Lebanon defaulted on its sovereign debt for the first time in March this year. It was bound to happen, because its economic model was fundamentally broken. Decades of dismantling organized labor while concentrating power has left Lebanon one of the most unequal societies in the world: the bottom 50 percent earn about the same as the top 0.1 percent, while the top 10 percent takes home almost 60 percent of incomes. The top 1 percent in Lebanon owns more of its national wealth than their counterparts in China, Russia, and the United States.
Before the financial crisis in 2008, Lebanon was a hub for trade, finance, and tourism, which accounted for about a third of incomes. Together with remittances and transfers, these service sectors almost financed imports from abroad. But unlike most other emerging market economies with similar levels of imports, Lebanon had basically no merchandise exports. The domestic economy was based around several market monopolies and unions had been decimated. So, to finance spending on imports, it relied on foreign direct investments and services exports.
In the years preceding the crisis it allowed the central bank, Banque Du Liban, to accumulate foreign reserves. More money flowed into the country than left, even with a chronically negative trade balance of around 30 percent of GDP every year. It also meant the economy was vulnerable to external shocks. The economy was concentrated in the hands of the few, who had fought to suppress broad ownership of production and undertaken few productive investment domestically.
Growth in the Middle East stagnated following the crisis of 2008. As tourists stayed away and no one wanted financial services, money started to dry up. Instead of reorganizing the economy away from imports, or broadening the tax base, Lebanon turned to financialization to keep imports high.
To keep spending unchanged, a lot of financing was needed: almost 20 percent of GDP was required every year. There are two ways to finance such a shortfall: either you can draw down on your foreign reserves, if you have any, or you can borrow it. Lebanon did the latter, relying on other people’s savings intermediated by the banks.
It worked for a while because the Lebanese currency was pegged to the US dollar. To attract money from abroad, Lebanese banks promised high interest rates on deposits, with the central bank promising to exchange Lebanese pounds for dollars at a fixed rate. It looked like a free lunch: there was no currency risk because the government had promised to keep the currency pegged. Meanwhile, people who put money into the banks received more than 5 percent in interest on deposits. The interest rate was far higher than investors would get if they placed their money with, say, banks in the United States. It was a great deal for investors in the region, who piled money into Lebanese banks. The money could have been used for productive investments but stayed in the financial system. That was step one in the “bezzle.”
The second step required the banks, flushed with deposits, to turn around and lend the money to the government, via the central bank. The banks had promised to pay a high interest rate on the deposits, but the central bank promised to pay even higher interest rate to the banks. It ensured the system could keep going for a little while. The banks turned around and lent the government a lot of money, pocketing the difference between the two interest rates.
The loans the banks gave to the government were (broadly) of two categories. The first was money deposited at the central bank. The central bank used the money to purchase securities, of which a large part was from the Ministry of Finance. The second was through the purchase of government bonds issued in both US dollars and Lebanese pounds (either directly or intermediated by the central bank). Both types of loans carried high interest rates that the government paid to the banks. But the government needed the money, and the size of the financial system kept growing.
Government revenues were low, and the budget deficit was around 10 percent in most years. Tax enforcement on the rich was weak. The government opted to finance its deficit by selling government bonds to the banks. Meanwhile, the central bank required deposits to facilitate the currency peg and replace the money flow from fewer exports. The new debt that the collective system took on far outpaced any new assets, with the result that Lebanon became a little poorer every day.
While money flowed into the Lebanese financial system on the promise of high interest rates, the banks turned around and financed the government’s various deficits. However, as with all Ponzi-like schemes, it can only last if new money come in. The money stopped flowing in 2019. Many factors help explain why: a recognition that the system was unsustainable; an economic slowdown; the Saudi kidnapping of Prime Minister Hariri; and geopolitics. The outcome was that the system could not go on because not enough new deposits came to the banks.
The central bank started spending its foreign exchange reserves to keep the currency stable in the face of outflows, but the money quickly disappeared. The government had large financing requirements every month from trade and fiscal deficits. Just the fact that inflows into the banks stopped was enough.
An Economy in Ruins
The Lebanese banking sector represented financialization on steroids. Its size was more than four times that of the total economy in 2019. Most of the banks’ assets were in the form of government debt and deposits with the central bank. Given the government could not possibly pay its debts, it meant the banking system was insolvent, too.
Fast forward to 2020. The government cannot pay back its US dollar debt because it has run out of foreign exchange reserves. The government debt in Lebanese pounds carries a high interest rate. The currency peg meant foreign reserves disappeared, and by now the government debt-to-GDP ratio is at 175 percent. The debt, that the government cannot pay back, is to the banks. The banks owe money to their depositors, which they cannot pay back, and no one can bail out the ordinary depositors.
Inequality was high to begin with. But the financialization of the economy means there are few good immediate options available. As the crisis escalated, the black-market exchange rate moved away from the official rate. Some currency controls are in place now, but only since the foreign exchange reserves ran dry. Unemployment has shot up, growth has deteriorated, and inflation has risen, leaving workers much poorer. The country is still highly reliant on transfers from abroad for income.
The government finally defaulted on its dollar debt in March. By then, much of the external debt was in the hands of hedge funds and asset managers. If recent sovereign debt restructurings have shown anything, it is that bondholders usually get paid: look to Argentina, where holdout creditors extracted large sums in a later settlement; Greece where bondholders were paid in the middle of an austerity program; or Puerto Rico, where bondholders argued for downsizing the government. Years of propping up an unsustainable system means creditors are circling, while the working class is left with austerity.
The economic model relying on an outsized financial system to fuel growth has left the Lebanon’s working class with the bill. The establishment managed a rentier economy, got their money out in time, and left an economy in ruins. Lebanon’s crisis show that an unchecked financial system run for the benefit of the establishment wreaks havoc, rather than aiding in the development of a more just society.