Debt crisis? Let’s just call it quits

15th October, 2011

We keep hearing about a eurozone debt crisis. But who owes the money? And to whom?

The simple answer is that a lot of people owe a lot of money to a lot of other people and it’s all rather messy and difficult.

If we all owe the debt to each other, can’t we just wipe the slate clean?

If you owed £100 ($158) to me and I owed £100 to you, we could agree to shake hands and call it quits. But even then there would be complications. You might have promised to give me £100 by tomorrow while I promised you £100 by Christmas 2015. Those two promises don’t quite cancel out, especially if both of us urgently need the £100 on Monday morning.

Why would we owe each other money like that?

We wouldn’t. But governments and companies do issue IOUs called bonds. The bonds have set time frames and are traded, so that kind of scenario isn’t fanciful. Anyway, the point is, it’s messy. And it’s not the case that all the debt cancels out: some people and institutions are net creditors and some are net debtors.

“Neither a borrower nor a lender be.” – Polonius

Polonius was a sententious fool. There are plenty of reasons to be a borrower or a lender. Cash is a claim on goods and services, and if you have cash but don’t need the goods and services right now – say, you are a middle-aged person looking ahead to retirement – then it makes sense to be a lender. A young person, however, could perfectly prudently borrow to pay for a home or an education. All this talk of wiping the slate clean sounds very tempting if you’ve just borrowed money to buy a house; it’s less tempting if you’ve spent your life saving and suddenly your savings disappear as part of a slate-wiping project.

We aren’t talking about little old ladies. Or are we?

Only indirectly: most government debt is owed by states to large institutions such as pension funds, insurance companies or other governments. Pension funds and insurers are natural creditors as they have cash now that they don’t need.

Now we’re getting somewhere.

Perhaps. The Office for National Statistics says, for example, that the three key holders of UK government gilts (basically, bonds) are pension funds and insurers, foreigners and banks. That list includes the Bank of England, which has bought a lot of UK government debt and is planning to buy more. The three sectors hold about 30 per cent each of UK gilts.

And what about Greece?

Greek debt has increasingly been taken on by national and multilateral institutions. Barclays Capital has published estimates of Greece’s largest creditors and at the top of the list is the European Union, the Greek state pension fund, the IMF and the National Bank of Greece. Foreign private banks are further down the list, although as Dexia proved last week, even a thin slice of Greek government debt can be enough to poison a bank.

Are banks particularly vulnerable, then?

You have to ask? Yes, they are, and this is why the “clean slate” view is so unrealistic. If you have a pension pot of £100,000 and 10 per cent of it is invested in Greek government bonds, then if the Greek government defaults completely you’re going to lose £10,000, 10 per cent. That’s annoying, but the loss is not magnified. But if your bank has 10 per cent of its investments in Greek government bonds, then when Greece defaults, your bank could be close to bankruptcy. Other lenders will refuse to do business with your bank for fear of losing their money. You will – if you are wise – put your current account somewhere else. The bank will be at best a lame duck, desperately cancelling overdrafts and refusing mortgages as it scrambles to stay afloat. The damage could be much more than the original loss.

Gosh. If only banks had been properly reformed before this crisis hit.

No kidding. Although that wouldn’t have been easy – effectively we were looking to redesign the financial ship while it was still out in a storm, taking on water.

If the debt was repaid, wouldn’t somebody be sitting on a pile of cash?

I’m not sure I’d accept the idea that some international man of mystery (George Soros? Auric Goldfinger?) would end up with all the cash. But yes, if all the debt was paid back creditors would be sitting on trillions. But what use would that be? Creditors are creditors because they have money they don’t immediately need. If all the debt was suddenly repaid, creditors would immediately be looking for alternative investments.

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