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Monday, December 19, 2011

Money makes the world go 'round...

A lot of blame is being thrashed around these days. Blame on the part of borrowers against lenders (and vice versa). Blame on the part of importers against foreign exporters (and vice versa). Blame on the part of the South against the North (and vice versa).

I will not introduce another blame-theory but I want to focus on how the process starts.

An individual gets into financial trouble the moment he pushes the "transfer" button on his PC paying for something which isn't worth the amount of money which he is transferring (or which loses value afterwards). If he has transferred his own money, the trouble is his and his alone. If he has transferred money which he borrowed from someone else, that someone else may have to share in his trouble.

An economy gets into financial trouble when those who dispose over the economy's money transfer that money into poor investments and/or to weak borrowers. If the financial intermediaries make good reallocation-of-financial-assets-decisions, the economy will grow. If they make bad (or even silly) decisions, disaster may strike the economy.

Regardless how weak and/or irresponsible a borrower is, he cannot waste other people's money before it is lent to him!

So one could blame financial intermediaries for having made such reckless loans to governments? Would that be fair? Probably not quite, because governments represent probably the most difficult challenge for a risk analysis: there is no balance sheet; there is no revenue base from the sale of products; there is no marketable collateral; there are no market shares;  actually - a sovereign state as a borrower isn't really much of anything other than the government's political will to keep its house in order. And that political will can change from one government to another (or even within one and the same government). From that, I derive the following question: who is best suited to lend money to governments?

What if regulations stipulated that governments can take up debt for their ordinary course of business (regular budget) only from investors residing in their respective country? A government's revenues/expenses are generally domestic. Why should its borrowing not also be domestic?

It is government spending which triggers the need for taxes (tax laws are not the original cause of taxes; they only become necessary when there is government spending and the government has no other revenues like Monte Carlo does). If expenses exceed revenues, a deficit occurs which needs to be financed through debt. Such debt represents nothing other than "insufficient taxes paid" by current beneficiaries of government expenditures. The debt is the instrument which defers such tax payments to tax payers of the future (perhaps even future generations).

If all government debt were owed to domestic investors, debtor and lender would - in sum - be one and the same. Quite possibly, with today's levels of sovereign debt, it could well be that only few countries have enough domestic savings to finance the sovereign debt but it doesn't have to be accomplished overnight. It would be sufficient to start working towards that goal.

Extraordinary government expenditures (such as large infrastructure or other investments) should be exempted from those regulations. They are typically of a magnitude which would exceed the capacities of domestic capital markets in smaller countries. At the same time, they are typically project-oriented, thereby making it easier for foreign lenders to analyze the risk and make wise lending decisions.

The private sector (including banks) should not be prohibited from borrowing abroad. First, the private sector has expenses abroad which justifies borrowing abroad. Secondly, private sector borrowers are much more suited for a risk analysis by foreign lenders than a government is and wiser lending decisions can be expected. Finally, the private sector's investments should not be slowed down by any "crowding-out" of the domestic capital markets through the government's borrowing.

An economy's borrowing abroad means using the savings of other countries. Particularly in fast growing and/or still developing economies, those savings of other countries are absolutely necessary to finance domestic growth. The critical aspect is that those savings of other countries are invested wisely and not wasted foolishly. As explained above, when those savings of other countries are lent to the government, there is a greater risk that they are not invested wisely (or rather: that they are wasted foolishly).

And the more money goes 'round prudently and is invested wisely, the more living standard we will all be able to enjoy.

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