How To Fix Europe’s Problems Without Taxpayer Money
September 1, 2011
(This item originally appeared in Forbes.com on September 1, 2011.)
What is a “sovereign default?” People imagine that it is like some kind of bomb exploding, and buildings fall down or something like that. Of course this is nonsense.
A sovereign default means that a government bondholder doesn’t get paid as much as expected. The borrowing government doesn’t pay interest or principal as scheduled. Maybe, after negotiations, the borrowing government agrees to pay €0.50 for every €1 borrowed, and there is a default workout agreement.
That’s it. Instead of being paid €1.00, the lender is paid €0.50. For some reason an aura of mystery surrounds this process. There is no mystery. It is that simple.
A government which can’t pay its existing debt is also a government which cannot issue new debt. Thus, it is unable to engage in deficit spending. So, government spending may have to contract dramatically. If you talk to government bureaucrats, they will insist that this is the End of the World. But, that is, shall we say, the perspective of a government bureaucrat. For the private sector, it is, perhaps, merely the way things should be. The private sector probably gets a certain amount of enjoyment from watching the agony of the bureaucrats and government employees who must finally “live within their means,” so to speak. As the private sector must do every day, in its business and personal affairs.
However, you may have noticed that the government is not particularly concerned with the wellbeing of the private sector. No, the government wants everyone to suffer together. Thus, the government may attempt to raise taxes, which can cripple the private sector. Ideally, a government will reduce spending without raising taxes. Instead, a very smart government will actually lower taxes, to strengthen the private sector, which would help pick up some of the slack from the shrinking government budget.
Does this sound unlikely? I suppose it is, but it does happen. Russia’s government defaulted in 1998. In 1999, the Russian government lowered the VAT rate to 20% from 23%. In 2000, Russia’s government passed a 13% flat income tax, which was implemented at the beginning of 2001. In 2002, the corporate tax rate was reduced from 35% to 24%.
In 2004, the VAT was reduced again, to 18% from 20%. Also, the Unified Social Tax, a payroll tax, was reduced to 24% from 35%. In 2005, inheritance and gift taxes were eliminated. In 2008, the tax rate on dividend income was reduced to 9% from 15%. In 2009, the corporate tax rate was again reduced to 20%.
So you see, sometimes a government that defaults immediately responds with major tax reform, and much lower tax rates. The idea that a defaulting government must immediately raise taxes is just an unfortunate fixation by governments doomed to failure.
And what happened to Russia? At the lows of 1998, just after the default, Russia’s RTSI stock market index hit a nadir of 38.57. In 2008, it hit a high of 2487 – an increase of 64 times! Maybe the 1998 Russian government default was the best thing to happen to Russia in the last hundred years, because it set off a political process of incredible wealth creation, centered on major tax reform.
So we see that a government default doesn’t have to be a disaster at all. It might be the start of a good thing.
How about those bondholders? Today, banks are major holders of government bonds, so the banks face insolvency if governments default.
The bankers are quick to insist that they need a “bailout,” funded by taxpayers. But this is not true at all. Banks can be restructured to regain their solvency without any taxpayer money.
Let’s look at a bank’s balance sheet. On the asset side, it has €1000 of loans and bonds. On the liabilities side, it has €900 of borrowed money (deposits and other borrowings), and €100 of equity capital.
Let’s say that this bank holds €300 of government debt which has defaulted. After some discussions, the borrower agrees to pay €0.50 for every €1.00 it owes. Thus, the bank’s €300 of assets are now worth €150. In other words, the bank takes a loss of €150.
Thus, the balance sheet looks like this: €850 of assets (after a €150 loss), €900 of liabilities in the form of borrowed money, and negative equity of €50.
This is a problem. What’s the solution? The best solution is in the form of a debt/equity swap. Out of that €900 of borrowed money, we swap €400 for equity. The bondholders become shareholders.
Now the bank’s balance sheet looks like this: €850 of assets, €500 of liabilities (borrowed money), and €350 of equity capital. This is more than enough equity capital, which gives the bank the ability to declare and absorb any other losses it has, thus becoming a fully healthy bank.
Now the banks are fine. And, it didn’t cost a penny of taxpayer money.
In practice, this is a little more problematic than it sounds. Probably a large number of banks would have to do this balance sheet restructuring simultaneously. This would mean a “bank holiday,” a period of two weeks or so when all major banks in need of restructuring do so together. But so what. Just do it, and it is done.
Then there are the discussions of the euro itself. What does this have to do with default? Nothing. A defaulting government, instead of paying back a euro, pays half a euro. That’s it.
These are the normal principles and processes of capitalism. For some reason, Europe’s leaders seem terrified of these principles today. I am guessing that most politicians don’t even know that these things – tax reform following default, debt/equity swaps – are possible.
Most of the discussions regarding sovereign default and bank solvency today are drifting dangerously toward “metaphor economics,” in which colorful metaphors dominate discussion, and people tend to lose their grasp of the real situation and possibilities. This is quite common. But let’s make one thing clear: if Europe’s leaders blow it, and create disasters where none needed to happen, it is only because they are incompetents. They like to swan around the continent, staying in five-star hotels, holding “important discussions” and impressing the gullible with their attitude of superiority. They are merely a gang of clowns, blown here and there by events that they are barely able to understand, and for which they are unable to discern a proper solution.