In the academic debates about how governments should react to the credit crisis that began in 2007 sides quickly emerged over the limits of what governments should do. Reinhart and Rogoff argued that when the debt/GDP ratio of developed nations pushes beyond 90% long term rates of economic growth are reduced. Their critics argued that such a ratio was arbitrary and that seeking to keep economies below this threshold would in some cases dramatically reduce the ability of governments to respond to the crisis with temporary spending increases.
In recent years largely the same group of economists has begun to argue that austerity measures are unnecessarily reducing GDP growth. Their economic recovery plan is for larger government deficits in developed nations in order to lift stagnant growth rates. These “anti-austerity” campaigners point to John Maynard Keynes’s work that advocated governments acting as a stabiliser by running deficits in difficult economic times to support growth levels. This has led to them also being labelled as “Keynesian”, a title that is gladly accepted given the high regard that Keynes is held in.
The anti-austerity campaign has gained traction in the media assisted by the high profile of some proponents such as Paul Krugman. For the average citizen of the US, Europe or Japan and particularly those of peripheral European countries where spending cuts have been most substantial, it gives them a clear target for their frustrations. Whilst some economic indicators in some countries are showing improvement, the average man on the street is seeing little benefit of that improvement. The finances of life seem to be much harder to manage than they were ten years ago.
Those who support restrictions on government spending appear to be losing the popular argument but winning the academic argument. Some fairly basic tenets of how economies work are being avoided by the anti-austerity camp which must be challenged as part of the debate. These include:
- The economic past cannot be ignored in making decisions in the present and the future. Governments that enter a crisis with substantial debts have a reduced ability to respond relative to those with little or no debt.
- There are four ways to reduce or eliminate government debt – default/restructuring, inflation/money printing, reduced spending or increased taxes. None of these is painless.
- You are not a Keynesian simply because you support temporary government deficits in difficult economic times. You must also support surpluses and debt reduction in good economic times.
- Lenders choose the maximum amount that can be borrowed. This limit is not known in advance and is highly dependent on confidence that a borrower is capable of repaying their debt. As debt increases relative to GDP, confidence in its repayment reduces and the cost of issuing new debt increases. Eventually, at some unknowable future point confidence evaporates and no further borrowing is possible.
Working through each of these points will help illustrate the problems and the solutions.
You Cannot Ignore the Past When Planning for the Future
The first major misunderstanding of the debate is that all governments started the financial crisis on an equal footing. Many developed economies spent the decade leading up to the financial crisis running government deficits at the same time as business and consumer debt levels were increasing. The combined impact of the growth in debt levels was that GDP growth was far higher than it would have otherwise been. Many countries forgot that you cannot borrow your way to prosperity – this can only come from improving productivity. Greece is a great example of what not to do in the good years and how the starting point can skew expectations for the future.
Once accepted into the Eurozone and thereby being granted access to cheap debt, Greece increased the debt on their national credit card and lived a lifestyle well beyond their means. The profligacy was unsustainable. It’s not the austerity that is to blame for the fall, the economic growth and higher living standards were only achieved through use of financial steroids (debt). The economic decline is primarily the result of withdrawing the steroids and falling back to normal. Comparing Greece’s GDP per capita levels today with what they were is 2008 is a false comparison – it’s like asking why the best drug free cyclist today isn’t as good as Lance Armstrong was in his (drug assisted) prime.
Reducing Debt Levels Always Hurts Someone
Now that the false comparison of GDP per capita levels is understood, it is time to move on to the next fallacy of the anti-austerity movement. Recently some have begun to argue that increasing debt levels isn’t an issue because “debt is money we owe to ourselves”. There’s two major problems with this incredibly naïve view.
Firstly, debt is not owed to “ourselves”, there is a lender and a borrower and the lender has rights if the borrower fails to pay. Insolvency and enforcement is usually financially painful for both parties. Capital invested and income streams from the activity are lost by the borrower and principal and interest owed to the lender is often compromised. Both parties may reduce their employment and investment activities as a result. If this happens on a large scale in a country it produces a recession or depression.
Secondly, there is the situation where the borrower might completely renege on their obligations and get away without their assets being seized. This is most common in situations involving international lending, particularly sovereign debt. Allowing borrowers to walk away virtually scot free from their debts creates disastrous incentive and moral hazard issues. It is essentially a legitimised form of stealing where the lender is defrauded and the borrower is enriched. We’ve already punished lenders and rewarded borrowers too much with negative real interest rates.
We are not all Keynesians
We all support Keynesian theory in a crisis in arguing for increased government spending. However, far fewer were Keynesian in calling for using the boom years before hand to run surpluses and reduce debt levels. In practice there were some notable exceptions including Australia and Canada, which used some of their commodity booms to run surpluses, reduce government debt and save for the future. Their comparatively solid foundation gave them an ability to run larger deficits for a longer period than other developed nations that began the crisis with much higher government debt to GDP ratios. These positive examples are typically ignored by anti-austerity proponents, who prefer to focus on short term ways to boost countries that failed to prepare for less rosy economic times.
Whilst Keynes is helpful in understanding what to do in a crisis, it is Hyman Minsky who is most helpful in understanding what causes a crisis. Perhaps the greatest economist not to win a Nobel Prize and arguably more deserving than some who did win one, Minsky’s focus on practical economics rather than theoretical models has meant his legacy was greatly underestimated by academic economists. This has changed somewhat in the wake of the financial crisis.
Minsky explained the primary cause of recessions, the withdrawal of the availability of credit after credit had previously been easily available. He also categorised lending into hedge, speculative and Ponzi groupings. Understanding all of this gives economists and investors an ability to understand how much lending is irrational and subject to a high probability of default when the next downturn occurs. Investors who grasp the concepts of the credit cycle are much more likely to avoid countries, industries and companies based on unsustainable levels of debt.
The application of Minsky’s work to the current issue of growing levels of sovereign debt points to likely problems for a number of large developed nations. Whilst Greece currently dominates the headlines in this regard, Japan and Italy are slowly burning away in the background. Spain, Portugal and Ireland may also be caught up when a developed nation next defaults (either formally or informally) on its debts. The failure of all of these nations to use the good times to reduce debt levels and reform their economies, rather than creating asset bubbles, leaves them subject to the withdrawal of the availability of credit at the most inopportune time. They may find in the future that when Keynesian theory is advocating running deficits there is no one prepared to lend to them or rollover their existing debt.
Confidence in Borrowers Evaporates Quickly
As many governments and companies found out in the financial crisis, the credit tap can be turned off very, very quickly. Borrowers that previously seemed to have an unlimited capacity to borrow suddenly found than lenders were not just unwilling to lend more, but were also demanding full repayment at maturity with no appetite for rolling over existing debt. Ultimately lending is all about confidence in a borrower’s ability to repay, which is subject to the whims of the markets and risk managers.
Whilst there are no rules or formulas that define who survives and who doesn’t, for sovereigns the amount of leverage and the amount of external debt both have a major part to play. In times of crisis, the lender focus switches from maximising returns to minimising the risk of loss, with the borrowers with the least leverage best placed to attract new capital. Reinhart and Rogoff calculated that developing nations, on average, lose the confidence of their lenders and default when their debt to GDP is at 69%.
The second major factor is the amount of debt owed to international lenders. Here Japan is a case in point. The most recent measures place government debt to GDP at 227% of GDP, a level that is almost without precedent. At current rates the interest due is minimal, but a return to anything like normal levels for interest rates would cripple the budget position. This is a situation that is clearly a bubble, but it hasn’t yet popped as the debt is almost all owned by Japanese investors who retain their confidence in the government and the debt. However, this situation cannot last forever.
For Japan, the falling currency and the recent sales tax increase are reducing the ability of the large base of retirees to afford what they used to be able to afford. The miniscule interest earned on Japanese government bonds doesn’t afford much, so retirees are likely to be gradually redeeming their bonds and spending principal to maintain their retirement living standards. If Japan wants to stabilise its financial position then writing off at least two-thirds of the current principal would be necessary. This would also need to be accompanied by more tax increases and welfare reductions – further reducing the spending power of Japanese retirees.
The economic mess faced by Japan and Greece brings us back to the beginning of the discussion. The fairy tale that austerity can be avoided and that “temporary” deficits can continue indefinitely is incredibly naïve. Debts incurred in the past inflated GDP levels and will inhibit the ability to respond to the next crisis. There’s no easy way to reduce debt, it will always hurt someone and reduce economic growth in the short term from what it otherwise would have been. If debt levels continue to increase lenders will eventually lose their confidence in the borrower’s ability to repay and will refuse to lend more. For highly indebted sovereigns, it is simply a choice of doing the painful things now or delaying until their lenders force far more painful changes upon them.