Coronavirus, war rhetoric and public debt
The expected rise of financial repression
Abstract
This article looks at the accumulation of public debt and the means available to governments to reduce it. As war vocabulary is emerging to describe global efforts against COVID-19, this study presents the evolution of public debt prior to 1914, as well as that related to the two World Wars. This debt was eliminated between 1945 and 1980 thanks to the growth of the Glorious Thirties and a widespread use of “financial repression”. The Great Recession of 2008 has not yet been purged that we are already entering another phase of massive indebtedness. There is a good chance that in the absence of growth over the next decade, financial repression will make a strong comeback. The article concludes on the possible combinations to manage a rise that seems uncontrollable, and the risk of seeing a non-transparent financial panoply impose itself as the only concrete means of reduction with the consequence of a lasting and widespread discontent.
The COVID-19 pandemic has risen without warning to the status of a global war. Under the guise of self-discipline, it was tempting for governments here and there to brandish the atomic weapon of national cohesion: “we are at war”. Used against terrorism (“war on terror”), capitalism (“my enemy is finance”) and now the coronavirus, war rhetoric allows a few shortcuts.
But conducting war is expensive. The world economy is struggling, yesterday quite healthy, today moribund. While we are still in turmoil and decisions are taken on a day-to-day basis in the quasi-absence of national consultations, let’s look at the question of financing. Surely if there is any sense in a militarization of discourse, we must find interesting parallels in our history textbooks to shed light on the present.
I. Numerous historical precedents
War mobilizes resources even before it breaks out. Direct income tax was introduced in France on July 14th 1914. Wikipedia tells us: “In the midst of the First World War, it was initially intended to finance war efforts and the reconstruction of France”. In England and Germany the same debates took place on the painful but necessary tax reforms to finance the arms race. When the conflict broke out, the cost exploded and financing was then obtained through borrowing, as tax revenues were largely insufficient. All the belligerents in 1914 and 1939 actively paved the way in the decade before hostilities, mainly through taxation and reallocation of existing resources, but the industrialization of conflict brought the world’s public finances to their knees.
The following graph illustrates the point:
It shows the world public debt between 1880 and 2018, expressed as a ratio of each area’s gross domestic product, for developed (green), developing (red) and poor (blue) economies.
The two World Wars, the 1929 crisis and the 2008 crisis are clearly visible. It also shows the international initiatives to alleviate the debt of poor countries, including the HIPC (“Heavily Indebted Poor Countries”) programs of 1995 and the MDRI (“Multilateral Debt Relief Initiative”) of 2005. NB: as of 2016, the total amount of debt forgiven by the two programs is $126.6 billion. Of the 39 potentially eligible countries, 36 have benefited from the maximum aid. Of the 36, 30 are in Africa].
More startling are the following findings:
- Prior to 1914 the world was in a generalized and uninterrupted debt reduction movement — even in the decade before World War I. The case of Great Britain is particularly edifying, we will come back to this below.
- Between 1970 and 2000 developed economies were at peace with each other, and yet debt is exploding. It is obviously towards budget deficits that we have to turn for an explanation:
It seems that no developed economy has managed to control its public budget over the last 50 years (there are 3 here but examination of other countries leads to the same conclusion). Great Britain even found itself obliged to ask for a loan from the IMF in 1976, a loan that was accompanied by a budget tutelage with drastic cuts.
So we live in a world where governments are unwilling or unable to balance their budgets, and where debt is accumulating. For those who doubt it, the Congressional Budget Office offers the following forecast (for the United States alone):
This forecast dates back to 2015, well before the current crisis.
But all hope is not lost: would these graphs actually be reassuring? In the aftermath of each conflict, all economies have managed to reduce their accumulated debt. Admittedly, budgetary discipline has not been a widespread concept over the last 40 years, but surely it is possible to get rid of a pile of debt? The human and material devastation of the two World Wars cannot be the only explanation for the economic growth and debt relief that followed?
II. The pre-1914 world
In fact, to those who wonder whether it is possible for France or the United States to balance its budget, the answer is: “yes, but that was a long time ago” (in a very distant galaxy might we be tempted to add). The three graphs below show the deficits and public debt for France, Great Britain and the United States before World War I:
France and the UK came out of the Napoleonic Wars extremely indebted, as did the United States after the Civil War. Yet all three countries were able to massively reduce debt over the decades that followed. The case of Great Britain is particularly striking since the country went from a debt of 200% of GDP to … virtually 0. It took a century, but the effort is remarkable. These three graphs show the primary budget balance (right-hand scale), which is very largely positive. It is essentially a budgetary effort that has absorbed debt in all three cases.
Debt reduction policies have, of course, been widely studied. When growth and fiscal management are not enough, the debt problem is dealt with in a less visible way, through “financial repression”. This involves a number of tools, the first of which is inflation, which allow a government to “dissolve” its debt through a monetary policy that punishes lenders, the vast majority of whom are domestic investors. Punitive is to be taken in the primary sense: debt holders are not sufficiently remunerated and are therefore indirectly taxed. In practice, governments get rid of debt through a significant and systematic erosion of purchasing power for their citizens.
Before examining this mechanism, two detours must be taken. First we must ask: why is debt a problem? After all, we live in highly indebted economies, Japan leads the way with 220% of GDP, and no one seems to suffer from this state of affairs. The truth is that debt is growing with widespread indifference. In addition, we must also take a detour to examine the concepts of real and nominal interest rates.
III. So what anyway?
What does a world in debt look like? It’s an easy question, we live exactly in such a world. What are the consequences of this situation? We are right in the middle of it with the COVID-19 crisis.
For a household, the analysis is straightforward: debt mobilizes resources that cannot be used elsewhere. Property loans, car loans, consumer loans for the TV set(s), payment facilities (which are disguised loans), all those add up to cash flows that reduce available income to the detriment of, for example, savings. How many households realize how little they have left after early-month deductions? Everything that is drawn down for a loan cannot be saved or be spent on something else, such as holidays. Admittedly the car is brand new, and this new phone is a marvel, but the consequence of all this is the obvious fragility of the household. A pay cut, an economic layoff, and everything collapses. Cash flow difficulties set in: you have to refinance such or such loan to make room, make savings here and there to meet your deadlines. Certain types of debt make a lot of sense: an individual can, for example, take out a loan to live while he or she goes back to school. If the diploma allows him or her to significantly increase income, it is a profitable calculation: he or she will have the means to repay the loan after which it will be possible to live durably on increased income. Conversely, does it really make sense to go into debt for a new phone that will be obsolete in 3 years anyway? Debt creates fragility to hazards of life. The higher the debt, the more immediate and potentially devastating that weakness is. Getting out of this situation is not easy: you have to earn more, or save more and therefore potentially sacrifice your standard of living. Even if you contracted debt for good reasons (buying your home), you have to live (for a long time) with the efforts that are required.
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For a corporation, the same reasoning goes: large debt mobilizes resources that are no longer available. Some investments must be legitimately financed this way, since the idea is to create future income that will allow repayment. Debt is therefore the right solution when it finances investment, but not current expenses. And the overall level must be carefully managed, as total capacity is limited.
If the consequences are easy to identify for a household or a business, would they be different for a state? Yes, there is one fundamental difference: a state issues money and can therefore operate the printing press whenever it wants. However, this mechanism is inflationary, i.e. it impoverishes the population just as much as it replenishes the coffers of the state that uses it. A 10% inflation per year means that whoever earns €1,500 per month will have lost €150 in purchasing power next year. It wouldn’t be a problem if the salary was adjusted by 10%. But in practice is it? A state can limit its use of the money press so as not to cause too much inflation. However, in this case, it is necessary to continually find investors who are willing to extend credit. The day these investors believe that there is a risk that they will not be repaid, they will ask for a higher remuneration, or even decide that they no longer want to lend. They will also keep an eye on inflation: do I really want to lend at 5% when I lose 10% of my purchasing power every year because of inflation? Probably not. The effect of indebtedness on a state is exactly the same as on a household: it takes part of its income hostage to remunerate lenders, and these resources are no longer available to serve other needs. An alternative is to borrow more, but more lenders must be found at an acceptable price.
The crisis unfolding before our eyes offers a textbook case. Support packages are specifically designed to help companies’ salvage their cash flow. Laying people off is socially unacceptable (in Europe, less so in the US). There is no question of liquidating assets, such as aircrafts for an airline: first there is no buyer and then those aircrafts will end up flying again (or…will they?). But how can debt be repaid then? It is symptomatic that the first measure proposed by many governments was a debt restructuring for small businesses. Those incompressible repayment streams immediately stress treasury and can drive a restaurant or hotel owner out of business, even if the business was healthy under normal circumstances.
The public authorities mobilized colossal resources in 2008 to deal with the crisis. This was necessary to reduce the devastating social consequences. Problem is, this debt is still far from being paid off. Another episode is looming today, of at least the same magnitude — or so are we told. Governments’ budgetary flexibility has been seriously undermined since 2008. Public budgets are going to be called upon again…what latitude will remain for the next crisis? What capacity will governments have to mobilize further resources to finance emergency measures? It is decreasing every day. What resources will remain in 20 years for the education of our children, or any other nation-wide public service?
IV. Real interest rates
These simple but not simplistic explanations introduce the notion of “financial repression”. Let’s look for a moment at the situation of an individual who has savings to invest. He can buy a government bond that earns 5% a year. For €100 invested, he will get back €105 after one year. At the same time, INSEE is forecasting a 3% inflation for the coming year. This figure means that the same basket of goods and services will cost 3% more next year. So if our investor lends €100, and gets it back in a year’s time, the basket he could have bought today for €100 will cost him €103. Since he gets back €105, his real gain is only 2%, he will have to spend €3 more. So the 5% rate does not reflect the whole reality. It is a “nominal” rate. The “real” gain of the investment is €2, the “real” interest rate is 2%. Hence the following relationship:
Real interest rate = Nominal interest rate — Inflation
A government that borrows at 5% with inflation at 3% makes a good deal. If inflation rises to 7%, the real interest rate becomes negative: the lender is literally robbed since he does not receive enough to maintain his standard of living. The government takes advantage of this windfall since its debt is quickly erased with inflation. A government that finds a way to “force” its citizens to accept a negative real interest rate is engaging in financial repression. It is a magical way to get out of debt, which was used massively at the end of the two World Wars. In the absence of default, and in addition to reasonable fiscal policies, it was the only way to pay off the cost of war.
V. So how did we get out of it?
Let us now return to the original question, how do governments get rid of their debt? The answer is:
i. Pre-1914: Strict fiscal discipline, including large budget surpluses
ii. 1945–1980 (World Wars and Great Depression): combination of financial repression and economic growth linked to reconstruction (the “Glorious Thirty”)
iii. 1980–2008: difficult to answer as there has been virtually no debt reduction in developed economies since 1980. In the United States, growth in the 1990s led to a decline, unfortunately largely eradicated by the Great Recession of 2008.
iv. 2008–2020: Financial repression is back, economic growth to a (low) extent. However the result is inconclusive, there has been no significant reduction since 2008.
v. Post-2020: while the 2008 vintage has not been purged, growth has come to a standstill and deficits are through the roof… What are the options left?
The following graph illustrates point ii:
It shows the proportion of time spent at certain levels of real interest rates. Between 1945 and 1980, we lived in France and the UK 66% of the time with negative real interest rates, while it was still a respectable 50% in the US.
VI. Financial repression?
The term may seem surprising, yet it is justified. What does financial repression look like? Any measure that allows a government to borrow below the rate the market would demand for the level of risk involved. What risks are we talking about? Credit risk and inflation, both of which reduce the value of future repayment flows.
The ultimate in this regard is the negative real interest rate. As explained above, a negative real interest rate is a tax on the lender that impoverishes it to the benefit of the borrower. It so happens that today a considerable proportion of public debt has a negative nominal return, even before the effects of inflation. Barclay’s bank calculates an index of the total size of sovereign debt in negative territory (see here), which is about $11,200 billion at the end of 2019 (about 20% of the total outstanding).
In practice, there are many measures that make it possible to constrain real rates: control of capital flows, lowering of key rates, capped interest rates for certain deposits, compulsory savings, inflationary monetary policy, etc. Here are two examples: the Livret A passbook savings account and the LCR (liquidity coverage ratio) of financial institutions.
The livret A is not public debt, but a savings product. It is specific to France, and very popular with 55 million passbooks open, and it will serve our purpose very well. With its cousin the LDDS (“livret d’épargne durable et solidaire”, a savings passbook dedicated to impact investing), it collects €455 billion from the French. The amounts collected by these passbooks are used to finance national issues, particularly housing. It is therefore not public debt, but rather funds with a public investment purpose.
The remuneration of Livret A is set by a formula that includes inflation to protect savers, but the Governor of Banque de France has the power not to apply it and to impose a rate. The Livret A has experienced several periods of negative real interest rates, the last one in early 2020 (see a graph here). Of course, no one forces a saver to invest in Livret A. However, it is an extremely popular investment, especially in times of uncertainty, and setting the rate is a meaningful economic decision.
The case of LCR is quite different. Without going into details, the LCR is a result of European regulation, which requires banks to hold liquidity reserves to deal with an unexpected crisis (such as 2008). This liquidity reserves can only be invested in risk-free instruments, and what better choice than European sovereign debt? It is estimated that 10% of balance sheets of European financial institutions are invested in Eurozone bonds, particularly German ones. A large proportion of these bonds have negative rates…bingo. This is exactly a case of financial repression since the LCR is not subject to negotiation.
VII. Conclusion
Public debt does not evaporate: in the absence of default, it is repaid or it decreases (proportionally) because national wealth increases. Given that economic growth cannot be decided, in the absence of budgetary rigor, financial repression is the most concrete lever of debt reduction available to a government. This idea was widely applied between 1945 and 1980.
What should be done today and especially after COVID-19? The chronic impossibility of financing our economies through a constraining public budget relegates this financing to shadow, hidden provisions that impose indirect, invisible taxation, likely to generate widespread discontent through uninterrupted erosion of purchasing power. Moreover, keeping interest rates artificially low and liquidity abundant generate a multitude of other risks, including that of repeated speculative bubbles. How do we get out of this dangerous equation?
Bibliographie
“The Liquidation of Government Debt“, Carmen M. Reinhart and M. Belen Sbrancia, IMF Working Paper WP/15/7, Jan-15
“Reducing Debt Short of Default”, Preparatory documents for the IMF Conference on Sovereign Debt, Sep. 13–14 2018, Tom Best, Oliver Bush, Luc Eyraud, Belen Sbrancia
“Lessons from a century of large public debt reductions and build-up”, S. M. Ali Abbas, Nazim Belhocine, Asmaa El-Ganainy, Mark Horton, Dec. 2011
“Public Debt Through the Ages”, IMF Working Paper WP/19/6, Barry Eichengreen, Asmaa El-Ganainy, Rui Pedro Esteves & Kris James Mitchener, Jan-19
