Are markets incompatible with democracy?

Protesters in Greece carry banners reading "IMF and EU are stealing a century of social progress" and "Take the money thieves and not the workers".  Greeks are not alone in feeling that markets wag the democratic dog. 

The new British government is rushing through $8.8 billion of spending cuts within 10 days of their appointment.  The Spanish government, under pressure from the European Central Bank and the US president, is cutting pay for 2.5 million public sector workers by 5 percent. The Romanian government is attempting to push through a 25% wage cut to its public pay.

Politicians who impose these types of punishments don’t get re-elected, so what could possibly cause them to act so far against the popular will?

Government spending comes from two places.  The first is directly from taxpayers; citizens of the nation.  Taxes are not paid symmetrically.  The rich, and big companies, pay more in absolute terms than does anyone else.  They are also more mobile than others so there is an upper limit on how much they can be billed.

A large number of governments spend a lot more than they earn in tax.  The credit crisis, when some of the biggest taxpayers collapsed, means that expenses now make up an even greater proportion of expenditure.

If you spend more than you earn you may cover the difference with a credit card.  If credit isn’t available then you have to cut back.  If things get really bad you may sell your house, move to a smaller place, sell the second car and cut your lifestyle.

Governments can issue debt directly through government bonds.  This is the second wing of state revenue.  Someone needs to buy those bonds otherwise such deficit spending cannot continue.

The big buyers of government bonds tend to be other governments.  China and Japan both have trillion-dollar investment funds.  That said, there is still a momentous amount of debt that gets bought by private investors.  Your pension fund might just be buying some Spanish government bonds as you read this.  You own a bit of Spain.  How would you like it if they couldn’t repay that debt and took away money you were expecting to retire on?

Exactly. 

When I first wrote about the expected bailout for Greece it was supposed to cost $40 billion.  Within a week that amount had ballooned to $120 billion and caused panic on markets around the world.  What happened is that private investors were expected to make up the $80 billion.  When European governments looked as if they weren’t taking things seriously, and the Greek government declared that they saw no reason to cut their spending, private investors had a choice to make.

Should they buy $80 billion of bonds and see their investment wasted as Greece continued to throw money around like Julius Malema buying bespoke wrist-watches, or should they put their money somewhere safer?

Investors not only chose to keep their money but also started selling their existing investments.  As cash disappeared the Greek government found it could only attract lending by offering higher interest.  Greek debt requires interest rates of 8.4% while next-door Germany can get away with as little as 3%.

European governments, in panic, chased through a $1 trillion contingency fund to cover any future bailouts in the region.  Investors clearly don’t believe this is sufficient and continue to keep their money at home.

The response from governments has been to accelerate their budget-cutting plans against the objections of their voters.  Does that mean markets aren’t democrats? 

Investors aren’t making any statements about democracy.  They’re simply worried about default.  If anything, by giving immediate feedback to governments about the future impact of present voter choices they act to limit wildly popular policies that may result in tremendous future pain.

Instead of fighting against that governments should be doing all they can to improve their ability to listen.