Government debt and wealth in the Global South

7 Conflicts of interest between and within generations

Unit 22 of The Economy 1.0 introduces this area of economics. It includes many reasons why governance and designing public policies are so difficult.

Unfortunately, countries, governments, and political systems are much more complicated entities than individuals or households. The reason is that they are ‘collectives’: groupings of heterogeneous people with different interests, world views, or political preferences. To be able to make collective decisions, countries set up political systems and governments through complicated historical, institutional, and social processes that sometimes generate many complex problems.

Conflicts of interest and ‘short-termism’

principal–agent relationship

This relationship exists when one party (the principal) would like another party (the agent) to act in some way, or have some attribute that is in the interest of the principal, and that cannot be enforced or guaranteed in a binding contract. See also: incomplete contract. Also known as: principal–agent problem.

asymmetric information

Information that is relevant to the parties in an economic interaction, but is known by some but not by others.

One of the most important issues is a type of principal–agent problem, which you can read more about in Unit 6 and Unit 9 of The Economy 2.0: Microeconomics (Unit 6 and Unit 19 of The Economy 1.0). The principal–agent problem is relevant to public debt issues because it allows us to understand how differences in information (information asymmetries) and incentives between a country’s citizens and officials can make public debt decisions deviate substantially from what is in the public interest.

The principal–agent problem refers to the possible conflict of interest between two people involved in an economic or political interaction where one person delegates a task to someone else. For example, citizens delegate the job of governing to specific people who serve in government posts as policymakers. One job that citizens delegate to the government could be deciding how much public debt to take and negotiating the terms of that debt (the term and the interest rate) in the market. The principal is the person who delegates (in this case, the citizens) while the agent is the person (in this case, the public official) who takes an action that affects the principal.

The principal–agent problem usually derives from an imbalance in information between the two. Usually, the agent knows more about the problem and hence can make decisions that are in their own interest, rather than in the principal’s interest. For example, the government has more information about debt markets and the state of the country’s finances than the citizens do. Moreover, sometimes the agent can make decisions that the principal isn’t even aware of because it may be very costly and difficult to find out what is going on in the day-to-day running of the government or it may be very costly to understand sophisticated legal matters, convoluted financial transactions, or complicated policy options.

The worst expression of the principal–agent problem at the heart of government is, of course, the sort of corruption scandals with which we started this Insight. In those cases, the principal–agent problem is such that the information advantage allows the agent to steal money without the principal noticing until it is too late. But principal–agent problems don’t have to be about corruption to be problematic. Sometimes it’s enough for the incentives faced by public officials to deviate substantially from the interests of the public.

To learn more about short-termism and how it affects policy choices, read Section 22.14 of The Economy 1.0.

short-termism

This subjective term refers to the case when the person making a judgement places too much weight on costs, benefits, and other things occurring in the near future than would be appropriate.

One of the consequences of the principal–agent problem that has the most problematic effects on the debt issue is ‘short-termism’: a situation in which the person who is making decisions (the agent) places too much weight on the costs and benefits occurring in the near future than would be appropriate. This is potentially very dangerous when the decision involves acquiring debt since, obviously, this would preferably be undertaken with a long-term perspective. There are several reasons for this short-termism in debt issues. A relatively obvious one is that in countries with some sort of democratic electoral system, political coalitions that hold the government usually want to be re-elected. Inevitably this can induce them to prioritize policies that are suboptimal from a long-term perspective but generate short-term benefits for the population.

In Figure 11 we illustrate the problems caused by short-termism. We start with an economy that has the same problem as in Figure 6: it has very little income in the present and expects to have more income in the future. We discussed how, if the country has access to international credit, they may choose to move from the autarky endowment point A to point B, where they can reach a higher indifference curve, \(\text{CIC}^\text{B}\).

Now consider the possibility that government officials do not face incentives to include their citizens’ preferences when making decisions. One way of representing this is through an alternative set of indifference curves that have stronger preferences for present consumption (at every point on the indifference curve, the decision-maker is willing to trade more units of future consumption for one unit of present consumption). We call them policymaker indifference curves (PMIs). With these alternative preferences, the country may end up at point C on indifference curve \(\text{PMI}^\text{C}\), which the policymakers prefer to point B. However, the citizens prefer point B to point C.

The same problem can occur in a country that is taking debt to finance investment. We represent the situation in Figure 12. Just like in Figure 8, we start with a country that is taking a loan, committing to an investment that allows them to produce combination D and consume the combination E, which is on the citizens’ indifference curve, \(\text{CIC}^\text{E}\). However, the policymaker prefers point G to point E and takes on additional debt. Segment \((C_\text{p}^\text{G}-C_\text{p}^\text{E})\) is the additional debt that the country takes due to the short-termism of the policymaker. Segment \((C_\text{f}^\text{E}-C_\text{f}^\text{G})\) is the loss of future consumption due to that additional debt. At point G, the citizens are on a lower indifference curve (\(\text{CIC}^\text{G}\)) than they were at point E.

The costs of short-termism can be substantial; however, they are not always the result of irresponsible, greedy, or abusive public officials. Sometimes the problem is more profound than that. For example, sometimes governments face crises that require substantial liquid resources in the short term (a good example of this is the COVID-19 pandemic). But there are other reasons that may drive governments to short-termism.

Intergenerational conflicts of interest, government credibility, and government debt

The ‘veil of ignorance’ is a mental exercise proposed by philosopher John Rawls as a method of considering welfare and equality issues. You can read more about this concept in Section 5.3 of The Economy 2.0: Microeconomics (Section 5.3 of The Economy 1.0) and in Section 19.4 of The Economy 1.0.

People alive today care about their own welfare during their lifetime and that of their descendants. However, unlike the intertemporal decision that we discussed above, in this case the people of the future are not present today when the debt decision is being made, and hence, the intertemporal distribution of consumption is being decided. Their ancestors are making the decision for them. It is not clear that, if they could be consulted, they would agree with the debt level being incurred by those alive today. People alive today may down-weight future people’s welfare and may be willing to take on more debt than if they made the decision behind a Rawlsian ‘veil of ignorance’ and they didn’t know which generation they would be born into when they made the debt decision.

If people today would make a different decision under the veil of ignorance, this means that if future generations had the chance of revising past decisions, they would modify them. There is thus a conflict of interest between generations: the ‘descendants’ would prefer if previous generations weighted their welfare higher. Unfortunately, there is very little that the descendants can do about it. Such intergenerational conflicts of interest can substantially affect government debt levels, usually making governments take on more debt than they would otherwise.

In many legal systems, children cannot inherit the debts of their parents. But the situation is different for the state, which lives forever. The citizens of the next generation do inherit the debts of the previous generations, but they also inherit the government’s ability to borrow and to tax. The question is: how do the borrowing decisions of the current government affect the welfare of future generations? When a government sells bonds, it sells a contract promising to pay a sequence of repayments for the length of the bond (such as ten years) and to repay the principal when the bond matures. Normally, the government renews the debt when it matures, which is called ‘rolling it over’, by issuing new bonds. However, nothing can prevent a future government from defaulting on the debt despite the negative impact that may have on the economy and on the citizens at that time. It might choose to default because the burden of debt has made the terms on which it can borrow in international markets very expensive and it does not want to raise taxes or reduce its expenditure.

Since the nature of politics is cyclical, it may be the case that a country changes from governments that take on more debt as a part of an economic and social development policy to governments that are more fiscally conservative and prefer lower taxes. An incoming administration that feels burdened by the level of debt it inherited from previous administrations may feel that it must default on the debt and try to renegotiate terms.

International capital markets are aware that this is a possibility when lending in government debt markets. This means that they must consider that in the future the behaviour of the country to which they are lending may change substantially, not because circumstances have changed but because the priorities of the government have evolved. A promise (to service the debt) that seemed reasonable and credible in the past may cease to be so and demographic and political changes may affect the probability of the debt being paid.

The result is that traders in international capital markets buy and sell bonds when beliefs change about the risk of default on the bonds of a particular country. Since prices act as signals, the markets ‘price in’ the possibility of default, which is a finance term used to describe when a cost or contingent liability is accounted for in the price. Essentially, the markets make a call on how credible the promises to honour the servicing of their bonds of each country are and charge different interest rates accordingly. Countries that are less credible will get higher interest rates; more credible countries will get lower interest rates.

Figure 13 shows the default risk by plotting the evolution of the Emerging Market Bond Index (EMBI) spreads. This is the interest rate difference between what international capital markets charge a specific country and what they charge the government of the United States (which has historically been considered the safest government debtor). People in finance use the term ‘emerging markets’ to refer to low- and middle-income countries that are perceived to be transitioning to high-income status; or countries that seem to be following a successful development path. The EMBI tracks the interest rate of the debt issued by those countries. The figure is in ‘basis points’. Each basis point is 0.01 percentage points, which is a method people in finance find useful for discussing interest rates, because sometimes very small movements that would not seem relevant to the public can be extremely important for the creditor and the debtor. Sometimes a couple of basis points involve millions of US dollars lost or gained.

In panel a of Figure 13 we show four EMBI indices: the global EMBI, for all ‘emerging markets’ and the index for Asian, European (mostly Eastern European), and Latin American emerging countries. Consider the global EMBI. Its last point is 355 for August 2024. This means that on average, emerging countries that issue debt in global markets are being charged 3.55 percentage points per year more than the US government is when it borrows. The interest rate on a 10-year US Treasury note in August 2024 was 3.87%. So, the average EMBI Global rate was 3.55% + 3.87% = 7.42%, almost double what the US government is charged. This can be a lot of money.

Consider the differences between regions in the EMBI index. Latin America has a relatively bad reputation (maybe some of the stories we tell in this Insight help to understand why) and seems to have the highest spread; next is Europe; and last is Asia. On average, in fact, European emerging countries are charged 132 basis points more than the average Asian emerging country, while Latin American countries are charged 234 basis points more. These are large differences in the rate being faced by these countries. A big part of these differences has to do with the credibility of governments in specific countries. For example, consider what happened to European EMBIs with the start of the Russian invasion of Ukraine at the end of February 2022. In January the spread was at 383, only 44 basis points more than the global average. By March it was peaking at 942. As we mentioned before, the European EMBI is mostly composed of Eastern European countries that were either directly involved or indirectly affected by the war.

In panel b of Figure 13 we disaggregate the Latin American EMBI between four countries: Argentina, Brazil, Chile, and Mexico. This panel shows that there can be enormous differences within regions. In fact, the particular difficulties that Argentina has faced with its debt requires that it has its own axis. In August 2024, that country was facing a 1,529 point spread (an annual rate that is 15.3 percentage points higher than that faced by the US) while Chile was facing 132 (23 points less than the average of Asia). Such different rates can be difficult for a government that is trying to fund its spending needs.

The key message of Figure 13 is that credibility is very relevant in international debt markets, and losing it can be very costly.

Exercise 7 EMBI spreads

Find an EMBI spread index series for your country. If you do not live in an LMI economy, find data for the closest LMI country to where you live.

1. Make a line chart to show how the EMBI spread changed over time.
2. Calculate the average spread and the average stock of government debt for the entire period that data is available.
3. Calculate the cost of the spread. How much money would the country have saved if it could have contracted debt without a spread with the United States?

The Odyssean problem within public choice

peg (currency)

A currency peg is another way of referring to a fixed exchange rate regime, that is, a situation in which the central bank of a country (or the central government) fixes the price of its currency in a certain amount of another country’s currency (usually the US dollar).

Figure 14 shows how Argentine debt has evolved from 1980 to 2022. By the late 1980s the financial troubles of the Argentine economy that we have discussed in Section 4 had become worse. The economy was trapped, once again, in a vicious cycle of hyperinflation, over-indebtedness, and fiscal deficits. In 1989, when the new government of president Saúl Menem took office, total debt stocks were at 93% of GNI. In 1991, Domingo Cavallo, the Argentine Minister of the Economy, implemented a policy called the convertibility plan. The idea was to peg the value of the Argentine currency to the US dollar. To do this, the government replaced the old currency, called the austral, with a new one called the peso, which was worth 10,000 australes. The number of pesos in the economy was set to be exactly the same as the number of US dollars in the central bank reserves, and the peso was made convertible, meaning that you could exchange it for US dollars at the offices of the central bank.

The idea of making the new peso ‘equivalent’ to a US dollar was to drive Argentine inflation down to US levels, and to force the number of pesos to be equivalent to the reserves generated a credible mechanism for stopping the bad habit of printing money to finance the fiscal spending that was behind so much of Argentina’s inflation history. To make this commitment as credible as possible, the convertibility plan was not adopted as a central bank policy, but rather as a constitutional-level law that was, supposedly, very difficult to change. The authorities wanted international markets, the business community, and the public to be as sure as possible that, from now on, one Argentine peso was worth one US dollar and that the government would only print money if it accumulated reserves. The convertibility plan was not just a monetary policy. It was also accompanied by a huge swathe of reforms directed at deregulating and privatizing the economy, which is still politically controversial in that country to this day.

For some years the plan seemed to work: inflation fell and the economy seemed to grow at a healthy pace. But you probably won’t be surprised to know that the mechanism ended up failing terribly and plunging the country back into crisis. The reason is quite simple. The underlying problem was excessive fiscal spending and the absence of political mechanisms to control it and a culture of political discipline that could enforce it.

fiscal federalism

A situation in which budget and tax decisions are divided among different parts of the state. An example is geographic fiscal federalism that occurs when subnational entities such as states or provinces have sovereignty over parts of the budget.

Among several reasons that the government could not control fiscal spending is that Argentina is a federal country where states (called ‘provincias’) have a lot of fiscal autonomy and are not always aligned politically to the central government. The situation in which power over the budget is divided between different parts of a state is called fiscal federalism. It has some potential benefits, in particular because decentralizing fiscal power could help make government decisions more pertinent to local communities. However, it also entails a danger: that the central government can have difficulties in controlling overall spending. In Argentina, fiscal federalism is not only geographic, but also occurs among different parts of the state and government agencies. The objective of controlling overall fiscal spending was easier said than done.

So, as time went by, and the government could not print money without foreign reserves, it started to borrow them from abroad, and government debt crept up from 30% of GNI to over 50% of GNI and counting. Slowly but surely the tight conditions of the convertibility plan were dismantled one by one, and in 2001 the peg was abandoned. The peso lost about two-thirds of its value and inflation came roaring back. As we discussed in the introduction of this Insight, when the currency of an indebted country devalues, the debt it owes in US dollars becomes larger relative to the economy and the budget. In this case Argentine debt peaked at over 160% of GNI in 2002.

public choice

A branch of economics that uses its analytical tools (including mathematics, microeconomics, and contract and game theory) to analyse problems usually studied by political science, such as elections, institutions, and political problems in general.

National debt levels or sovereign wealth fund savings are determined by government policies. And, despite the fact that governments could, in principle, reflect in their policies the will and preferences of their citizens, this is not necessarily the case. The field of economics that studies this sort of phenomenon is called public choice. Governments last for a couple of years and politicians feel, quite rightly, that their reputations and prospects depend heavily on their performance during those years. Hence they have a stronger incentive to improve the welfare and prosperity of the people who are around during their time in power than for future citizens. Countries around the world, at different times, have tried a plethora of institutional arrangements, laws, policies, and rules to limit this problem, just as the Argentinians tried with their convertibility plan.

The inability of a government to commit to future actions is an old problem. The Odyssey, the ancient epic text attributed to classical Greek poet Homer (eighth century BCE), tells the story of the journey home of Odysseus, the hero and veteran of the Trojan war.

In one chapter, following the advice of the beautiful and deadly witch goddess Circe, Odysseus and his crew decide to visit the island of the sirens, which according to Mediterranean folklore is actually the island of Capri in the Gulf of Naples. Odysseus wishes to see the sirens with his own eyes, but knows that this is very dangerous since they are famous for luring sailors and ships towards deadly shoals and rocks with hypnotic songs. He knows he is unable to commit credibly to his future actions. Even if he swears an oath to look at the sirens from afar and not steer his ship into the rocks, once he and his men are under the spell of these wicked beings, they will be unable to escape from disaster.

However, Odysseus is famous for his intellect and he comes up with a plan. He seals his crew’s ears with beeswax and orders them to tie him to the mast of his ship and not follow his orders or abide by his gestures until they have sailed past the island. He is able in this way to survive the experience and satisfy his curiosity about the beauty and magic of the sirens.

Many countries have tried ‘Odyssean’ tricks to deal with the problem of credible commitment in their fiscal, budgeting, and debt policies, but with limited success. For example, in 1917, the United States needed to raise money to finance the First World War, but knew that it would be difficult to distinguish between necessary expenditures and opportunistic spending by a particular administration. So, Congress established a ‘debt ceiling’, which authorized the government to issue bonds to finance the war but only up to 15 billion USD. The debt ceiling was the equivalent of the beeswax and Odysseus being tied to the mast in the story.

It probably won’t surprise you to learn that the debt ceiling was never really binding. In fact, since 1960 it has been raised over seventy times and is now at 31.4 trillion USD. What happens is that, if the ceiling were taken seriously, reaching it would mean shutting down significant portions of the government and social services. The fact is that even very fiscally conservative citizens that agree, in principle, with the idea of the debt ceiling find it unacceptable that the government does not pay their pension or that garbage does not get collected. The government and Congress know this, so, usually after a short blame game, end up lifting the ceiling again and again.

Another example of an Odyssean trick was tried in Chile in 2001 when the country implemented a budget policy known as ‘structural balances’. Chile had been, up to that point, a very successful middle-income economy for more than a decade. The country had benefitted from the end of a 17-year-old dictatorship and an orderly transition to democracy in 1990 just when the world economy was going through a period of expansion that generated enormous demand for commodities including those exported by Chile (such as copper, fruit, cellulose, and fish).

The boom in the Chilean economy had been quite astonishing. During the 1990s it had averaged around 6.5% annual growth in its GDP, meaning that the size of the economy in the year 2000 was almost twice that of 1989, while the population had only increased by 15%. Chile had been through the same sort of debt troubles as other Latin American countries in the 1980s, but now it was able to pay the debt down. In fact, it had started with a level of debt around 50% of GNI in the late 1980s but had managed to lower it to nearly 15% in 1997. Moreover, since it had also managed to save some of the revenues of the export boom, its net debt (gross debt minus fiscal reserves) was, at that point, –1% of GDP. It could pay back its whole debt if it wanted to.

How did Chile do this? Well, during the whole decade it managed to maintain an average fiscal surplus of 2% of GDP. By the year 2000, however, it seemed clear that the international conditions for Chilean exports were going to deteriorate. World markets declined because of the bursting of the dot-com bubble, which was the first crisis in the stock prices of communications and online shopping companies of the internet era.

The government in Chile knew that it needed to run deficits to sustain social spending but needed to maintain its global fiscal discipline and not crash into the sirens’ rocks. They came up with a methodology called ‘structural balances’ by which the budget was calculated according to long-term commodity prices, so that when they were in a transitory low the government could run a reasonable deficit but would compensate with surpluses when they were high. It sounded reasonable and actually worked for a couple of years. In fact, in 2007 Chile achieved its lowest historical level of gross debt at around 5% of GNI and in 2008 it achieved its best net debt at around 20% of GNI. It lasted for a while. In 2016 Chile still had a net debt of 1% of GNI and a gross debt of 20%. However, recent years in Chile have not been as good in terms of growth. Governments have consistently found reasons not to abide by the structural balances principle, and, as of 2024, gross debt is back at slightly over 40% of GNI, with net debt close to 25% of GNI.

The challenge is to establish some norm that allows the institutions of a country to ignore (or at the very least to limit) the short-term wishes, instincts, and interests of authorities in office. An example of this sort of institution is the European Central Bank (ECB), which can claim independence from all of the governments that constitute the eurozone and, hence, make decisions that may or may not be coherent with their short-term interests. The problem is, unfortunately, harder to solve for countries and political systems than for heroic Greek sailors. Odysseus clearly defined the norm to which he wanted to return. Once the ship had sailed clear of the island, he would recover his authority as captain and the sailors would remove the beeswax from their ears. In the case of a government, the norm is not necessarily as clear-cut. In the end authorities are voted into office or appointed to make decisions as representatives of the citizens. In many cases these decisions involve important changes in spending, taxes, and public debt. Sometimes, facing important crises, authorities may decide that it is in the best interest of their countries to incur more debt. How can you distinguish between situations in which there is a legitimate and urgent need and others in which the authority is, in fact, surrendering to the sirens of short-term political convenience and personal ambition? It is not easy to establish a set of rules or a legal framework that makes this distinction.

Many countries around the world faced exactly this problem during the height of the COVID-19 pandemic. It seemed very reasonable for governments to increase debt or spend savings (held in the form of reserves or sovereign wealth funds) to finance aid for those segments of the population most affected by the lockdown of the economy. In some cases, this took the form of direct cash transfers to families, or essential consumption baskets. In other cases it took the form of furlough schemes that transferred cash to firms so that they could avoid firing workers or tried to convince firms, through monetary incentives, to lower working hours instead of firing people. During the pandemic, all around the world a significant increase of public debt and a depletion of sovereign savings and reserves could be observed.

It is very hard to distinguish between an increase in debt that is reasonable, given the circumstances, and an excess increase that is, instead, in the short-term interests of those in office at the time. Moreover, it is very hard to set in place rules or institutions that determine when governments will be allowed to relax debt constraints and when they will not. Reality always surprises us with unexpected shocks (such as the pandemic) that require the engagement of criteria, human intuition, wisdom, and ultimately politics.