Ponzi Planet The Danger Debt Poses to the Western World
Part 5: Strategies for Reducing Debt
What can a country do to not only curb increasing debt, but also to reduce the size of its overall debt? There are many possibilities, and they are differentiated mainly by the magnitude of the sacrifices, and by who bears most of the burden.
The most brutal method is the debt haircut, which is reserved for hopeless cases like Greece. Creditors are forced to give up a large share of the funds they are owed. Banks and insurance companies and, ultimately, ordinary savers and the insured, whose portfolios and policies also contain Greek bonds, are the ones who suffer.
A government bankruptcy -- which is precisely what a debt haircut amounts to -- is by no means an unusual occurrence in economic history. France declared bankruptcy eight times between 1500 and 1800, while Spain could not meet its obligations seven times in the 19th century alone. "The progress of the enormous debts which at present oppress, and will in the long-run probably ruin all the great nations of Europe, has been pretty uniform," Adam Smith, the Scottish philosopher, wrote in 1776.
In the early 19th century, as a consequence of wars and revolutions, Greece spent half of its time in insolvency or debt-restructuring. The euro-zone countries ought to have been forewarned when they accepted the Greeks into the currency union.
Greece experienced a particularly unusual bankruptcy in 1922, when then Finance Minister Petros Protopapadakis ordered that all banknotes be cut in half. The one half remained currency, but was worth only half as much as the original note, while citizens were required to exchange the other half for a government bond. A quite literal debt haircut.
From Flirtation to Marriage
A softer, almost elegant strategy to achieve debt relief is the path leading through inflation. Prices increase, as do incomes and taxes, while debts remain nominally the same, thereby losing value in relative terms. They are essentially eliminated by means of inflation, with citizens being partly expropriated in the process.
If an inflation rate of 4 to 6 percent were tolerated for several years in a row, as American economist Kenneth Rogoff argues, countries would be able to make significant strides in the direction of solving the debt problem. However, the rate of inflation cannot be controlled at will. As the saying goes, if you start flirting with inflation, you will have to marry it.
Most of all, the inflation solution is only effective for getting rid of old debt. For each new euro a country borrows, creditors will demand higher interest in return, which ultimately increases the debt level even further.
Which leaves the two conventional methods of debt reduction.
First, the government can increase its revenues by simply raising taxes. The financial basis for such an emergency move certainly exists: Germans possess total net monetary assets of about 3 trillion, as well as real estate assets worth about 5 trillion. But the most likely candidate is the inheritance tax. Despite the estimated 300 billion in assets that are transferred to heirs each year, in 2010 Germany collected only 4.4 billion in inheritance tax. Even the electricity tax generates more revenue, at 6.2 billion.
The second option is for the government to reduce spending by limiting goods and services. The government will in fact be forced to take this cost-cutting approach because new debt ceiling limits will soon apply. Under these rules, the federal government's new borrowing is limited to 0.35 percent of GDP, which is currently about 9 billion. The instrument inspires hope that the trend to incur more and more new debt can finally be stopped. It is "the only correct approach," says entrepreneur Goebel.
Far More Difficult to Generate Growth
But there are also exceptions to the law. The government can loosen the debt brake during economic downturns, as well as in the case of natural disasters. What is also missing is a clause stipulating that surpluses in good years be used to pay off old debts -- and not for tax cuts.
But a consolidation of finances is certainly possible, as Italy, Spain and Belgium demonstrated in the late 1990s. These countries managed to substantially reduce their debt levels. Spain, for example, trimmed its debt from 67 to 36 percent of the country's economic output within 10 years. Of course, this sort of turnaround was also made possible by the fact that Spain's economy proved to be so dynamic at the time.
Growth is undoubtedly the best way to get out of the debt trap. After World War II, the American economy grew at a faster rate than the national debt. As a result, the debt ratio was automatically reduced.
Nowadays, however, an aging and shrinking population makes it far more difficult to increase economic output. This means that slow-growing countries like Japan or Germany can hardly serve as the reliable borrowers of tomorrow. Rising economies like China, India, Indonesia, the Philippines or Vietnam offer more security. Ironically, for the rating agencies, it is the shaky candidates of the past that could very well be the most reliable economies of the future.
In the West, on the other hand, it is now the state that must increasingly assume the role of growth engine. To do so, it borrows money and tries to reduce government debt with the additional value added. Kurt Biedenkopf (CDU), the former governor of the eastern German state of Saxony, describes this as a fatal process in which the government takes on new debt to finance growth in order to pay off old debt.
The Power of the Purse
Biedenkopf recently proposed a concept with which he argues the debt burden could be paid off within a generation. Under the concept, all liabilities would be transferred to a foundation, dubbed the "German Financial Agency," to which a portion of tax revenue would be allocated in order to slowly reduce the debt, thereby bypassing the parliament. But it is questionable whether the members of that parliament would readily agree to be deprived of the power of the purse.
A plan unveiled by the German Council of Economic Experts in November seems more realistic. The council proposes establishing a fund that would assume all the debts of euro member states that exceed the Maastricht ceiling of 60 percent of economic output. Under this plan, the total debt of about 2.5 trillion would be paid off within 20 to 25 years, partly through tax surcharges.
Whatever approach the Western world uses to combat its debt crisis -- be it austerity measures, taxes, inflation or, what is most likely, a mixture of the three -- solving this problem will shape the lives and work activities of a generation.
"If history is a model, we can expect to see many years of debt repayment," the McKinsey management consulting firm predicts in a study. In other words, the debt avalanche is inevitable, and the only question is whether countries can protect themselves in time.
It is not as much a question of putting a stop to speculators or penalizing rating agencies. Such skirmishes are merely a distraction from the responsibility that politicians bear when they constantly incur new debt to service old debt. But it is also the responsibility that voters bear for rewarding such behavior, and that the banks bear for being so consistently dependent on the government to bail them out whenever they gamble away their money.
Secretly, they all know that a Ponzi scheme has never turned out well.
Translated from the German by Christopher Sultan
- Part 1: The Danger Debt Poses to the Western World
- Part 2: Of Good Debt and Bad Debt
- Part 3: Germany's True Liabilities
- Part 4: The Failures of the Political Class
- Part 5: Strategies for Reducing Debt