U.S., Britain will “deflate and debase”: Ferguson

The world may deride the PIIGS economies (Portugal, Italy, Ireland, Greece and Spain) for their debt woes, but their concerns pale in comparison to the debt crises that await the U.K. and the U.S.

Debt levels can quickly spiral out of control, turning so-called stable economies into full-blown crises, according to Niall Ferguson, the Laurence A. Tisch Professor of History at Harvard University and William Ziegler Professor at Harvard Business School.

The generally accepted tipping point for a debt problem to reach a state of crisis is somewhere in the neighbourhood of 90% gross debt to GDP ratio. In the worst case scenario, Britain could spiral to 500%, and the U.S. could see 425%, he says.

“The important thing to learn is the non-linearity of this kind of progression,” he says. “You’re fine until you’re not fine, with an excess of public debt. When your market turns against you and the credibility of your fiscal policy is called into question, you very quickly find yourself in a tailspin, a kind of death spiral, because the rising costs of interest payments makes your deficit uncontrollable.”

“It’s not a gradual glide path,” he adds. “On the contrary, because the bond market is often the driver of major shifts in the geopolitical landscape, it can be a very, very short and painful ride.”

Limited options With a debt level that high, options very quickly become limited.

Traditional tactics to reduce debt include such rosy options as growing the economy, cutting interest rates or resorting to a transfer payment from a higher level of government.

None of these three options is on the table for either the U.S. or the U.K. Neither country can simply increase their GDP growth, and most of the debt is held by external creditors, so policymakers have little control over their interest rates. And as large sovereign economies, there is no one able to bail them out.

There are other options, but none are painless:

Fiscal Tackling fiscal imbalances takes a two-pronged approach of cutting benefits to voters while raising taxes.

According to the IMF, the U.S. is already at 93.6% and the U.K. has reached 81.7% debt-to-GDP ratio. The real problem? Decades of tax cuts and increased spending means the debt is structural.

To return to 60% debt-to-GDP, the U.S. and U.K. would require massive fiscal contraction policies. Between 2010 and 2020, the U.S. would need 8.8% fiscal contraction per year, while the U.K. would require 12.8% contraction.

Unfortunately, the only historic precedent for this is the debt reduction of Great Britain, between 1815 and 1914, which came with the tailwind of the industrial revolution.

Seigniorage It’s a fancy way of saying inflation. The U.S. has the option to debase its currency, making it easier to pay creditors whose claims are denominated in U.S. dollars.

“At some point there will be a question mark over the dollar. It’s possible that there just won’t be a fiat money that deserves the name reserve currency five years from now,” Ferguson says. “More and more investors are sensing that we are on the edge of chaos. The ends of the era of fiat money could be upon us.”

Britain can take this option as well, but no single country in the Eurozone has control over its currency, putting debasement out of their control.

Default This option need not be as dramatic as declaring the country bankrupt. It can come under many guises: repudiation; standstill; moratorium; restructuring; rescheduling of interest or principal repayment. But they all mean the same thing: the debtor will not comply with the original terms of their debt obligations.

Both the U.S. and the U.K. tackled mountainous debt in the 20th century. In the 45 years following the Second World War, the U.S. decreased its debt-to-GDP ratio by 90 percentage points, while the U.K. cuts it’s own ratio a stunning 212 percentage points (from over 260% to a low of about 50% in the late 1980s).

This period will serve as a template for the 21st century, according to Ferguson. But those who use it won’t completely eliminate problems.

In the U.S., GDP growth eliminated 56 of 90 percentage points, while inflation accounted for another 53 percentage points. Budgetary spending hampered the endeavour, as spending added 21 percentage points back.

In the U.K., the approach was more lopsided. Growth accounted for 98 percentage points, while inflation reduced the debt-to-GDP ratio by 228 percentage points. Fiscal restraint went out the window, with spending actually adding 124 percentage points.

These fiscal history lessons show that governments saddled with what Ferguson calls “World War size debt” will not:

• Slash expenditures on entitlements

• Reduce marginal tax rates on income and corporate profits to spur growth

• Raise consumption taxes to curb deficits

• Protect their currency against devaluation.

What they usually do, is:

• Oblige their central bank and commercial banks to hold government debt

• Restrict overseas investment by companies or individuals

• Break promises to politically weak groups and foreign creditors

• Hang the whole mess around the necks of bond holders, who receive negative real interest rates.

This assumes that everything goes according to plan, Ferguson points out. What could happen instead is that the so-called bond vigilantes will drive nominal yields higher before the onset of inflation, as shorter-term debt is rolled over.

This could result in rising real rates on longer bonds, which would hamper growth in highly leveraged economies. Long-bond rates dictate interest rates on a variety of consumer debt instruments, from residential mortgages to auto loans and credit card debt.

The pressures of higher consumer interest rates and slower growth would lead to “intense domestic political conflicts and ultimately to defaults,” Ferguson says.

Given the tough political choices these debt emergencies require, It would appear to some that democracy and debt may be inextricably linked.

“We’ve moved from a world in which warfare drives the debt crises to one in which welfare drives the debt crisis,” he says. “The reason that we’ve done that is that we’ve transitioned from unrepresentative government to semi-representative government to wholly representative government.”

(06/09/10)