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The West’s Day of Fiscal Reckoning, Part II

In theory, there are four options to address the West’s debt overhang.

October 15, 2013

Credit: Mopic -

Return to part I.

In Hans Christian Andersen’s short tale “The Emperor’s New Clothes,” nobody dares to tell the emperor that he is naked. Today’s developed economies are also naked. Just as at the court of the Emperor, we are refusing to accept a simple reality.

Daniel Stelter
The West’s Day of Fiscal Reckoning
Part I
Part II
Part III

Debt levels are unsustainable and more people are starting to leave the economic system than new people are entering it. It is high time for us to start dealing with reality.

How can we solve the debt crisis? In theory, there are four options to address the debt overhang:

  1. Save and pay back
  2. Grow out of the problem
  3. Inflation
  4. Debt restructuring

Option 1: Save and pay back

Saving and paying back — also known as austerity — is a recipe for a long, deep recession and social unrest. During the Great Depression of the last century, nominal debt of private households in the U.S. was reduced by more than one third between 1929 and 1933.

Fifty years later, the corporate sector in Japan (which had caused a debt boom in the country during the 1980s) reduced its debt-to-GDP ratio by 30 percentage points.

In both cases, the deleveraging had significant negative consequences for the real economy. It caused the Great Depression of the 1930s and the first of the Lost Decades in Japan.

The years after 2007 have been a preview of what deleveraging could look like. Asset prices started to fall. The need to reduce debt levels led to distressed sales that caused further price reductions.

The economist Irving Fisher summarized this vicious cycle in his Debt-Deflation Theory of Great Depressions. Savings by the private sector lead to a reduction of consumption and investment activity. That reduction translates into negative economic growth, rising unemployment and lower income levels. This development makes it more difficult to repay debt and can lead to a long stagnation with shrinking prices (deflation).

Because saving and paying back reduces economic growth and leads to a recession, it tends to increase debt levels rather than to reduce them. If at the same time, governments try to balance their budgets, as is currently happening in parts of Europe, a deep recession — or even depression — follows.

A reduction in government spending of 1% of GDP usually causes a GDP reduction of less than 1% because it is compensated by lower interest rates or more exports due to a weaker currency.

But in times of economic crisis, this multiplier is larger than 1, according to recent findings by the IMF. This is especially so in Europe where the euro makes it impossible to react to economic shocks with a weaker exchange rate and where interest rates are set for all countries by the ECB.

The examples of Greece, Spain, Portugal and Italy show that the efforts by governments to deal with their debt problems by budget cuts and tax increases lead to even lower growth. This also increases the risk of social unrest.

A recent study shows that as soon as expenditure cuts exceed 3% of GDP, the frequency of protests increases significantly. The demonstrations that occurred in some European countries are only the beginning. And the fact that a majority of Italians voted for anti-austerity and anti-European parties should not have come as a surprise.

Option 2: Grow out of the problem

The best way to solve the problem would be to grow out of it. Holding the total amount of debt constant and increasing the GDP as the denominator of the fraction can decrease the debt burden.

However, this is not a valid option, as the developed world’s traditional model of economic growth appears to be broken. This is partly a consequence of the debt problem itself, as high levels of debt negatively affect economic growth.

The research of Reinhart and Rogoff showed that a government debt load of 90% of GDP or more leads to lower growth of an economy. This research came under severe criticism after a mistake in their calculations was found.

What their critics did not point out, however, was that even after correcting for that mistake, the research continued to support the hypothesis: higher debt levels do indeed lead to lower growth rates.

Accepting this view does not require sophisticated statistical models. As long as debt levels are low, new debt leads to more demand and growth in the economy. Once debt cannot increase further or is only used to “pay” the interest on outstanding debt, the growth rate of the economy falls back to the fundamental growth rate.

The number of people in the workforce and the productivity per capita drive an economy’s fundamental growth rate.

To prove this point, the Bank for International Settlements supports the hypothesis of Reinhart and Rogoff, but also demonstrates that it is not only a high level of government debt that has negative implications. The same applies to private household and non-financial corporation debt as well.

In short, the toxic combination of too much debt, stagnating or shrinking workforces and lower productivity growth make growth out of the problem impossible in many countries.

Option 3: Inflation

We thus find that neither growth, nor saving and paying back can realistically solve the Western debt problem. Many observers, including the IMF, therefore, suggest that an increased inflation rate could support the process of deleveraging.

They refer to the successful deleveraging of the United States and the U.K. after World War II when investors were forced to invest in lower-yielding government bonds.

Back then, with a nominal growth rate of the economy higher than the interest rate on the government debt, the debt-to-GDP ratio came down significantly, on average by 3 to 4 percentage points of GDP per year. This “softer” version of the inflation solution is called “financial repression.”

But could financial repression work today? Assuming a five-percentage point difference between nominal growth and nominal interest rates, it would take between 4 years (in Germany) and 19 years (in Ireland) to return to a sustainable level of 180% of GDP. This scenario is quite aggressive as it assumes that the total debt burden only grows by its interest rate.

If we assume a repression of just one percentage point, the period of financial repression needs to be much longer — between 17 years in Germany and 89 in Ireland.

It is important to keep in mind that the overall interest load of the economy needs to be below the nominal growth rate. It is not sufficient if only the government pays low interest rates.

Financial repression would require close political coordination. Governments would have to intervene significantly in financial markets, including banning cross-border capital flows and imposing strict regulation on how savings have to be invested in order to secure low interest rates across all sectors.

In 2011, Germany, France, the U.K. and the U.S. managed to achieve a nominal growth rate above the interest rate, mostly thanks to higher inflation, with real economic growth remaining sluggish. The other major Western countries are still struggling with interest rates far above nominal growth rates.

In today’s low-growth environment, financial repression can only be achieved through higher inflation levels while keeping average interest rates at extremely low levels for all sectors. The Federal Reserve, like the ECB, aggressively lowered interest rates following the financial crisis of 2008, leaving interest rates at record low levels.

The key precondition to achieving low interest rates is creditor trust — trust in the central bank’s ability and willingness to fight inflation and trust in the debtor’s ability and willingness to pay its debts.

For countries such as the U.S. and Germany, the market assumes no credit risk (in the U.S. case, one may very soon have to say “used to assume”). Provided the U.S. Congress comes to its senses, it seems highly probable that these countries will be able to hold their interest rates low.

For other countries in the eurozone, though, it will not be possible to lower interest rates enough for financial repression to work, unless the ECB continues to buy these countries’ bonds in large volumes—in effect, monetizing government debt.

Is inflation really an option?

Inflation is difficult to achieve in an environment of deleveraging, as it requires an increase in demand. As long as this is not the case, any additional money offered by the central banks will flow into asset markets and lower the interest burden on existing debt.

Continued quantitative easing is therefore to be expected, as there seems to be no pain-free alternative on how to deal with the debt overhang.

Nevertheless, a significant risk remains. At some stage, the public starts losing trust in money. If this were the case, a spike in inflation rates would be possible. It would be similar to the shaking of a ketchup bottle that first leads to no outflow and is followed by a big “splash.”

Continue to part III.


Saving and paying back — also known as austerity — is a recipe for a long, deep recession and social unrest.

The efforts by governments to deal with debt problems by budget cuts and tax increases lead to lower growth.

As soon as expenditure cuts exceed 3% of GDP, the frequency of protests increases significantly.

The best way to solve the debt problem would be to grow out of it, but the economic growth model is broken.

Too much debt, shrinking workforces and lower productivity make it impossible to grow out of the problem.

Inflation is difficult to achieve in an environment of deleveraging, as it requires an increase in demand.

We can expect continued quantitative easing, as there is no pain-free alternative to deal with the debt overhang.

The risk is that the public starts losing trust in money, which could cause a spike in inflation rates.