If anybody rewrote Liza Minnelli’s most famous song these days, they would probably call it “Debt, debt” instead of “Money, money”. Oh, yes—whether we like it or not, the global economy is all about debt.
Think about it for a second. Credit cards, leasing, mortgages, small or large project financing, even pension funds (as future payment obligations)—everything around us is debt. Government debt, consumer debt, corporate debt, institutional debt, debt that straddles our generation well into the next one...
Debt is used to pay down debt
When debt is used for productive and value-adding purposes, then the economy does fine. It grows and is able to repay what is owed. But if the debt is used to repay other debts or to fund non-productive projects, then its value diminishes and repayment becomes almost impossible. This is largely what is happening today on a global scale: debt is used to pay down debt. It’s like a merry-go-round, with new players jumping on from time to time but with nobody jumping off. The contraption just keeps getting bigger and going around faster then anyone could have guessed. We are all so far in debt that every new-born child owes several thousand dollars when it takes its first breath.
Is there a right amount of debt
And then of course comes the billion dollar question: is there a right amount of debt and, if so, how much? In the private sector I think the answer is simple. As long as a company can service its debt and still have enough money left over to continue operating profitably, then it will be alright. The problems really start when we try to apply this at the government level. Budget deficits are all too common these days; few countries run a surplus, and for those that do it is usually fuelled by royalties on abundant natural resources or by emerging growth.
The rules actually aggravate today’s problems
Obviously there are exceptions, but let’s focus on the rule. The US, France, Germany, Japan and the UK, to cite a few of the biggest names, are all running annual shortfalls with no sign of being able to balance their accounts in the next few years. So we know for sure that debt is here to stay. It could also be argued that, in the end, if everybody is issuing debt then it can’t be so bad after all! But this again begs the question of what the right amount should be. Japan doesn’t really show that it cares: it just keeps running up more debt and nobody blinks an eye. The US raised its debt ceiling this summer and will probably jack it up higher in the coming years. Meanwhile the EU is struggling to maintain some absurd rules on annual deficits and debt-to-GDP ratios. But those rules were grossly violated by its biggest members, paving the way for the undisciplined ones to really exaggerate and throw the ratios out of all proportion. They have been proved unrealistic and useless by political necessity and economic reality, with no central decision-making process to control who gets what. They actually aggravate today’s problems, making it impossible to apply them in the near future.
Why can’t we have more than a 3% annual deficit? Why would it be so bad if the EU accepted a debt-to-GDP ratio exceeding 103% or 105% for a period of ten or more years? Technically speaking, these levels are well thought out and calculated on the basis of averages during phases of healthy, steady economic growth. And that is exactly the point. When you run into periods of poor, choppy economic growth, if any, these rules should not apply and governments should be allowed above all to provide stimulus and protect the welfare of their citizens. Such is the approach to debt on the other side of the Atlantic. The US authorities are constantly creating mountains of debt in order to jump-start their economy and bring consumption back up to previous levels. Later on they will probably create some inflation to …deflate their debt. Let’s be clear about this: we should adamantly oppose bad budget practices and the kind of system abuse that we have seen in many cases. But to enforce unsustainable rules in an economic environment that simply cannot afford them is both difficult and dangerous.
Debt v. social unrest and/or stability is a very dangerous equation
As long as a country’s debt is directly linked to the average citizen’s standard of living, any government will have serious problems reducing it and, if it does so, will probably not survive beyond the next election. We have already seen this in Portugal and Spain, and I am afraid that many more examples are on the waiting list. Debt v. social unrest and/or stability is a very dangerous equation, especially in democratic societies where too much pressure is sure to result in a change of government. For any incumbent government it is a fine line balancing harsh debt-reduction measures against an electoral defeat, and that line is easily crossed.
The EU’s situation is a good illustration of this. Voters will react if they are asked to offer their tax euros to provide massive support to other indebted countries that do not appear to be pulling their weight. Likewise, voters in problematic countries will overthrow governments that try to adopt stringent fiscal policies on short notice. Fiscal discipline is a virtue that needs time to be vested and cannot change from one year to the next. It must be applied in a measure that proves effective against debt creation but is also socially acceptable. The biggest risk facing Europe is not higher interest rates or debt; it is massive social unrest. The sooner the EU adopts a common fiscal policy for all its member states, the sooner we will be able to find effective, long-term ways to address the issue of debt. Debt pooling and a joint central policy are the only solutions for a truly united Europe that will be free from the spectre of debt, as well as from the spectre of social unrest and everything that goes with it. The sooner we understand this, the better off we will be in dealing with the problem. This requires a political solution and not just an economic one. EFSF, Eurobonds and a one-off wealth tax are likely ways to tame the European debt problem. But now we need to move fast.
Imagine if debt were to freeze at some point in time
Debt will continue to make the world go round and very much so. Imagine if debt were to freeze at some point in time. The bulk of economic activity would stop, trade would come to a standstill and debt securities would disappear from the financial markets. There would be total chaos. Throughout the history of Western societies, debt and credit have always been abundant. Actually that is what made capitalism succeed and allowed free economies to thrive and emerge as the leading system at the end of the 20th century.
Coming back to the question of what the right level of debt should be, I don’t think there is a “right” one. What is enough in periods of strong growth and wealth creation is clearly little in recessionary periods. The Maastricht rules proved this point beyond a doubt. Actually the level of debt per se has nothing to do with fiscal discipline. I am a strong believer in very tight fiscal management, but at the same time I cannot see modern society reducing its level of debt at a fast pace. Countries that currently have huge debt burdens will have to shrink them to a sustainable size or face bankruptcy. This will have to be done at a much slower pace than we currently expect, and the way will be long and full of hurdles.
T. Gontikas, november 2011