The cure that dare not speak its name could solve debt crisis


OPINION:THE RECENT elections in France and Greece have concentrated minds on finding a durable solution to Europe’s debt problems, with growth, as opposed to austerity, the buzzword.

However, one should not read too much into the results. Citizens will rarely vote en masse for policies likely to reduce their standard of living. Indeed, the victory margin of French president-elect François Hollande was, if anything, surprisingly modest given the strong personal dislike on the part of many for Nicolas Sarkozy.

It is a truism that faster growth will help ease the debt problem.

Budgets would gain from increased tax revenues and lower unemployment benefits. The debt-to-GDP ratio would be automatically reduced as the denominator rises. These effects were decisive in reducing dramatically Ireland’s debt ratio from the mid-1980s through the 1990s.

However, higher growth does not come about merely by attaching a declaration to the fiscal compact treaty. Many of president-elect Hollande’s suggestions are already on the agenda (for example increased investment financed by the European Investment Bank).

Stimulus packages do not seem feasible for the peripheral countries facing near unsustainable debt. While Germany could inject some domestic stimulus, this would increase its own debt burden and be resisted domestically.

Moreover, in a recessionary environment pro-growth structural reforms such as deregulation are likely to be strongly opposed by entrenched interests.

Bailouts do not in themselves reduce the debt. They merely allow countries to run higher budget deficits for longer while they try to gradually adjust their unsustainable expenditures. But the debt owed elsewhere, to the EU and the IMF, will continue to rise.

Nor does debt default eliminate the debt burden. The losses associated with sovereign defaults have to be passed on somewhere. Governments (ie taxpayers) may well end up footing a significant part of the losses of banks, as we know only too well in Ireland and as happened last week in Spain.

If growth prospects at the moment appear uncertain at best and if bailouts or defaults in themselves only kick the can down the road, does the solution still largely consist of “classical austerity”, ie cutting budget deficits sufficiently so as to eventually repay debt?

And if citizens simply refuse to vote for such plans, is there an impasse?

There is another solution, only spoken of in whispers but used by countless governments over the centuries. It consists of trying to inflate the debt away.

For example, if inflation were to increase from 2 per cent currently to, say 5-6 per cent, other things being equal, the debt-to-GDP ratio would fall by over one-third in less than 10 years. The stock of debt would remain more or less fixed in nominal terms while the denominator would rise.

Such a possibility has been raised recently by some eminent economists, including Kenneth Rogoff, former chief economist of the IMF, hardly an institution known for advocating “easy money”. Apart from reducing the real value of the debt, higher inflation might also boost growth if consumers believe they should spend today before prices rise tomorrow and their financial savings are worth less.

Increased inflation could also help ease budgetary pressures.

Governments may find it more feasible politically to reduce salaries in real terms than via nominal cuts when Croke Park agreement-type constraints are in force. Moreover, revenues can be boosted if tax brackets are not raised in line with inflation.

How might this happen? Both European and, especially, US banks are currently sitting on large pools of cash reserves following recent injections of liquidity by their respective central banks. Barring a tightening of monetary policy the banks could decide to lend these funds to customers, leading to a major expansion in liquidity. Alternatively, an external inflationary shock (for example a sharp spike in oil prices) could lead central banks to adopt an accommodating monetary policy stance.

Why have there not been more widespread calls to follow the inflationary route (sometimes referred to euphemistically as “socialising” the debt)? A main part of the answer, of course, is that allowing inflation (the “cruelest tax of all”) to rise is profoundly undemocratic. Central banks, with the implicit support of governments, can impose this tax without seeking any approval from parliaments.

Inflation hurts those on fixed incomes (often the most vulnerable) and penalises savers (although in the present circumstances that might well be a defensible objective). Those richer groups owning fixed assets such as property tend to gain. Moreover, there is no guarantee that inflation could be held in check and a permanent wage cost spiral avoided.

Of course politically Germany, together with some others, would resist such a solution to the end. One does not have to have had a great-grandmother who lived through the Weimar Republic to understand their concerns. And the European Central Bank, imbued with German-style values, would also find this a bitter pill to swallow. Nevertheless, while the ECB is required by statute to pursue monetary policy independently , there is flexibility as to what constitutes an appropriate target for inflation.

And the ECB has been known to bend its rules before.

Inflation , the “cure that dares not speak its name”, is a last resort for governments trying to deal with their debt . All other avenues should be pursued resolutely before going down that road.

But if the citizens of the northern countries are not willing to shoulder a greater share of the burden explicitly they might end up confronted with the bill anyway, but in a way that is anathema to their own interests.

Calling insistently for austerity, even if that makes sense from a “good housekeeping” viewpoint, does not necessarily make it happen. Nor can debt be made to go away via a stroke of the pen.

Donal Donovan is a former deputy director of the IMF. He is currently adjunct professor at the University of Limerick and a visiting lecturer at Trinity College Dublin. He is the co-author, with Antoin Murphy, of a forthcoming book, The Fall of the Celtic Tiger, to be published by Oxford University Press.

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