is: why should these institutions not be allowed to invest in government debt if they want to do so? Why can a free market not solve the problem?

The flip side of this whole idea of limiting government budgets is that investors have to invest their capital in the private sector. Which is not a bad idea, most of the times. As it stands, however, they don’t want to. Financial institutions are sitting on hundreds of billions of euros, dollars and so on, which they are unwilling to invest. Given that private firms have gone deep into debt without any concern that the huge debt might not be paid back, that is not really surprising.

The big questions, as I see it, is this: how can people always complain about government debt and what a burden that would be, when in the last years private sector firms went deep into debt and defaulted on a lot of loans while stock market valuations went down by 40% and more? We have channeled much money to private sector firms. That is debt. And firms have wasted that money, so the debt cannot be repaid.

So, again, why are governments not allowed to increase their debt while private sector firms can do so as they wish? A lot of that private sector debt will never be repaid (Lehman Brothers, Chrysler, …), but nobody says: I want a law which states that firms (or even banks!) in the eurozone can increase their debt only up to an amount of 3% of their turnover.

Let me summarize: I believe in the market. Banks should have the choice between investing in private firms (high risk, high yield) or in government bonds (low risk, low yield). Limiting the supply of government debt (to an extra 3% of GDP per year) is something which I consider a bad idea. If governments are likely to default on their loans, investors wouldn’t invest into government bonds or demand an interest rate that is high enough to compensate them for the extra risk. Why should the market not work? Economists assume people to be rational in all financial models, so why are they irrational when they supposedly give a loan to a government which is known to squander the money?

The Stability and Growth Pact stands in the way of solving the economic mess we are in. Banks are sitting on hundreds of billions of dollars and euros, and it seems that they would only invest that money in government bonds. We need this money to be invested to get our economies moving again. There is no scientific explanation of why the Stability and Growth Pact should be there in the first place (and who came up with that 3% rule anyways?). It should be demolished.

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