Countries Do Not Borrow, They Are Bought

A lot of the criticism of peripheral countries in the euro area relies on an implicit comparison with households or firms. The argument goes like this: these countries borrowed excessively after they joined the euro at the end of the 1990s in order to live beyond their means and then got in trouble when they could not pay back the money. This argument is usually directed at the public sector in countries like Greece and Italy, at the private sector in Ireland and Spain, and at both the public and private sector in Portugal. These countries have all received their comeuppance and–like any firm or household in a similar situation–they now have to live within their means.

This analogy between countries on the one hand, and households or firms on the other hand, is misleading if not completely wrong. The reason is that countries do not ‘borrow’ in any conventional meaning of the term–at least not under normal circumstances. When things are going well, countries do not fill out an application with various lenders. They do not have to provide a business plan or show any bank statements. They do not offer up collateral or enlist the support of co-signers. These things only take place once a country gets into trouble and needs some kind of international bailout. ‘Borrowing’ for countries in a conventional sense means that something bad has already happened; it is the symptom and not the cause.

In normal times, countries don’t borrow; countries are bought. When we talk about ‘borrowing’ in an international sense, what we really mean is that some foreigner has come into the domestic market to make an investment. Most likely they bought government bonds or some kind of bank paper. But they can also take an equity stake in one or more large companies, they can deposit money in local banks or purchase those banks outright, or they can set up some activity of their own like a branch, subsidiary, or startup. These ‘investments’ from the foreigner’s perspective will show up as ‘borrowing’ for the country that receives the money in exchange for the assets that are bought from abroad.

You rarely if ever see this kind of activity in either households or firms. Nobody comes into your home and starts paying your bills or goes into your firm and starts paying your workers–all with the expectation that you will pay that money back to them with interest at some point in the future. You don’t wake up one morning to find that someone has refinanced your mortgage or started making you breakfast or taken over mowing your lawn expecting you to pay a fee for this service. Money doesn’t just appear in your bank account with a note attached that it might be called upon later. Moreover, if anything like that did happen you would probably want to get the police involved. It doesn’t matter that these new ‘creditors’ might be doing things better and more cheaply than the more self-sufficient alternative. You would fear the power they suddenly acquired over your daily life and you would want some say in how that played out.

Countries are not allowed to express that suspicion. On the contrary, the law tells domestic governments not to get involved. That is what capital market liberalization is all about. It is a commitment to let foreigners buy things in the domestic economy as cheaply and as easily as domestic residents. This is what was promised with the completion of the single market in Europe; it is what motivated the financial services action plan and the Lamfalussy process; and it is behind the current project to create a capital markets union as well. In all these cases, European countries had to sign up to a commitment to let foreigners buy whatever they want at whatever price the market will offer. Moreover, they signed up to that commitment long before the euro ever existed and whether or not they had any intention to join the single currency. The idea behind doing so was that allowing money to flow from countries with surplus savings to countries that have good opportunities for investment will make everyone better off.

That idea is true in the aggregate. Capital market liberalization does improve overall market efficiency and so also general welfare. But capital market liberalization also redistributes income and risk in ways that work better for rich countries than for poor ones. Consider a situation like Italy. A lot of foreigners took advantage of capital market liberalization in Europe to buy Italian government bonds. Only about six percent of Italian bonds were held by foreigners in the early 1990s; by the late 1990s more than a quarter of Italian government bonds were held by foreigners; that figure rose to almost half the total for Italian government bonds in circulation by 2007. This huge inflow of foreigners was a boon to the Italian government because the treasury was able to sell bonds at a higher price and therefore a lower rate of interest. But it was a problem for Italian savers who were used to getting a good return on government debt instruments and who suddenly found themselves priced out of the market. They had to park their savings in riskier assets as a consequence.

What was true for Italy was true elsewhere on the European periphery as well–again, both before the euro was created and whether or not the country joined the single currency. These were not places where people were looking to live beyond their means. They were places where foreigners were eager to take advantage of low prices and high rates of interest (or return) on their investments. And the more foreigners moved into the market to buy up the best assets on offer, the more they pushed the people who struggled to save money in these countries to look for less expensive and therefore lower quality alternatives. The foreigners made life cheaper, but the locals had to accept more risk.

Then there was a financial crisis in the United States that started in U.S. mortgage markets early in 2007. This crisis had little direct connection to firms or households on the European periphery, but it had a big impact on international investors who suddenly needed money to cover their losses on bets they made in U.S. mortgage instruments or investment banks. Those investors could not sell their U.S. holdings because the markets there were already in free fall and so they started to call the money back from peripheral Europe instead. In other words, they started selling the peripheral European assets they had bought in the 1990s and early 2000s. This selling began in 2008, it gained momentum in 2009, and it became a self-reinforcing process during the period from 2010 to 2012. Foreign investors in peripheral countries sold government bonds and bank paper; they liquidated equity stakes; they closed their bank accounts; they disposed of their banks; and they shuttered any branches or subsidiaries. Meanwhile, other market participants who anticipated this would happen took out derivatives in order to bet that prices on the European periphery would fall. The domestic residents in peripheral Europe did not have the resources to purchase everything that foreigners were hoping to dump onto the markets and they also could not replace the services or the money that foreigners had once provided. The problem wasn’t that these people had been living beyond their means; it was that they had been pushed by foreign investors into doing other things with their savings.

Worse, the investments made by domestic residents were even less liquid than those made by foreigners–because the foreigners had bought the best assets available, where by ‘best’ we should understand both most secure and easiest to sell. As a result, the economies of those countries on the European periphery suddenly stopped functioning because the money to finance normal life was no longer available, because huge amounts of wealth had been lost as asset prices fell, and because the cost of routine working capital was higher than anyone could tolerate in their business models or household budgets. Moreover, membership in the single currency was not a necessary condition and the countries on the euro area periphery were not alone in suffering from the sudden loss of foreign capital. They were joined by other countries on the periphery of the European common market as well–including places as diverse as Iceland, Latvia, Hungary and Bulgaria.

The mythical Swabian housewife used by German Chancellor Angela Merkel to illustrate financial common sense in typical households has never experienced something similar to the buying and selling of financial instruments or key services on the periphery of Europe–at least not since the 1920s or 1930s. They haven’t seen their mortgages double overnight, their credit cards cancelled, their loans called in, their bank overdrafts cut, and their wages left unpaid. Neither has any small or medium-sized enterprise in Europe’s industrial heartland. But that is what took place for whole national economies in peripheral Europe. By implication, there is simply no parallel between what happens to household or firms and what happens to countries.

The countries that live on the periphery of the European common market did not choose to live beyond their means; they were convinced to let foreigner investors have equal access to their assets. Those foreign investors started buying assets almost immediately–and they continued to do so right up until the U.S. financial crisis started fifteen years after Europe’s 1992 target to complete the internal market. Then, instead of buying, the foreigners started to sell. The citizens of countries like Greece were left to suffer the consequences.

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