France may show us the way
Firms routinely go out of business in a modern dynamic economy. Very often there are innocent victims of the failure. A business collapse usually involves financial creditors who may, or may not, be prepared to take their share of the losses. Banks, for instance, make provisions for bad debts in their accounts and monitoring.
Particularly difficult are failures of financial institutions which trade on promises-to-pay. Often a failure has knock-on effects, especially if creditors have borrowed to invest in the institution. We may survive a single financial institution falling over, although some creditors and innocent parties may suffer badly. Sometimes a concatenation of institutions collapses with serious consequences elsewhere. That is a financial crash, the topic of this column.
You know all this. You may, like me, observe firms collapsing every time you look at news-site with reasonable business coverage. You don’t panic – what you are seeing is business as usual. But you look for patterns which may suggest the next financial crash is looming. You ask not ‘if’, but ‘when and how’ the crash will happen.
I have explored a possible crash from an overstretched AI industry and the possibility of a cryptocurrency crash, which is probably not big enough to have a widespread international impact. The Chinese financial economy is a mystery wrapped in an enigma.
The possibility of a sovereign debt crisis is beginning to appear in the news. That occurs when a state faces severe difficulty or an inability to repay, service, or refinance its public debts. Many governments have defaulted on sovereign obligations at least once. But a default by the biggest ones has been rare in the post-war era. That possibility is being considered for France, one of the ten biggest economies in the world; there are other candidates.
The financiers’ concerns are seen in the rising interest rates which France is paying. Rates are rising everywhere but France’s spread – the margin it pays above the base international rates – is increasing. That signals that lenders are concerned that France may default on its debts.
France’s General Government Net Debt net public debt is about 110% of annual GDP according to the IMF. The ratio is rising. (The IMF records New Zealand’s equivalent ratio at about 28%.) French borrowing has for over a quarter of a century been exceeding the ‘legally bound’ limit for a member of Europe’s Economic and Monetary Union (EMU) of 3% of GDP.
That debt is not fully backed by tangible assets. They are about 80% of GDP. France's public sector net worth – the total value of all public sector assets (financial and non-financial) minus total liabilities – is more than negative 30%. (New Zealand’s is positive 39%.)
These assets do not include the value of the sovereign right to tax. (Ours do not either.) It is difficult to value. In principle a country could tax all its GDP but, practically, even a dictatorship is constrained by requiring some popular consent. (Tax avoidance also restricts high tax rates.) That consent requires that most of the tax raised is being used to provide government services and transfers to the public. (Which is why inflation is popular among governments. It is a tax on wealth which does not have to be imposed by popular consent.)
Lenders to France are doubting that there is sufficient demographic consent for it to restrain increasing its debts. They are nervous about the current rioting, while on the horizon is the possibility that the president who follows Emmanuel Macron will not be fiscally disciplined either.
A useful, although not exact, analogy is one of the causes of the 2008 Global Financial Crash. Particularly in the US, most of the public had not experienced significant real income growth for some decades, partly because of slow growth but also because the income redistribution was favouring the rich. The financial system, flush with the rich’s wealth, eased the pressure on those suffering stagnation by lending to them on housing, lending that would leak through to other private consumption. Borrowers felt better off.
The lenders thought their debts were more secure than they proved to be – stagnant incomes still have to service rising debts. This imprudent lending was a major contribution to the 2008 crash. (Not relevant to this analogy, as far as I know, the US financial sector got into some fancy – and ultimately irresponsible – financial innovation.)
Much the same seems to be happening today, except the lending is to nations rather than to households and is secured on the sovereign-right-to-tax rather than houses. Facing slower growth, the borrowing nations have boosted consumption by keeping taxes low and spending high, borrowing for consumption not for investment. Hence the growing gap between France’s debt and tangible assets.
While it is the same state which services and repays the debt, the population which actually pays is different from those who benefit from the borrowing.
Intergenerational income transfers are tricky to analyse. They may be between cohorts at the same point in time, as when workers pay taxes which are used to support the elderly. This transfer seems to be accepted by the young – provided it is not too generous (especially to the rich elderly) – presumably because they expect that, in turn, younger generations will do the same for them.
There are also intergenerational transfers through time. This column is about an important one. The state can borrow to fund one generation’s consumption; the burden of that debt falls on later generations.
That is not how the rioting French students see it. They began with a concern about poor quality education – decaying school buildings, chronic teacher absences, overcrowded classrooms, and an unpopular university admissions system. This is despite the French Government’s big spending and borrowing. Its loans are being used to support an aging population where currently the legal retirement age is 62 years, 9 months. Meanwhile it squeezes its spending elsewhere.
I cannot tell you when the next sovereign debt crisis will occur – it may not be France’s – nor how it will be resolved. Some of the complications of predicting are indicated by considering why New Zealand cannot borrow like France has. Why not run a large public deficit for consumption purposes and increase net public debt to say, 100% of annual GDP, while failing to offset the borrowing by tangible investment in publicly owned assets? (It would mean higher domestic interest rates.)
The basic answer is that we are not France. New Zealand’s economy is small, about a fifteenth of the size of the French economy. We are not too big to fail; if we were to fail, the world financial system might brutalise us as an example to others.
Nor do we have many close ‘friends’ who would help bail us out, because our bankruptcy would threaten their stability. France has the EU. The European Central Bank was closely involved in the Greek bailout, as brutal as that was. New Zealand has no strategic significance by location or resource base. All we have is reputation; the New Zealand Government has never defaulted on a loan. Few others can make that claim.
Even if France has been prudent – an unlikely assessment – New Zealand’s borrowing has to be much more restrained, although like France and many other countries the political temptation is imprudence for consumption in the short term at the expense of future generations.
The next crash is most likely to arise from the financial instability of AI and allied industries. But we should keep the possibility in mind of a destabilising sovereign crash.