Tag Archives: credit

Debt and Coercion

17 Nov

Among the Solonic reforms that made Athens democratic was the abolition of debt-bondage. In his history of Rome, Livy wrote that the Lex Poetelia of 326 BC, abolishing debt-bondage was “the dawn, as it were, of a new era of liberty for the plebs.” It is probably no accident that Nietzsche, classical philologist that he was, took the connection between debt and subjection to its radical conclusion. Nietzsche thought the notion of moral agency underlying modern life was servile, and that this servility was revealed in the basic idea that morality is keeping one’s promises. For Nietzsche, this subjection of our future selves to promises we make today had its origins in the institution of debt. We don’t have to be Nietzscheans to think the the practice and institutions surrounding debt raises major questions regarding freedom and subjection, and these are issues that have arisen in a major way since the credit crunch of 2008.

Recently, we suggested at least one way in which the use of debt imposes an undesirable discipline on people. When debt becomes the way to gain access to basic goods it forces downwards the expectations and narrows the horizons of debtors. Our main example was the the discipline that student debt places on their subsequent educational and professional choices – they will be less willing to take risks on interesting classes, career choices with riskier or longer-term chances of having a payoff, or that are simply lower-paying. We should have added that having to take debt adds discipline on top of already existing compulsion. Since most people are forced to sell their labor in order to learn their living, it is an added, unjust imposition to say they must finance their consumption with debt burdens they have little chance of being able fully to payoff.

Over at Rortybomb, Mike Konczal reminded us of a number of other ways in which debt is connected to coercion, using what we might initially think is an odd source: corporate finance. Konczal’s post has a bunch of insights, but there was one that caught our eye in particular. Quoting another scholar, Konczal observes that

“Under financial distress, but in the absence of liquidation, the nonrepayment of debt puts the creditors in the driver’s seat. Roughly speaking, creditors acquire control rights over the firm.  They need not formally acquire such rights.  But they hold another crucial right: that of forcing the firm into bankruptcy.  This threat indirectly gives them some control over the firm’s policies…”

Where we had discussed the disciplining effects of debt on individual’s choices, Mike reminds us of the obvious, background threat of coercion. The threat is not just of coercive enforcement of debt contracts by the state, but of handing to creditors coercive control over debtors themselves when they fail to pay up. In the case of the firm this all sounds somewhat benign because a corporate person is not a real person. In fact, in some sense, corporations can be made slaves of their creditors in ways that real persons cannot (which is incidentally another implication of corporate personhood.) Now the disanalogy between corporations and persons here regarding who can be made slaves is less relevant than the analogy. The relevant analogy here is the way the law is structured to permit or limit the kinds of coercion that can and cannot be applied. In other words, underlying all of this is a question of who controls the state (or whatever apparatus it is that enforces debt contracts). That is in fact the lesson of ancient history – when the people acquired political power, they limited the kinds of power that creditors could legitimately exercise over individual debtors. It is also a lesson of the present, as the struggle over whose claims will win out continues apace.

On the flip side, creditors are always angling for the ability to increase their control rights over debtors in the case of default. After all, what they want is a risk-free rate of return. Having a right to control the debtor in the absence of the debtor’s ability to pay is a way of grabbing hold of the value stream from the other end – not the debtor’s earnings, but his or her labor power itself. While formal debt-slavery is obviously illegal, and debtors prisons are (with creeping exceptions) banned, the recourse powers of creditors like suspending time limits on debt or ability to garnish wages and seize other assets are all similar raise similar questions about the kinds of coercion we are or are not willing to allow creditors to have over debtors. For example, when it comes to student loans, the state has made it possible to garnish funds from Social Security checks, and there is time period after which unpaid student loans are discharged, these loans stay with you for life. That means a person with student debt can be placed in a kind of debt-bondage – a life of permanently paying off a debtor.

To be clear, the issue is not the ex post one of whether debts should be forgiven or modified in certain conditions – that is a separate though related question. Rather, it is about the ex ante legally enforceable powers granted to creditors that are part of the contract itself. And the thought is that there are some kinds of coercion that might be incompatible with a democratic society – that is in some sense the point with which the demos and plebs were concerned with. No free society allows that kind of servitude to exist, no matter the promises they made.

Importantly, reducing the kinds of coercive control rights of creditors over debtors would not be any kind of threat to contracts. It would simply be risk-shifting. As mentioned, creditors always want what they can’t have – risk-free investments with high rates of return. The risk-free part is secured by increasing the kinds of control that can be exercised over debtors who miss payments. Taking away that kind of control defends some freedoms of debtors by forcing creditors to accept more risk.

Debt is not always a source of unfreedom. It is, or can be, enabling too. Economics textbooks like to point out that debt helps smooth out consumption. We borrow against future earnings to consume more now. As the FT recently had it “debt is thus a hugely efficient wealth distribution mechanism.” Of course, it isn’t that if what we are doing is substituting for lack of earnings (our point about the debt-based social model) rather than borrowing against future earnings. But even so, it isn’t just consumption choices that debt opens up. Taking a bet on the future is what makes possible innovations and long-term collective economic projects. The human potential that is set in motion when a company decides to make a new airplane is immense – from scientific research to basic manufacturing to industrial design. But we would not be free to engage in these enterprises if we could not take a bet on the future. Companies have to take out major debts to engage in the decade(s) long development of such products. The problem is not so much the taking out of these debts, but the way the laws are structured regarding access to credit, control of companies, who benefits from success, and who suffers from failure. That is true of corporate debt just as it is true of household debt. Yet the general point is still valid – even in a very different, more egalitarian and free society, making bets on our future productivity would open up present possibilities and make possible collective economic action that would otherwise be impossible.

The problem as we see it is that the structure of our economic life maximizes the coercive aspects of indebtedness relative to its emancipating aspects. And most of that has to do with the actual laws surrounding debt, as well as the radically unequal economic power of different market participants. In other words, it is a political question of who controls the state.

Guest Post: Europe and Democratic Funding

27 Oct

Editors’ Note: The European banking crisis continues to unsettle markets, and to raise serious doubts about not just the economic but also political future of current European institutions. As our guest post today by Anush Kapadia points out, underlying the turmoil is the achingly familiar ‘democratic deficit’ problem, but this time present in a new form. The basic democratic challenge this time reaches beyond the question of the EU’s institutional structure to the question of how its member states, and supranational institutions, relate to (financial) markets. As Kapadia points out, this democratic challenge, though it has special characteristics in the European case, is a general one facing any state seeking funding yet also seeking to retain enough autonomy to remain under the control of its citizens.

Europe and Democratic Funding

Anush Kapadia

The European crisis is one of legitimacy, not of the European project per se but of the financial fundamentals of moderns states. The lopsided nature of the European project merely serves to highlight the potentially undemocratic side of the financial undergirding of state power. It also foreshadows a potential solution to the problem.

It is not hard to notice that while scorn is routinely reserved for the unelected Eurocrats who want to squash national sovereignty, very little seems to be said about the legitimacy of unelected markets dictating terms to sovereign states. Morality, it seems, is on the side of the creditor: sovereigns, like us ordinary folk, should pay their debts.

But sovereigns, like people, have a responsibility to maintain their own autonomy to the extent they can. When governments fund themselves in ways that put their sovereignty at risk, they are abrogating their democratic duty. This is the double-edged nature of government borrowing: democracy can be aided by the flexibility and liquidity of marketing government debt, but beyond a point debt turns to poison.

So how can democratic states take advantage of the bond markets without being consumed by them?

The answer from creditor-morality is simple: don’t borrow beyond your means. And there is truth in this homily. The problem of course is that the very extent of ones means is subject to the judgment of the self-same creditor. To a large degree, solvency is in the eye of the creditor.

For any economic unit, the pattern of cash inflows rarely maps perfectly on to the pattern of cash outflows. Individual cash (dis)hoarding can of course mitigate this mismatch; what we call “banking” is merely the socialization of this liquidity-matching function: units with excess inflow lend to units facing outflow constraints via the intermediation of a bank. If the matching process stops, a borrowing unit’s cash commitments can swamp its cash inflows: the unit is dead. If your creditors stop rolling over your debt, the music stops very quickly indeed.

Prudence dictates that the unit steer clear of such peril. Yet when faced with myriad constraints, units will load up on credit if that dimension is eased. The market price of the unit’s debt is meant to be an indicator of proximity to peril. Yet as we have seen, this indicator is notoriously fickle: one day the unit is extremely creditworthy, the next day it’s bust.

Now especially if the economic unit is a democratic state, it has a solemn duty to avoid such peril. This means that it has a solemn duty to avoid fickle funding. And this in turn means avoiding the bond market beyond the point of prudence.

This is exactly what Europe has been groping towards, willy nilly. It is precisely because Europe lacks a common fiscal authority that it is seeking this solution. In so doing, it foreshadows a more democratic method of state funding.

Most see Europe as an unfinished federal project and indeed weak on that score. What they miss is that Europe is a new experiment in interstate relations, not a slow-motion rerun of US history. The people of Europe do not want to be part of a federal state. This is axiomatic; it renders the nation-state analogy for Europe nugatory. Our imaginations are constrained by this nation-state frame.

This national impossibility is what ultimately ties the hands of the ECB as an effective lender of last resort; its paranoid ideology is merely icing on the cake. A prudent lender of last resort mitigates the fickle nature of market funding by stabilizing the credit system as a whole when the market mood inevitably turns. This function can only perform its stabilizing work if it has credibility; it has credibility because it is backed by a fiscal authority.

Thus if the ECB were to act as an adequate lender of last resort in this crisis, it would implicitly call into being the absent European fiscal authority. And this cannot happen because the European people don’t want it. The Bundestag is merely the institutional expression of this desire. Of course, if the ECB acts as a lender of last resort in this crisis without at least implicitly calling into being a common fiscal leviathan, the ECB itself will take the place of the impaired sovereigns as the target for the markets. A lender of last resort without fiscal backing is not credible; the markets will gnaw away at it until implicit backing is made explicit. The assets that the ECB purchases will lose value to the point where the ECB’s own balance sheet will start to look shaky; the Euro itself would start to melt away.

Hence all the machinations around the EFSF (recent summit statement here). One can see how this institution might be the kernel of a common fiscal authority, at least in its borrowing power if not (yet) its taxation power. And that’s what the fight is about now. The Germans want to keep it small and limited so that it won’t prefigure some kind of common fiscal mechanism, but if it’s too small it’s not credible enough to function as a lender of last resort.

So no ECB, no EFSF. And the markets are completely roiled. Where oh where can a distress sovereign go for funding? China.

Well, not literally, but certainly figuratively. With the ECB and EFSF hamstrung because of the latent common fiscality they imply, Eurocrats have to find another set of balance sheets with spare capacity. This is where the special-purpose-investment-vehicle (SPIV) solution enters the fray.

Without getting into the details, there are two current plans to bolster the capacity of the EFSF (ignoring the somewhat loopy French plan to turn it into a bank): make it an insurance company or make it a kind of collateralized debt obligation (remember those?). There might be some combination of these solutions, but the latter is the one to focus on.

Floating a SPIV by the EFSF means that the latter would create and underwrite an entity that would issue highly-rated bonds; the proceeds of this sale would be used to buy encumbered sovereign debt. (Note: The same structure was used to by mortgages; the resulting securities were thus called mortgage-backed securities. The same tranche structure is envisioned here so that private money take come in and take the more risky elements of the vehicle). And who are the potential sources of funding for this vehicle? Sovereign wealth funds and other “international public investors.” The patient, institutional capital, in other words, not the fickle market money.

Since these new investors have very deep pockets and have their eye on the very long-term (some of them are sovereigns themselves after all), they are not subject to the same incentives as normal players in the bond market. The latter tend to be highly-leverage and work on the narrowest of margins. Having drastically underpriced sovereign risk, the fickle money markets are now drastically overpricing it; yesterday’s promise of growth has turned in today’s demand for austerity. Long-term investors look at long-term value rather than short-term prices; think Buffet rather than Bear. These investors would typically hold the bonds to maturity and can ride out short-term fluctuations because of their deep pockets. And at the moment they are getting a deal.

The absence of a common fiscal authority in Europe has lead to a credibility crisis at its heart. Most see the solution to this as an aping of the history of the nation-state: “build a fisc already!”, this position screams. But that way is closed to Europe. They are charting a new history.

Because of these constraints, the Europeans are finding that another route to stability is in effect to de-marketize some portion of their sovereign debt and place it with buy-and-hold institutions. What we might consider is that Europe’s ex post crisis response might be a way of insulating democratic states from the fickle markets ex ante.

The analogy with bank funding is clear: part of the problem with banks leading up to the crisis was that they were funding in highly liquid markets at ever-shorter maturities and in ever-greater proportions. This made them vulnerable to a run; subprime burst the bubble and the inevitable run followed. What is the proposed solution? Mandatory funding durations imposed by the regulators: long-term assets ought to be funded by long-term liabilities to the extent possible.

The state is a long-term asset, our long-term asset. It needs a funding structure adequate to its long-term democratic duties. A state simply cannot legitimately allow itself to be bossed around by the markets. This means that the state (and the banks it underwrites) should not be allowed to fund in fickle markets beyond a certain point; no matter how cheap and liquid this funding appears, the cycle will turn and austerity will result.

The East Asians learned this after their crisis and responded with cash hoarding. But this is globally suboptimal: banking was invented so that we wouldn’t all have to keep our cash under our mattresses. Better lend it out to those who need it; if we are long-term savers, we can afford to lock it up for a while.

That’s what pension funds do; that’s what sovereign wealth funds do. We know that how we fund our governments matters for its legitimacy, but our democratic common sense ties only taxation to representation. Yet the structure of state borrowing is equally critical. It is to this patient structure of funding that Europe’s experiment now turns, at least at the critical margin. There might be a lesson in there for all of us.

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