The Battle of the Bonds

LONDON – Everyone knows that Greece will default on its external debt. The only question concerns the best way to arrange it so that no one really understands that Greece is actually defaulting.

On this topic, there is no shortage of expert plans – among them bond buy-backs, bond swaps, and the creation of Eurobonds, a European version of the “Brady” bonds issued by Latin American countries that defaulted in the 1980’s. What all such schemes amount to is piling one lot of bonds on top of another in an attempt to square the circle of Greece’s inability to pay, and to minimize the losses faced by its creditors – mostly European banks.

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Every week, a preposterous coterie of European bankers and finance ministers drags itself from one capital to another to discuss which default/restructuring plan to adopt. Meanwhile, Greece’s agony continues, and the “markets” wait to swoop down on Portugal, Ireland, Italy, and Spain.

No one who is not well versed in financial legerdemain can make much sense of this battle of the bonds. But behind it lie two moral attitudes, which are much easier to grasp.

The first is traditional disapproval of debt. The oldest rule in personal finance is to avoid debt – that is, never spend more than you earn. Economists and moralists have been united in believing that you should actually spend less than you earn – in order to “save” for the proverbial rainy day or for old age.

Getting into debt was long associated with profligacy or fecklessness. And, if a person became indebted, it was a point of honor to repay the obligation when it fell due, by selling assets, reducing consumption, working harder, or some combination of the three. Indeed, it was often more than a point of honor: failure to repay debt on time landed the debtor in prison.

The same attitude governed institutional debt. Banks grew out of a practice by gold smiths and silver smiths, who, for a small price, accepted deposits for safekeeping. When they became lending institutions, their earliest rule was to keep almost 100% of cash reserves against their loans, so that they would not be caught short if most of their depositors decided to withdraw their money at the same time.

Similarly, before the introduction of limited liability in the nineteenth century, a company’s shareholders or partners were each liable for all of the firm’s debts, which severely restricted businesses’ willingness to borrow to finance trade.

For public finance, too, the orthodox rule was that budgets should always be balanced; except in emergencies, governments should never spend more than they “earned” in taxation. Again, it was a point of honor for governments to pay back such debts as they were incurred, whatever the sacrifice to the country. Until recently, the conventional view was that “mature” sovereigns always honored their debts, while only banana republics failed to do so.

These historically embedded norms and practices were only slowly superseded. But, in the twentieth century, with greater security of conditions and continuous economic growth, it became normal for individuals, companies, and governments to borrow in anticipation of earnings – to spend money they did not have, but that they expected to have.

With fear of bank runs and defaults receding, banks’ reserve ratios became ever smaller, thus increasing their lending facilities. On this bedrock rose an imposing edifice of bond markets and banks that drove down the cost of finance, and thus sped up the rate of economic growth.

It was this system of financial intermediation whose near-collapse in 2008 seemed for many to justify the ancient warnings of the perils of indebtedness. In their exhaustive historical review of financial crises, Carmen Reinhart and Kenneth Rogoff write: “Again and again, countries, banks, individuals, and firms take on excessive debt in good times without enough awareness of the risks that will follow when the inevitable recession hits.”

But there is a contrary moral attitude, the essence of which is that, whereas excessive debt is to be deplored, the blame for it lies with the lender, not the borrower. “Neither a borrower nor a lender be,” Polonius admonished in Hamlet. Lending money at interest was identified with “usury,” or making money from money rather than from goods and services – a distinction that goes back to Aristotle, for whom money was barren. The moneylender was the most hated figure in medieval Europe.

The last legal restrictions on taking interest on money were lifted only in the nineteenth century, when they succumbed to the economic argument that lending money was a service, for which the lender was entitled to charge whatever the market would bear. But the theory of usury survived in the view that it was morally wrong to extract some additional amount that was made feasible by the borrower’s weak bargaining position or extreme need.

These two moral attitudes confront each other today in the battle of the bonds. The demand for debt repayment confronts the philosophy of debt forgiveness. In the lender’s view, the 17% interest rate that Greece’s government now has to pay for its 10-year bonds accurately reflects the lender’s risk in buying Greek government debt. It is the price of past profligacy. But in the borrower’s view it is usurious – taking advantage of the borrower’s desperation.

The sensible middle position would surely be an agreed write-off of a portion of the outstanding Greek debt, combined with a five-year moratorium on interest payments on the remainder. This would immediately relieve pressure on Greece’s budget and give its government the time and incentive to put the country’s economy in order.

In the long run, however, we will have to answer the broader question that the eurozone’s various debt crises have raised: Is the social value of making finance cheap worth the days of reckoning for stricken debtors?