Mega sovereign writeoff could work
A massive sovereign debt reduction is the right way to reduce the ridiculously high indebtedness of governments. The idea might sound crazy, but it makes economic sense, and could be done, albeit after some serious preparatory work.
Many rich country governments have been borrowing excessively in recent years. In 1991, when the calculations from the International Monetary Fund started, gross government debt of advanced economies was 60 percent of GDP. This year it is expected to be 108 percent of GDP, or about $51 trillion.
The current level is much too high for the overall economic good. Heavily indebted governments spend too much of their tax revenue on interest payments and spend too much time trying to placate bond buyers, who rarely support useful long-term investments. Rumours of possible default can spark a financial crisis. And the excessive supply of sovereign obligations encourages parasitic speculation. The economically pointless trades of supposedly risk-free government debt pay much of the high salaries at investment banks.
Governments have brought the problem on themselves. The underlying issue is the longstanding refusal to match taxes to expenditures, especially during years of peace and prosperity. Governments resort to borrowing to bridge the gap, because politicians like to appear to give more than they take. However, someone must pay – debt is only a temporary substitute for a tax. Bondholders may think they have made an investment in a financial asset, but in reality they are standing in for taxpayers.
Writedowns make the reality clear. The loss converts some of the government bond’s purported value into what it should have been in the first place – a tax. Foreign bondholders simply lose out, since they would not have paid domestic taxes. Some domestic lenders may also be treated unfairly, even after considering the taxes they would have paid if governments had run balanced budgets.
The damage is regrettable, but needs to be set against the gains that would go with a massive debt writedown. A cut of about $25 trillion, a 50 percent reduction, would let governments throw off the suffocating debt blanket.
The idea would appal most mainstream economists. They agree that government debts are currently too high. Yet they do not want any writedowns, let alone massive ones. The subtitle of a 2010 Staff Position Note from the IMF is typical: “Default in Today’s Advanced Economies: Unnecessary, Undesirable, and Unlikely”. The standard prescription is many years of sound government finance. That technique can succeed, but only if there is an implausibly long period of political restraint and reasonably strong economic growth.
Massive debt forgiveness would solve the problem quickly and safely – if they are done right. There are three plausible ways to get rid of large quantities of unwanted bonds.
The first is through a large writedown. Basically, governments would re-issue all their debt with half the face value. For this “Reissue Day” approach to work, careful preparations and international agreement are required. Disaster can be avoided, although it would be tricky. A powerful propaganda campaign is a prerequisite, as is a clear plan to recapitalise banks, in part with new government funds. And all countries must agree to recognise losses on their holdings of foreign government sooner rather than later.
Alternatively, instead of writing down debts, governments could inflate up wages and prices. For example, a mandatory one-time doubling of all wages would quickly almost double nominal GDP, mechanically almost halving the economic weight of the government debt burden. The “Rescale Payday” would be technically and legally complex, a bit like dividing one currency into two. Forethought and flexibility would be mandatory.
Finally, governments could print debts away. As borrowings mature, they would be redeemed with newly created money. The monetisation would be followed quickly by new taxes which would reduce the expanded money supply to non-inflationary levels. The reclaimed funds would then be destroyed. The round trip sounds complicated, but the separation of bond redemption from tax recuperation would help governments arrange the details of the “Less for More Exchange” to allocate losses as fairly as possible.
I doubt that any of these techniques will be tried out, for both good and bad reasons. On the good side, there is the ethical concern about breaking financial contracts, the risk of social tension after a sudden redesign of a key part of the monetary system and the innumerable diabolical details. On the bad side are mainstream economists’ lack of intellectual courage and the inability of politicians to organise something as daring as the monetary equivalent of post-war reconstruction.
It is almost always easier to muddle along than to do something bold. In this case, though, the costs of inaction, or of the painfully small and slow writedowns of euro zone sovereign debts, are quite high. In an over-leveraged world, default is actually the safest default option.