Photo: epsos.de

The global financial crisis has exacted a heavy toll on public finances around the world. Deficits have rocketed and in many developed countries, government indebtedness has soared to levels not seen since 1945.

Dealing with the perils of this has become one of the biggest policy issues of our time. The US economists Kenneth Rogoff and Carmen Reinhart have pointed out that high levels of public debt are associated with low growth and high inflation. Jittery bondholders might take flight if deficits in some countries are not swiftly curbed. Several eurozone countries have already been forced to seek assistance because of their inability to refinance their borrowings, and Greece now seems to be teetering on the brink of outright default.

It is not just problem countries like Greece and Portugal that are suffering. The entire developed world seems ill placed to bear the burden of all this debt. The economic outlook for some countries—especially in Europe—is poor thanks to a toxic combination of poor demographics and rising energy costs. The number of workers relative to dependent pensioners is declining. Yet, at the same time, the ability of those countries to offset a dwindling labour force by increasing productivity is being undercut by higher energy costs. This is due both to greater competition for resources and poor policy choices.

“In the last forty years, the world has been more successful at creating claims on wealth than it has on creating wealth itself,” writes Philip Coggan, the financial editor of the Economist, in his new book, Paper Promises. This is, he argues, partly the consequence of the adoption in the 1970s of floating exchange rates and the subsequent dismantling of capital controls. These removed any restraint on the creation of paper money other than the maintenance of public confidence.

When combined with financial liberalisation, they unleashed the conditions for the rapid and dramatic build-up of debt. “The economy has grown, but asset prices have risen faster, and debts have risen faster still,” he writes. Given this dynamic, it is all too possible that borrowers have made promises that they will ultimately be unable to fulfil. Greece may be just the first of a number of debt crises about to break over the developed world.

The debt numbers certainly make sobering reading. Heading the list of fiscal deadbeats is Japan with gross debts of 227 per cent of GDP. It is followed by Greece (150 per cent), Italy (120 per cent), and the US (100 per cent). All are above the 90 per cent point at which Rogoff and Reinhart claim that economic sclerosis kicks in. Worse, these figures do not even take into account contingent liabilities, such as healthcare and pensions. The OECD reckons that such unfunded liabilities are 150 per cent of GDP in Japan and 130 per cent in Italy. Without significant changes in fiscal policy and age-related spending, then, already overblown ratios will soar even further.

Public debt is not the only problem. Households have leveraged to buy consumer goods and housing—a process facilitated by the process of financial liberalisation. Moreover, as the crisis has bitten and the private sector has sought to reduce its borrowings, a game of financial pass-the-parcel has started with debts being shuffled across via banks into the hands of the public sector. In the UK, for instance, direct financial guarantees to the financial sector alone amounted to 50 per cent of GDP. The European bailout packages can be seen as the final stage in this game—where debts pass from weak governments to strong ones. “The next test is how much of those debts the governments are willing or able to absorb,” writes Coggan.

In spite of the modern conceit that public debts are “risk-free,” governments have defaulted on loans as long as there have been people willing to lend to them. In the pre-modern era, sovereigns borrowed mainly to wage war and repayment was contingent on their success in conflict. Even when credit became more secure, a residue of mistrust persisted. In the mid 18th century the philosopher David Hume argued that a profusion of public credit would cause Britain to slide into a “state of languor, inactivity and impotence.” Adam Smith believed that when “national debts have once been accumulated to a certain a degree, there is scarce, I believe, a single instance of their having been fairly and completely paid.”

Yet governments do not always dishonour their promises. The most extreme example is Britain, where public debt reached a whopping 250 per cent of GDP at the end of the Napoleonic wars. Not only was there no default, but over the rest of the 19th century, debt levels fell steadily as a proportion of GDP.

True, it helped Britain that its crisis took place in the pre-democratic age. Its creditors were domestic, drawn from a rentier class that was well represented in parliament. Narrow suffrage made it easier for the state to impose a deflationary squeeze on the population (and to ride out the resulting disturbances, such as the events that culminated in the 1819 Peterloo massacre). Once military expenditures declined, government budgets were tiny and the structural deficit non-existent.

But in recent times too, countries have hauled themselves back from the brink of bankruptcy without resorting to default or inflation. Sweden, Finland and Canada, have succeeded in cutting their public debts from high levels. After a banking crisis in 1993, Sweden found itself with debts of 84 per cent of GDP. They have since almost halved.

Before the crisis, sovereign defaults tended to occur in developing rather than advanced economies. Bankers in London and New York would make too many imprudent loans to emerging economies and then stampede for the exits when the capital cycle turned. (Foreign loans have always been dodgy: in the 1820s a Scot, Gregor MacGregor, even managed to raise a loan in the City of London by posing as the ruler of a fictitious Latin American country). But this time it really is different. In the years leading up to the credit crunch, far from borrowing heavily, emerging markets ran current account surpluses by selling goods to developed nations. These surpluses were then recycled to back to borrowers in those developed countries, where they were used to finance more purchases of yet more goods.

These imbalances must inevitably lead to contraction following the crisis. As the US economist Richard Duncan has observed, western consumers, who had been buying goods on credit, can no longer afford to do so. Asians, having expanded production to service this market, are stuck with excess capacity when it falters, which must in turn lead producers to cut their prices. The cumulative effect is to reduce growth across the world.

While some countries might try to grow exports by devaluing their currencies (a method Tom Streithorst recommends in his recent blog), this is not a route that every country can follow. That would require some of them, as the Financial Times columnist Martin Wolf is fond of saying, to export to the moon.

This interaction between the crisis in the developed world and the international monetary system, Coggan believes, makes the situation especially perilous. While individual countries like Sweden could recover from debt crises because demand elsewhere was strong, “global debt crises are much more dangerous.” The closest parallel is to the international crisis that followed the first world war. This too was caused by imbalances; in this case those built up during the conflict by warring European nations that ran massive trade deficits with the US.

Having built up a huge advantage, the Americans were unwilling to reduce their trade surpluses, instead forcing the Europeans to cut wages hard to restore their competitiveness (essentially what Germany is now willing on the eurozone periphery). When the world fell into depression at the end of the 1920s, the tensions ruptured the prevailing international trading order—built on the gold standard. Trade relations descended into an undeclared war of competitive devaluations and tariff increases.

The choices facing western nations today look pretty much as ugly as they were for the Europeans then. The happy way out—that of high growth—looks unlikely because of persistent imbalances and unhealthy demographics. Both presage a long period of sub-par demand. The virtuous alternative is deleveraging and stagnation. But this can be eye-poppingly painful, as the case of Greece shows. Simply to stabilize its public debts at the current level requires Athens to run a primary surplus of about 10 per cent of GDP. That requires either considerably higher taxes or less public spending—or a combination of both.

Such a policy would risk unleashing a deleveraging spiral, where debt liquidation leads to distress selling, leading to a contraction in the value of collateral and further asset sales. This is the world of Irving Fisher, in which “each dollar of debt unpaid becomes a bigger dollar” because “the liquidation of debts cannot keep up with the fall in prices it causes.”

Nations faced with excessive debts have in the past tended finally to choose between inflation and default. The former has a long and dishonorable heritage. Dionysius of Syracuse was the first ruler to debase his coinage to reduce his debts back in the fourth century BC. The arrival of paper currency in the 18th century simply magnified the opportunities for debasement. The first true hyperinflation occurred after the issuance of so-called assignats to finance large deficits during the French revolution.

Greece cannot inflate its way out of trouble. Because of its membership of the eurozone, it now issues debt in a foreign currency that it cannot debase. But countries that issue their own currencies face no such barrier. In 2002, the now Governor of the US Federal Reserve, Ben Bernanke, gave an uncompromising speech in which he declared America’s determination to resist deflation.

“The US government has a technology, called a printing press (or today its electronic equivalent), that allows it to produce as many US dollars as it wishes at essentially no cost. By increasing the number of US dollars in circulation, or even by threatening credibly to do so, the US government can also reduce the value of the dollar in terms of goods and services, which is equivalent to raising the prices in dollars of these goods and services,” he said.

The British economist John Maynard Keynes called inflation “nature’s remedy, which comes into operation when the body politic has shrunk from curing itself.” If the creditor nations of the world push the burden of adjustment from the imbalances on the debtors alone, there seems little doubt that (where they can) this is the route they will choose. Countries like the US and the UK will not be—like 19th century Britain—“as good as gold,” but will inflate.

Is there another way? Since the crisis broke, the main trading nations have talked about the need for rebalancing—which involves creditors spending more to help the debtors pay down their debts. But the reality is that the existing monetary order—based on floating exchange rates in the developed world and managed rates in the emerging economies—makes this unusually difficult. Goldman Sachs has estimated that to promote the sort of rebalancing the world needs, the emerging economies would have to revalue their currencies by about 20 per cent. The likelihood of this happening is about zero.

But without an organized rebalancing, the risk is that international tensions will rise. Tempers are already fraying, with creditors complaining about western countries debasing their currencies through policies such as quantitative easing. As pressures rise, developed countries may be tempted to throw up tariff barriers to protect employment— which would risk a re-run of the beggar-my-neighbour policies of the 1930s.

As Coggan observes, the monetary system has changed before at times of economic stress. It may need to change again. The possibility of a return to some sort of gold standard—again linking the currency with a tangible store of value—seems remote. The technical difficulties are extreme, and it would pay havoc with the enormous global financial system that we now have. Some have talked of the idea of creating a synthetic global reserve currency, although it is hard to see how this would attract sufficient liquidity unless it was adopted by merchants around the world.

That said, politicians are at least exploring the idea of moving to a more managed trade regime. Last year, the US treasury secretary, Tim Geithner tentatively proposed the idea of countries agreeing to limit their current account surpluses to 4 per cent. A number of countries have started to raise capital controls.

Change will be hard to achieve. The snag is that the Americans and the Chinese, the key players in such a hypothetical grand bargain, would only agree in order to protect vital interests. For China that would mean to avoid huge losses on its holdings of US government bonds. The US will be hugely reluctant to accept anything that would curb either its budgetary freedom or its ability to denominate its international obligations in its domestic currency.

It will take more imagination than either side has hitherto shown. While the Europeans and the US have urged Asian nations to wean themselves off the need to “insure” themselves against economic insecurity by piling up foreign reserves, they have resisted Asian calls for reform at the International Monetary Fund. Yet surely one of the goals of such a reform would be to help the Asians to build confidence in the idea that they could run deficits without inviting attacks on their currencies. A greater stake in IMF governance would encourage the belief that it would support them.

The choices are not easy. But the west needs to decide whether it wants to lead the way in rebuilding a new trading order. Otherwise it risks having the rules set ultimately by others—who may not have its interests at heart.