Thu, Oct 13, 2011 - Page 9 News List

Bleeding the foreigners: the psychological dynamics of debt

By Harold James

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 US. 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 to simply 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. However, in both cases, the lender was distant and anonymous. US mortgages were no longer held at the local bank, but had been repackaged in esoteric financial instruments and sold around the world. Likewise, Greek government debt is in large part owed to foreigners.

Because Spain and France defaulted so much in the early modern period, and because Greece, from the moment of its political birth in 1830, was a chronic or serial defaulter, some assume that national temperament somehow imbues countries with a proclivity to default. However, that search for long historical continuity is facile, for it misses one of the key determinants of debt sustainability: the identity of the state’s creditor.

This variable makes a huge 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 16th century Habsburgs borrowed — at very high interest rates — from Florentine, Genovese and Augsburg merchants. Ancien regime 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.

However, the Netherlands and Britain 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 adventure — 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.

This story has been viewed 3187 times.

Comments will be moderated. Keep comments relevant to the article. Remarks containing abusive and obscene language, personal attacks of any kind or promotion will be removed and the user banned. Final decision will be at the discretion of the Taipei Times.

TOP top