Public debt is not the real problem, Confidence is

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During this crisis we are constantly being barraged by all these big numbers of money owned by governments. We hear of public debt amounting to hundreds of billions, or even to a few trillions of euro/dollars and of the debt’s ratio to GDP being at extraorbitant rates that are in theory non-sustainable. We hear of debt to GDP going beyond 100%, meaning that the money owned is more than the total production of a country (within a given period of time).

In such cases common sense would suggest that if you have to pay more than what you can produce you simply go bankrupt as there is no way to cover the debt. The alternative is to restructure the debt, meaning that only a part of it will be paid. At any rate when ones hears that the debt is greater than the total production immediately thinks of bankruptcy or restructuring (which is in practice partial bankruptcy). So in that sense public debt is a huge problem. However this is not really true.

The problem is not the existence of public debt, nor its ratio to GDP. The problem starts when people who can lend money fear that they will not get their money back. In the parlance of economics, this translates into the expectations of the markets being (very) negative. When the markets lose their confidence in the ability of a state to cover its debt, then -and only then- start the problems.

This shows the vital role expectations play and how important confidence is. But most importantly this depicts the central position financial institutions have in shaping those expectations. I am not referring to any institutions but to the credit rating agencies, of which the biggest (and most influential) are Moody’s, Standard & Poors and Fitch.

Though these institution are considered to be “financial”, in fact they are political and the experience we have proves this. They claim that their role is to calculate the risk, but none of these institutions gave a negative grade to Lehman Brothers or to any other bank that invested in the housing bubble that brought the financial crisis, and in general their ratings were/are highly inaccurate. Hence their ability to predict and “calculate” the risk was pretty much immaterial.

Yet they still have a catalytic role in shaping expectations as markets listen to what they say. This means that if a country receives a negative rating, then it will have to borrow at higher interest rates and depending on the ratings and how negative those are, the interest rates go up. That is the problem. So when yesterday Fitch decided to downgrade Greece’s credibility it basically succeeded in making things even worse for the country.

Markets are based on speculations and the credit rating agencies play a key role in them. The point is that those forces have grown in power to the extend where a negative rating has similar effects to an embargo and depending on its intensity it can resemble a war.

The point here is that there need to be regulations regarding the way markets function and the way in which credit rating agencies work. Because as things currently stand, the real power lies in the hands of a few “shadowy” financiers who manipulate the expectations of investors and who erode their confidence in the ability of countries to pay their debt.

When we understand that this is the real problem we will find ways to solve it. So far everything we do is futile because we have not addressed the real problem and we think that public debt is what we should fix.

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