Debt Overload: The Path to Redemption

Fiscal conservatives want governments to cut spending. Progressives want governments to tax the rich. For quite different reasons they are both on a path to nowhere. Donald Trump knows the only feasible path to take. Mind you, there is nothing unique about it. Ronald Reagan trod it as best he could for eight years in the 1980s.

For completeness I will cover five potential options for tackling government debt—including cutting spending and increasing taxes. I will explain why four of them will not work; leaving only one with any chance of success. This option requires a leap of faith, which only conservatives will find remotely palatable. They should make the leap, I will argue; and not get stuck on their particular path to nowhere.

Oscar Wilde found temptation to be the only thing he couldn’t resist. To spend money you don’t have is tempting. Kings and governments have a long history of being tempted and of succumbing. In earlier times, wars, overseas adventures and extravagant indulgences were prominent in sapping national treasuries. Since the Second World War governments in the developed world have adopted a formula for conducting their affairs which almost guarantees endemic indebtedness. They have tended to spend big in good economic times to build the “Great Society”, to put it positively; or to buy votes, to put it cynically. Then, unfortunately, in bad economic times, under the prompting of misguided Keynesian economists, they have spent even bigger, supposedly to cure recessions.

At the end of 2015 German government gross debt stood at 71 per cent of GDP. In order of size, comparable UK debt stood at 89 per cent, France 96 per cent, USA 104 per cent, Italy 133 per cent, Greece 177 per cent and Japan close to a whopping 250 per cent. Importantly, Germany apart, all of these indebted countries, and numbers of others besides, were running budget deficits as a proportion of their GDPs which were greater than the real growth in their GDPs. Australia is similarly positioned. As estimated in the 2017-18 Budget Papers, the deficit over this and last financial year averaged about 3 per cent of GDP compared with growth of 2.2 per cent. In such circumstances, as a matter of arithmetic, the ratio of debt to GDP rises—unless price inflation sufficiently exceeds the average interest rate payable on outstanding debt. It bears emphasising and illustrating. If the budget deficit is, say, 3 per cent of GDP and the interest on outstanding debt is 2.5 per cent, then real growth plus inflation (nominal growth) would need to be above 5.5 per cent to bring about a fall in the ratio of debt to GDP. I will return to this maxim later on when referring to the benefits of economic growth.

An IMF rule of thumb is that 60 per cent of GDP is an “acceptable” level of government debt. That’s fine, but debt is a slippery slope. The situation can easily get out of hand, particularly if lenders demand higher rates of interest to rollover maturing debt or to take on additional debt. Even Australia’s internationally modest debt of 40 per cent of GDP is generating interest payments of over $15 billion a year, accounting for a large proportion of the budget deficit. In any event, whether the debt burden is 40 per cent and rising or already at 100 per cent and more, the question remains: How can indebted governments begin to get on top of the problem?

Defaulting has proved popular. There’s plenty of history of this for both kings in deeper history and for governments in more recent times. Edward III of England defaulted in 1340, I’m informed by Reinhart and Rogoff in their excellent book This Time is Different. Apparently Spain defaulted under Philip II in 1557, 1560, 1575 and 1596. Pity the poor creditors. They were probably given the option of their money or their heads. Certainly, according to Reinhart and Rogoff, “French Monarchs had a habit of executing major domestic creditors” to terminally rid themselves of debt. There have been many defaults right up to the present time. Reinhart and Rogoff list 235 defaults or reschedulings of externally-held debt in Europe, Latin America, North America, Asia and Africa from 1800 to 2008. During this period there were also a number of purely domestic defaults.

This essay appeared in a recent edition of Quadrant.
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To bring it up to date: banks holding Greek government debt “volunteered” to accept a 50 per cent “haircut” in 2011. In other words, the face value of the debt was halved. How voluntary it was, who knows, but it had to be voluntary in name to avoid the contagion of affecting institutions which had underwritten the debt by issuing credit default swaps. Contagion is a problem. Banks are large holders of government debt which, ironically, is regarded as a safe and riskless asset. Clearly a default by a country of any size would spread contagiously throughout the banking and financial system and bring mayhem. It is safe to take this option off the table.

A second option is for governments to partially default by inflating their way out of debt. A rapid expansion in the money supply increases prices of goods and services. If prices double, outstanding debt is halved in real terms. Before the development of paper money, debasement of gold and silver coins was the means available to monarchs to artificially boost the money supply. Scope to engender inflation became much greater in the 1800s when fiat currency (government-backed paper currency) came of age. Governments could just print money at will. This power has since dwindled to nought as a result of “private money” replacing paper currency as the principal means for making payments.

By private money, I mean bank deposits. This kind of money is now used for making most payments in the modern world. Cheques, debit and credit cards, and bank transfers result in one person’s or company’s deposit becoming another’s. On top of this, bank lending is the main way money is created. It dwarfs everything else. In lending a dollar banks create a dollar deposit. They create money. Unless they create a lot of money, inflation simply doesn’t take off.

Numbers of central banks have been undertaking “quantitative easing”. This is often misleadingly badged as “printing money”. It isn’t that. It is buying bonds. This does result in a relatively modest increase in bank deposits and a corresponding increase in bank liquidity. In turn, it gives banks the capacity to lend. But, unless bank lending responds strongly, the money supply grows only slowly. And this, in fact, has been the case. Money supplies have been growing relatively slowly across all major economies. Accordingly, governments have failed to create inflation, despite their best efforts. Printing money isn’t what it used to be. It seems clear enough that inflation is not going to be the path to redemption for indebted governments.

A third option to tackle indebtedness is to cut spending. This is the way beloved of fiscal conservatives. There is no shortage of fiscal conservatives complaining that governments have failed to cut spending or, more realistically, to contain its growth. Maybe I’ve missed it, but I can’t recall one that has actually identified and quantified exactly where material cuts should be made, and can feasibly be made. Why? The answer is simple. It’s just too hard.

It’s become politically and socially impossible to implement spending cuts. Government budgets, wherever you look, are weighed down by education, health, welfare and pension payments; broadly speaking by entitlements. In Australia 60 per cent of federal government outlays are for these purposes. In the US it is 65 per cent. And, large chunks of other expenditures are inviolable. In Australia’s case GST disbursements to the states and territories bulk large. In the US case over 20 per cent of spending is for defence. No one with any sense wants the US to reduce its defence expenditure. That would mean that Germany, Japan and other allies (including Australia) would have to stump up a fairer share of military spending—and so add to their deficit and debt woes.

Once you take out of consideration large, growing, and untouchable, components of the budget, it’s very hard to make significant inroads into overall government spending. And claims for more spending on education, health and welfare are never-ending. To be clear, the recalcitrant Australian Senate is only an apparent obstacle to entitlement reform here. Ronald Reagan and Margaret Thatcher failed to prevent the growth of entitlement spending in a less far-gone age of dependency. Winding back entitlements is a chimera. And, as I’ll come to, this realistic perspective apparently informs Donald Trump.

A fourth option, this time beloved of the Left, is to increase taxes. Taxes on whom? On the rich, of course. Where to begin to demolish this benighted delusion? Take the United States, the supposed bastion of self-reliance. Based on 2014 data sourced from the National Taxpayers’ Union, the top 1 per cent of income earners pay 40 per cent of all federal income taxes collected. The top 25 per cent pay 87 per cent. Those in the bottom 50 per cent pay only 2.75 per cent. As only 73 per cent of working-age Americans (those from ages fifteen to sixty-four) file returns, this means that close to 70 per cent of working-age Americans collectively pay less than 3 per cent of income taxes. How much more skewed would the Left like it to be?

One of the problems of further increasing taxes on the rich is that there are too few of them to produce a great deal of additional revenue, unless taxes become punitive. There are two problems with punitive taxes. Some of the rich will flee; and, that apart, the rich are adept at avoiding punitive taxation. But there is a bigger problem in imposing still heavier taxes on the rich. Only the rich save very much.

You don’t have to go back to 1848 and to the first edition of John Stuart Mill’s Principles of Political Economy, but it’s always a worthwhile journey. He pointed out that our prosperity depends upon building a stock of capital and that this, in turn, is fuelled by savings. To put it simply, we can’t build or repair a factory or power station unless there are some among us who’ve stopped short of consuming all of their income and, in so doing, freed up resources. Only the rich, and most particularly the very rich, save much. Ergo, without the rich the capital stock would decay; poverty would eventually replace prosperity.

To sum up so far: Reneging on debt is untenable. Creating inflation is undoable. Cutting spending is infeasible. Taxing the rich is counter-productive.

This brings me to the fifth option and to what I believe is the only solution offering the prospect of keeping debt to manageable proportions. The solution is on the supply side; on the making side. In effect, supply-side economics was economics until the John Maynard Keynes of vintage 1936 came along. Since then, economists have looked at economic outcomes from the demand side. They report on national economic growth figures by referring to the contribution of consumer spending and of other types of spending including, bizarrely, government spending.

It’s not spending that makes us rich but making. A shortage of spending is never a problem for too long. Not many people or businesses would find it hard to spend more if they had the means. Making more is the key to containing debt. If we make more we might be able to afford the growing tide of entitlement spending—because that tide is not going to ebb.

Here I want to go back to a previous point. The budget deficits of indebted countries, in terms of GDP, are on the whole greater than their rates of economic growth. In these circumstances, indebtedness tends to grow as a proportion of GDP. Making more—increasing economic growth—is of double benefit. It increases government revenue and lowers the budget deficit. At the same time, it also boosts the size of the economy and, thereby, lowers the debt-to-GDP ratio. How to make more is the challenge.

First comes faith. Without faith there is no solution. This isn’t faith in a deity. It’s faith in capitalism, in free-market economics, in “the worst form of economic system except for all the rest”, to paraphrase Mr Churchill. It’s faith in the system that has continued to make us richer, despite there being an increasing number of leaners as compared with lifters, to use Joe Hockey’s confronting turn of phrase.

The conservatives in the Republican Party grimaced when Trump shied away from entitlement reform. But, as Reagan and Thatcher found, nothing meaningful can be done to slow down the leviathan of welfare and social security expenditure. It is a waste of time, and of political capital, to try too hard. If you think otherwise, then how exactly, when in deep deficit and debt, did we get stuck in Australia with the unaffordable, underfunded NDIS? However worthy, it has to be paid for. When all is said and done and various token gestures have been made to control entitlements, the only possible way out is to make it all affordable by getting richer.

Leave aside the benefits that renegotiating trade deals may bring. Trump has two main strategies to get the US richer, both of which have transnational application: reduce taxes and reduce regulations.

Reducing taxes to reduce the budget deficit seems counter-intuitive. Surely taxation revenue will fall and the deficit blow out? Enter Arthur Laffer. Laffer was one of President Reagan’s economic advisers. He remains best known for the Laffer Curve. The principle behind the Laffer Curve is simple. If taxes are set at zero per cent, revenue will be zero. If taxes are set at 100 per cent, revenue will equally be zero because nothing will be produced. In-between is a parabola, which shows revenue rising as tax rates increase from zero, before falling at some point when increasing tax rates impinge on production. Where is the turning point? Unfortunately, no one knows. Economies are too complex and dynamic to find out. But, as a principle, it appeals to conservatives. It’s possible that reducing taxes will generate sufficient economic growth to increase revenue enough to reduce the budget deficit. Enter President Reagan.

Reagan markedly cut taxes. Under the eight years of his presidency, from January 1981 to January 1989, real GDP grew at an average annual rate of 3.5 per cent. The economy was 32 per cent larger when he left office. Government revenues grew strongly. Of course, predictably, so did government outlays, though not by quite as much. Average economic growth also exceeded the average size of the budget deficit, if only by a small margin. This made a contribution to lowering debt, though not by enough to prevent the debt ratio rising. This was primarily because of high interest on the debt. Put Reagan in today’s low interest-rate environment and this blemish would be gone. Interest rates (both nominal and real) were far higher then than they are now. For example, interest on outstanding US federal debt averaged about 2 per cent in 2015 compared with about 8 per cent in 1988.

Lowering taxes will undoubtedly boost economic growth. It’s certainly worth trying in Australia, as in the United States. The second thing that Trump wants to do, and is doing, is to reduce regulations. It’s hard to get a handle on the scope of regulations, which grow, and never decline, year on year.

Take this from the Washington Times on November 1, 2016:

The Obama administration is on a course to set a new record for red tape by year’s end. The 2016 Federal Register [of new regulations] hit 75,670 pages on Monday … on Tuesday alone, the administration added hundreds more pages to the Register, ranging from rules on herring fishing in the Atlantic Ocean to food labeling for nut butter spreads.

Red and green tape and labour market regulations (for example, on minimum wages and penalty rates) kill jobs and constrain economic growth. Let’s strike an ironic and optimistic note. The scope for lessening impediments to economic growth is greater than it’s ever been, precisely because there are now so many impediments which can be removed. Impediments abound. The ongoing vexatious delays in approving the Adani coal mine are emblematic of impediments in Australia.

There are those who reflexively oppose reducing taxes on the rich and who object to any lessening of regulations, particularly those regulations which are seen as protecting public safety, or employees, or the environment, or which are designed to protect us from our own misjudgments. What such people need to understand is that our prosperity and capacity to care for an increasing number of dependants is not a given.

Green-Left politicians and their fellow travellers can live in their own delusional world of windmills and a four-day working week. The rest of us have to live in the real world where bills have to be paid. Growing debt will eventually lead to national ruin. Only less-encumbered free markets offer a way through. Only economic growth will pay the bills.

I don’t want to give a false impression. It is essential also to fight the good fight to contain spending. But when it comes to entitlements much of this will be akin to whistling in the wind. Heavy lifting will need to be done on the supply side of the economy. Conservatives need to switch their focus towards the goal of reducing taxes and regulations, buttressed by faith in free-market capitalism to do the rest.