TCS Daily

Good Old Fashioned Fiscal Discipline

By Pavel Kohout - July 20, 2005 12:00 AM

Government budget deficits are a worldwide problem. Ondrej Schneider, an economics lecturer from Prague's Charles University, recently proposed a solution. Schneider outlined the idea of an independent non-partisan regulatory body, which would oversee fiscal policy in the same manner as central banks govern monetary policy. It has been convincingly shown that truly independent central banks can successfully tame inflation and reduce the risk of monetary crises. Why not use a similar prescription to cure the chronic fiscal diseases of modern economies?

The very notion of political independence of fiscal policy may sound oxymoronic to many. What's more political than state budget and public expenditures, after all? However, Schneider's idea not only has sound theoretical background, it is also time-tested. An arrangement based on an independent fiscal policy regulatory authority once worked in the Republic of Genoa -- successfully for centuries.

From 1407 until 1805, there was a financial institution called Officium procuratorum Sanctii Georgii super diminutione debitorum (St. George's Supervisory Authority to Reduce Indebtedness, literally translated). San Giorgio, for short. It was a specialized financial institution aimed at protecting the interests of government bondholders and diminishing the risk that the Republic would not meet her obligations.

San Giorgio was built on no profound economic theory. Its origins were purely practical. Until 1528, when energetic leader Andrea Doria came to power, the Republic of Genoa had suffered from notoriously weak government, the result of persistent conflicts between feudal nobility and the merchant class. The credit quality of the government was poor. Creditors formed associations to protect their interests. These organizations were subsequently recognized by the government as formal partners. By the beginning of the 15th century, public debt became so heavy that the Republic created San Giorgio, formed on the basis of these associations. San Giorgio was a tool to reduce the debt burden of public finance, says Professor Michele Fratianni, who wrote a remarkable and extremely thoughtful paper on Genovese financial history.

San Giorgio's legal status was as a joint-stock company with a banking license, whose shareholders were creditors of the government. It purchased government debt for its clients' money and collected the due part of taxes. San Giorgio was far more than just an interest group lobbying on behalf of creditors, though. Its main strength was expert knowledge in the field of public finance and risk management. The institution managed fiscal policy to the point that it dictated to the government the extent of maximum allowed indebtedness - in a similar manner in which modern risk management departments dictate commercial banks the allowed level of credit risk. Besides that, the government partially outsourced tax collection to San Giorgio - tax farming, as this practice was called. The most important favorable result of the independently governed fiscal policy was reduced risk of government default. The Republic of Genoa thus could have borrowed money at lower rates than it was common in other Italian city-states.

San Giorgio was admired by many historians and political scientists. The legendary Niccolò Machiavelli mentioned San Giorgio as a "state within the state", which he unambiguously meant as a compliment. Machiavelli stressed the importance of high professional qualities of management, which was a stabilizing factor in the politically unstable Republic. "Seldom in the history have creditors so forthrightly stepped in and effectively taken over a government by creating a parallel institution, the Casa San Giorgio, ostensibly existing outside normal politics, to protect their own interests," says historian Steven Epstein. San Giorgio featured an elaborate system of governance that protected all parties while efficiently eliminating possible conflicts of interest.

The financially savvy Genovese also invented a special class of securities: sort of a cross-breed between government bonds and preferred stocks.

"The Bank of San Giorgio issued, on behalf of the Republic of Genoa, placements of perpetual bonds, called luoghi, at a nominal value of 100 lira each. Their income was secured by specific taxes farmed out to the bank. The luoghi did not pay a fixed rate of interest [...] but paid dividends which depended on the amount of taxes collected after payment of the expenses of the bank," write Sidney Homer and Richard Sylla in their book, A History of Interest Rates.

The luoghi can be viewed as either dividend-paying government bonds or government preferred shares without voting power. Such a class of securities does not exist in the modern financial world, which is certainly a pity.

The dividend government bonds would be welcome in many risk-averse portfolios of pension funds and insurance companies worldwide, since they are inherently inflation-adjusted (unlike conventional bonds and stocks), carrying sovereign credit risk (as government bonds), but offering theoretically unlimited room for growth (as stocks). Their risk-return-correlation characteristics would most likely make dividend government bonds a desired class of securities. They would offer investors more possibilities of portfolio diversification, while reducing risk of government default and providing government treasuries more flexibility. Not surprisingly, luoghi were in high demand among charities in the times of the Republic of Genoa.

In the context of pension reforms (or discussions about pension reforms) in many countries, these characteristics are especially attractive. There are many people who admit that some sort of reform involving pension funds should be implemented -- in the U.S. as well as in the Czech Republic and perhaps other countries, too. However, one complaint always emerges when it comes to the question of how pension funds' portfolios should be invested.

Government bonds? Sorry, we are afraid of inflation. The government could effectively expropriate our savings, don't you remember the 1970s (in the U.S.) or the early 1990s (in the Czech Republic)? Stocks? Sorry, but we are too afraid of stock market risk. Can the government introduce mandatory pension savings accounts and force the people invest in risky securities? Of course it cannot, and thus all-embracing government guarantees would have to be introduced, causing huge contingent liabilities to the public finance, often argue critics of pension reforms. No such critic would make sense if government dividend bonds were available.

No government is currently planning to issue dividend government bonds. However, in the future, who knows? Maybe the centuries-forgotten instrument will be reborn in a modern package.


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