The Liquidation of Government Debt (Economic Policy, Volume 30, Issue 82, April 2015)

"This article explains how advanced economies, from the end of World War II up until the 1980s, paid for the very large debts that resulted from World War II. But the authors also draw from a series of other historical analogies, partly building on the book written by one of the authors, Carmen Reinhart, together with Ken Rogoff, This Time is Different , about how debt often gets high, but also, how sometimes it gets paid. Much of the emphasis in Carmen Reinhart’s and Ken Rogoff’s early work had been to do with how often we have sovereign debt crises, resulting in defaults, which is why their book was called This Time is Different . But right now it is more important here in the UK and the US to think not about sovereign default, but instead about the issue that is the focus of this article by Reinhart and Sbrancia, which is how the debt is paid. We learn that there is a common answer. You pay the debt in large part, around half of it, by running a primary surplus. ‘Austerity’ is the ugly word we use for that nowadays. ‘Fiscal responsibility’ is what they used to call it. But the other half of how the debt is paid off is by having interest rates lower than the growth rate of the economy. This is the particular point that Reinhard and Sbrancia make. “Over the past 25 years in the UK inflation has been at its lowest and most stable in 500 years” Of course, every policymaker would say, ‘Well, let’s just grow out of the problem by having high growth rates.’ But high growth rates push interest rates up, so they don’t really help you per se. What policy needs is that interest rates stay low while growth is high. And what policy can do something about directly, much more than delivering high growth, is keeping interest rates low. And how does it do so? Reinhart and Sbrancia point to financial repression. By that they mean forcing banks and financial institutions to keep interest rates low by holding government bonds, regulations that keep interest rates low, and constraining financial development so that people can’t avoid getting a low return on their savings. In doing all of these things, the government exerts financial pressure to keep interest rates low. If you are in the developed world and worrying about the debt and you don’t want to think about default as an option, then financial repression is the thing to read about when trying to think about the problem of high debt. Absolutely. That’s why I picked this one. When it comes to emerging markets, then we’re talking about debt forgiveness and we’re talking about sovereign default. That’s why I chose this article over the Reinhart/Rogoff book, which is more about defaults. What I wanted to give you was something that would help people think about the likely resolution for advanced economies. That means the US and UK, the euro area as a whole, Japan—essentially the G20. But there is an interesting side issue here, which is what happens if you only have one region in Europe with high debt and not the others. That was the novelty of 2010-12, that in a banking and monetary union a member state could not implement financial repression on its own. Only the Eurozone as a whole could do it. That’s going to be the big debate. I am not saying that we’re certainly going to see financial repression, but it is on the table, together with austerity, two ugly expressions. If you want to use pretty words, you can say ‘fiscal responsibility’ and ‘keeping financial markets in check’. If there isn’t going to be a default, then there will be some mix of those two. I think if people start reading about this, understanding it and being aware of those trade-offs, they will have a leg up in the debates that we’re going to see arising in the next three-to-five years in economic policy. In the end, it’s going to be a mix of the two, but what mix will be is, I predict, going to be a hotly debated topic in economic policy in many forthcoming elections. Absolutely. If we do see financial repression, there will be less cheap financing for people’s mortgages. With repression will come more segmented financial markets and more monopoly rents for the banking sector, potentially. An example of this comes from the United States in the 1970s. When policy tried to force financial institutions to hold government debt that paid a very low interest rate, the banking sector successfully lobbied for the introduction of laws that made it illegal to pay interest on deposits. So, banks earned very little return on the government bonds they held, but they also ended up paying no interest on deposits. So, who ended up paying for the financial repression? The poor depositors, those who could only have their savings in checking accounts, as opposed to other investments whose return rises with inflation. Those who had their savings in checking accounts were the ones that lost the most. And it’s from the 1970s, from precisely that episode, that comes the sense that inflation is the cruellest of taxes. One might say financial repression allowed inflation to be the cruellest of taxes."