The Menu
There are six obvious ways to deal with excess debt: (1) austerity, (2) mass defaults, (3) jubilee (debt cancellation), (4) redistribution, (5) financial repression, and (6) consumer price inflation. We will examine these options here. They are not mutually exclusive but are usefully treated separately before we consider possible combinations.
1. Austerity, colloquially known as “belt-tightening,” means cutting consumption. If you reduce consumption, you can use a greater portion of income to repay debt and reduce the debt load. Unfortunately, austerity is painful. Like dieting, it usually fails. We have seen that attempts to cut spending, especially at the government level, succumb to the demands of special interest groups and average citizens who benefit from spending. Elected politicians have to keep dishing out the goods in order to stay in office. Recent history provides a few exceptions, such as the semi-successful (so far) case of Greece, which has endured a long and deep austerity-induced recession after accumulating unsustainable debts. It remains to be seen whether Greece will be able to maintain spending reforms. It seems highly likely that if Greece weren’t part of the euro area and therefore had the ability to print its own currency, it would have chosen money printing and inflation rather than austerity.
2. Mass defaults are arguably as painful as austerity because anyone who holds debt as an asset (i.e., anyone who is a lender) is made poorer when only a fraction of the debt can be repaid. The suffering is not limited to the lenders, because they are often employers who have to either lay off or reduce the pay of their workers. This situation occurred in the Great Depression of the 1930s, and voters and politicians will likely not tolerate such an event again. The Global Financial Crisis of 2008–2009 demonstrated that when the economy freezes due to problems with debt, governments will deficit-spend and print money in order to avert mass defaults in the short term.
3. Jubilee (debt cancellation) is a phenomenon that occurred in Biblical times.⁶⁷ A new ruler would ascend to power and celebrate his rise by decreeing outstanding debts null and void. Needless to say, this curried favor with the majority of the population since most people were debtors rather than lenders. The concept is appealing, but unfortunately it looks a lot like the mass defaults (and depression) scenario described in the previous paragraph. One man’s debt is another man’s asset, so although extinguishing debt helps the debtor, it hurts the lender.
This is disruptive to overall economic output. Furthermore, it deals a strong blow to two of the linchpins of functional economies (and societies): consistent rule of law, including contract law, and property rights. If the sovereign can declare debts null and void, it’s not a large leap to decree the reallocation of property. This can be a popular policy in the short term, but it severely hampers long-term economic growth since entrepreneurs will cease to take risks if the fruits of their efforts can be capriciously stolen by the state.
4. Redistribution, or taxing the rich and giving to the rest including the indebted (whether individuals or the government), is another way to reduce aggregate debt. As I write this book, a 29-year-old member of Congress is making headlines by proposing a maximum income tax rates of 70%. While such high taxation levels are not unprecedented in U.S. history,⁶⁸ they are a historical rarity, and it’s not difficult to imagine high-earners going to great lengths to avoid such punitive rates. In the 2016 presidential election, Senator Bernie Sanders made a pretty strong bid for the nomination to become the Democratic Party’s presidential candidate. One of his key policies was free college for all. The popularity of candidates such as these shouldn’t surprise us. If taxpayers are going to support a generation that is eligible for Social Security benefits starting at age 66 and will likely collect them for 25 years in retirement, why not pay for college for all the 20-year-olds? I would not be surprised to see higher tax rates, but the rich are powerful, and the mobility of capital and the expertise of their lawyers and money managers will allow them to come up with clever ways of avoiding tax.
5. Financial repression, a term coined by Stanford economists Edward Shaw⁶⁹ and Ronald McKinnon,⁷⁰ can include a raft of government policies designed to deliver savers an artificially low rate of interest on savings. This can be accomplished by implementing capital controls and other policies that prevent money from “leaving” the system. Such policies are currently in force in countries such as China. Bank accounts in China provide very low rates of return.⁷¹ By making it difficult to move money out of China, the government has been able to largely keep wealth in the country, albeit at the cost of inflating a real estate bubble. Without capital controls, keeping interest rates artificially low is difficult because capital tends to be mobile and will shift overseas in search of higher investment returns.
However, central banks all over the world have so far managed to largely lower interest rates in concert (see Figure 6). These days, as illustrated in the chart, major countries’ government bond yields are at or near zero. Ten-year U.S. government bonds yield about 2.4%. Ten-year British bonds yield 1.1%, and 10-year German government bonds and 10-year Japanese government bonds both yield negative 0.1%. Such coordinated efforts to keep interest rates low globally help mitigate the capital flight problem since there is almost nowhere to go to capture a low-risk rate of return.