Debt Overload: The Path to Redemption

red tapeFiscal 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.

Peter Smith, a frequent contributor, is the author of Bad Economics: Pestilent Economists, Profligate Governments, Debt, Dependency & Despair (Connor Court).


14 thoughts on “Debt Overload: The Path to Redemption

  • Lawrie Ayres says:

    I am not an economist and I guess that will show in my comments. I do not see much difference between national and household financial management. As a small business owner (farm) with my wife we realised that to improve our financial situation we had to sell more cattle, make more chaff and find more buyers because our expenses were either fixed (mortgage, overdraft) or increasing (school fees, electricity, food, clothes etc). We needed to re-invest in infrastructure and productive machinery so house improvements tended to be overlooked at least in the short term. We did not take holidays, our entertainment was mostly home grown and our cars were kept longer.

    I note that my son and sons-in-law have a similar outlook and are all busily building their respective businesses by taking small wages and investing in capital. What concerns me most is the tendency of modern governments to see such success and proceed to take it from them to give to the layabouts and ne’er-do-wells.

    Householders have known this reality for decades, nay millennia, so how come governments and their economic advisers are so dumb?

    • Warty says:

      Not unlike Lawrie, I have enough economic knowhow to balance my own budget, which, as an ex teacher doesn’t amount to much. So Lawrie’s old fashioned economics resonates with me. Unfortunately, this current Gen Y, which appears to want everything now and therefore runs up credit card debt that would leave my mother, father, grandparents speechless, seems to have been adopted by a government which enjoys buying votes when interest is at record lows, with no noticeable safety provisions to deal with the level of repayments when interests are likely to escalate.
      My wife and I had a simple philosophy when it came to finance: scrimp and save in order to gather together the money for a deposit on a house. Scrimp and save in order to pay it off as soon as possible, forgoing going out to restaurants; driving our two cars beyond their use-by dates (we both taught, and both need a car) and living within our means. I believe there are still people who live by these old fashioned regiments, but they are in a minority.
      A government that seems intent on driving up electricity prices; increasing public debt; attacking our superannuation schemes; ensuring asylum seekers have a better standard of living than their elderly, does not attract my vote.
      My hope is that Cory Bernardi and his Australian Conservatives can rectify the balance. I suspect I’ll be compost by then.

    • ianl says:

      > ” … how come governments and their economic advisers are so dumb?”

      Well, because they are not. They do think, though, that most of *us* are – and they’re right. So buying votes works a treat for the long-enough period needed for said bureaucrats and politicians to ensure their own comfort. Along the way, they also have the added comfort of noble cause puffery. The long term ? Then we’re all dead … so said the hero Keynes.

      I’m aware that most people find this just too cynical. Perhaps, but are you sure you’ve correctly identified which are the cynics ?

  • Matt Brazier says:

    I spot a fly in the ointment with this type of strategy going into the long term future.

    Economic growth is largely driven by consumption growth — making more stuff. The immutable fact is that consumption cannot continue to grow ad-infinitum forever. Eventually uncontrollable factors will take over and reality will have the final say. Growth will stop and there will be nothing that anybody or any government will be able to do about it. As an analogy: If a child fails to grow the outcome is bad. But if an adult fails to stop growing the outcome will also be bad. Growth of itself is neither good nor bad. It is assuming or attempting perpetual growth that is the problem. Perpetual growth is the policy of cancer. There are persistent signs around the world that we are starting to see the beginning of the end of economic growth. Even relatively poor people in the developed world live live quite comfortably by historical standards. The average person simply doesn’t need to consume more than they do now. People can’t be forced to just buy more stuff that they don’t need or want.

    Governments ultimately can change their spending with the stroke of a pen. Whether people like it or not is another matter, but the government does have that direct control. Same with taxes. The government can choose, for example, to raise more taxes by making sure that everyone pays their fair share, which is what the Australian government is doing right now with respect to corporations — at the stroke of a pen. But no stroke of a pen can guarantee to conjure more economic growth. If there is no more growth to be had then no amount of faith will produce it. The trick might have worked in the past and it might work a few more times. But eventually it will be crunch time.

    What we need to work towards is a permanently debt free government and a steady state economy. On average over the long term we will get a steady state economy regardless. All that is in question is whether the transition will be planned and controlled or unplanned and uncontrolled. The objective should be to get things into permanent balance, not to try to solve problems by forever making more and more stuff.

    • Jody says:

      I agree with your comments about growth. Years ago I remember one economist saying that we, as a consumer society, had reached the “windscreen wipers for sunglasses” state. Redundant consumer products we don’t need and which head for the local land fill facility is where we are at the moment. Some argue that immigration promotes growth because people have to find a home, eat, buy clothing and services etc. But it all reminds me of this fabulous metaphor, which I’ve posted before:

    • acarroll says:

      “People can’t be forced to just buy more stuff that they don’t need or want.”

      It’s difficult to compel them but they can most certainly be persuaded into buying crap they don’t need.

      Advertising (targeted psychological manipulation) works.

  • Gordon says:

    Very good article and comments.

  • says:

    Restraint James, JUST restraint. AlanIO

  • lloveday says:

    Churchill is so often quoted as saying “Democracy is the worst form of government except all those other forms that have been tried from time to time”, but what he actually said, was “Indeed it has been said that democracy …….”. He did not claim ownership of the words, nor even admit to agreeing with them, although it is reasonable to think he did.
    He preceded those words with “No one pretends that democracy is perfect or all-wise”

  • says:

    This is a very much condensed version of Peter’s most enlightening book: “Bad Economics”. It struck me while reading that, and again with this article, that of the five options Peter discusses to “balance” the books, the last one, the only one he considers feasible, is the easiest to understand for the economically illiterate such as myself. It also seems the easiest to put into practice. What makes it nigh impossible to implement is the dominance of Marxism, nurtured by the ever popular notion of envy. Simply translated: rich is bad, poor is good.

    Besides all that, Matt’s comment above is eminently worthy of consideration. An economy that putters along smoothly at the same steady pace year after year is an appealing concept on many accounts. The only problem with it is the aspiration inherent in human nature. No, not the avaricious chasing after ever more riches, but the desire to devise better and better ways of doing things, invariably for the sheer pleasure of it. How to differentiate and separate that from greed is a considerable dilemma.

    • ianl says:

      > ” … Matt’s comment above is eminently worthy of consideration”

      Completely disagree. Matt’s comment is from Pollyanna land. Cultures, economies, populations (all are dynamically interlinked) are never in stasis long – either growth or retreat, vibrancy or decay. This is a core property of DNA, which is the driving force of evolution. Again, most people do *not* want to know this; it’s regarded as scary as a black hole. But it is the undeniable history of Life on Earth …

      • Bwana Neusi says:

        ianl – You lost me with your arguments – sorry!
        But whilst the fridge I bought twenty five years ago failed last year and it would cost more to to repair than replace, we bought a new one.
        The fridge mech cautioned that this one would only last about five to eight years – built in redundancy.
        Take that argument to the next level – just how many fridges must I buy to keep the “Supply side” ticking over and will it get to the stage where they will only last a couple of years? And would buying a second or third TV be the limit or should I need to replace them to keep pace with evolving technology?
        There is a physical limit to how much we can expand the “Supply side” and in many regards that is where we are today.

        • Jody says:

          Five years for the fridge is good, but consider how cheap they are compared to 25 years ago when you first bought your other one. I only buy cheap dishwashers and ovens now as they will have to be replaced sooner rather than later. Nobody wants to discuss the environmental aspect of this throw away society; land fill sites are filled with whitegoods and it utterly galls me that when we were intensive farmers we were accused of being environmental vandals because of dust, odour and noise (never mind the 2,500 trees we planted!).

          • whitelaughter says:

            The idea that redundancy will fuel growth is absurd. Yes, if the fridge fails you will buy another fridge…with money that you would otherwise have spent elsewhere.
            People won’t stop buying stuff. Is there anyone who truly can say they have everything they could possibly want? *Need*, sure, met long ago: but desire is limitless.

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