The Debt Disaster and Keynesian Delusions

It is generally recognised that the most intractable symptom of the global financial crisis which has gripped the world since 2007 is the huge burden of accumulated debt weighing on the economy, particularly in the industrialised (OECD) countries.

 

While the precise volume of global debt outstanding is hard to pin down – particularly if one takes account of the potentially hundreds of trillions of dollars of contingent liabilities represented by Credit Default Swaps and other derivatives (the actual amount of which can only be guessed because of the opaque nature of the markets) – it is a fact that accumulated debt (public and private) relative to GDP now far exceeds any previously recorded level. A recent report by McKinsey Global Institute (MGI) indicates that total debt (of households and financial and non-financial corporations as well as the public sector) in the 10 largest developed countries (USA, Japan, Germany, France, Italy, Spain, Canada, Australia, South Korea and UK) had risen to an average level equal to at least 300 per cent of GDP by mid-2011 – which is close to double the average ratio prevailing in 19901 , and much greater than anything recorded earlier It is important to note, moreover, that public sector debt accounts on average for no more than about 30 percent of the total debt outstanding – although in most cases its share has sharply increased since 2008 because of the need to bail out insolvent banks (virtually all in the private sector). This aspect of the MGI findings is all the more significant in that it serves to emphasise (if inadvertently) that the deepening fiscal crisis of states is mainly a symptom of the insolvency of the private financial sector, which had been allowed to run up unsustainable mountains of debt prior to 2007, only to dump them in the lap of the state in its capacity of “lender of last resort”. This poses in stark relief the reality that these massive bad debts have now brought the states themselves to the brink of insolvency, with nobody to bail them out as they have bailed out the private sector.

 

 

At the same time the cost of servicing all this debt at anything like a commercial rate of interest is also at record levels relative to GDP and is far beyond the capacity of the economy to meet it without either reducing most of the population to absolute destitution or inducing total financial collapse – although for the moment this problem is being substantially concealed by the artificial suppression of interest rates.

 

 

With the global economy in this state of debt paralysis mainstream economists are virtually unanimous in asserting the need for a revival of economic growth in order to generate the resources needed to pay down debts to a more sustainable level. Most of them also recognise that the orthodox recipe of cutting public spending to achieve this end will – as even the IMF has conceded – be self-defeating in that it is bound to be negative for growth and thus result in even higher public sector deficits and debt – as has already happened most conspicuously in Greece. Hence they see the only alternative as being to expand public borrowing and indebtedness further in the short term so as finance expansion in investment and output (and employment), while at the same time maintaining interest rates as low as possible with a view to encouraging consumers and businesses to spend – on the supposition that, in line with Keynesian theory, such extreme fiscal and monetary laxity will induce the required GDP growth.

 

 

Yet, as has been obvious since the start of the crisis in 2008, such a strategy is doomed to fail by the reality that a) in a situation where levels of public debt are perceived by the markets to be too high in relation to the capacity to service or repay them, further increases in public borrowing must tend to raise the effective interest rate demanded by the bond markets on government debt – because of the increased risk of default – thereby pushing states closer to insolvency, while b) most consumers and businesses are already “maxed out” on debt and thus need to “deleverage” (cut their indebtedness) rather than borrow still more.

 

 

In their desperation to escape from this impasse the authorities in the US and the UK have since 2009 started to employ a radical and high-risk stratagem – never explicitly pursued by any industrialised country until Japan began to adopt it in 2001. This is the practice of monetising public sector debt with currency electronically created (printed) by the central bank – i.e. to buy up government securities such as US Treasury Bills. This mechanism – officially called “quantitative easing” (QE) – is justified by the authorities as a means of averting the risk of deflation, which could easily lead to outright slump, in a situation where the official benchmark interest / discount rate has already been set at close to zero and therefore cannot be reduced any further. It is hoped by the governments concerned that this process of debt monetisation (printing extra money by any other name) will stimulate effective demand in the economy by expanding the money supply – even though the earlier Japanese experiment along these lines had no such positive impact. What is not stated is that QE is also seen as vitally necessary in order to support the market price of government bonds, thereby keeping down the effective interest rate on them. Failing this artificial support, it would be impossible to conceal from market investors that the unprecedented level of indebtedness throughout the economy (see above) must call into question the solvency of all borrowers, both public and private. Once that happens (as sooner or later it must) the market rate of interest on all debt securities will rise to unsustainable levels as investors perceive the soaring risk of default, precipitating mass bankruptcy, financial collapse and the probable breakdown of civil order.

 

 

     The failure until now of the Eurozone authorities to resort to QE – mainly because of German refusal to accept such an unorthodox and potentially inflationary policy – is the main reason the Euro area has seemed on the brink of financial collapse since late 2011. By early February 2012, however, it is apparent that – under the influence of a new and more permissive President of the European Central Bank – mechanisms have been devised for making available liquidity to the many Eurozone banks in desperate need of it, even if there has thus far been no explicit adoption of QE. This has eased some of the pressure both on the banks and on similarly insolvent member state governments who would otherwise only be able to cover their soaring budget deficits by borrowing at impossibly high market rates. However, the threat of a sovereign debt default is still ever present, most obviously in the case of Greece, where in fact such an outcome now appears inevitable – and imminent.

 

 

     Those economists, still the overwhelming majority, who hold out some hope that such “extraordinary measures” can facilitate a revival of growth and living standards choose to disregard or play down the significance of the unprecedented burden of debt weighing on all sectors of the world’s major economies. Many of them point out, quite correctly, that public debt in these countries has on numerous occasions in the past been much higher than it is now (e.g. in the UK in the 1940s and 50s) and that this did not prevent them paying down such debt to more normal levels at the same time as permitting a rise in average real incomes. What such die-hard Keynesians ignore, however, is the grim reality that a) overall debt (mainly in the private sector, as noted above) is now at totally unprecedented levels and b) that – in contrast to the situation in the past (such as 50 years ago) there is no prospect of debtor countries growing their way back to solvency, not least because already crippling debt service liabilities severely restrict the scope for expanding consumption and investment.

 

 

     The only (slender) hope for the ruling establishment is that QE, by keeping real interest rates negative – i.e. below the rate of inflation – will enable them gradually to shrink the debt burden in real terms down to a more sustainable level. The problem meanwhile with such “financial repression” is that, as the UK Coalition government has already discovered, it has the effect of squeezing the incomes of savers and the lowest paid (already stretched to breaking point by recession and fiscal austerity) while favouring debtors whose profligacy is rightly perceived to have caused the crisis. It is thus likely that such an approach will prove as politically intolerable as it is economically unviable.

 

 

     As such realities dawn on mainstream economists and political leaders alike it may be hoped that more of them will soon feel forced to confront what is for them a still more intolerable necessity: the inevitable write-off of all the massive bad debts crippling the world economy and the consequent destruction of capital values on a vast scale. Whether such an outcome would signify the end of capitalism may be debatable. What cannot be doubted is that it would entail drastic and urgent restructuring of the economic order along more collectivist lines and a consequent curtailment of the power as well as the wealth of “the 1 per cent” – or else a cataclysmic global upheaval at least as destructive as World War II. If, as seems all too likely, the latter course is chosen, it may well be doubted whether our species could survive such an apocalypse.

 

 

 

6 February 2012

 

 

 

1McKinsey Global Institute, Debt and deleveraging: Uneven progress on the path to growth

. January 2012

 

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