Luc Brunet – 1 April 2013
One of our subscriber recently asked me a simple question, or at least one that looks simple : why do countries contract debt?
As a matter of fact, a state can be compared to a household or a company. Any household (you can imagine by yourself the equivalent items for a company) has a number of financial resources and expenses, no point in listing them. In general, debt (credit) is used by households to match a temporary lack of cash, for example for the purchasing of a car or and a home. The situation becomes however critical when the level of debt grows above a certain level, and when credit is used all over the place, like it was the case in the US before 2008. It can sound like : house bought with zero dollar front payment and a 45 years credit with variable rate, then the house being used as a guarantee for getting credit to buy a secondary house, cars, high-end TV sets, and so on. It is clear that such households shall never be able to pay back, especially if interest rates go up, or one parent gets laid off…
For a country, the situation in terms of revenues/expenses is fairly the same, but the details are much more complex. Typically, resources are resulting from all types of taxes, while expenses are to be found in the country’s budget, including salaries of public servants, social costs like state pensions, education or healthcare, infrastructure development and support, as well as police and defense.
Looking back in history, countries or states (regional kingdoms or fiefdoms before the creation of nation states as we know them today) generated debt when they needed extra money because of an exceptional event, and this very often was a war. The high and unpredictable cost of wars, direct but also indirect like the diminution of tax incomes when many men are at war instead of producing, lead to most of the sovereign defaults in old times. However debt is also contracted to finance exceptional infrastructure development, or to help restart the economy after a slow-down, such debt being reimbursed when the economy gets better. Such situations are many, where the debt level of countries go up and down, depending on internal and external factors, but mostly stay under control.
Like for households, States can fall into the trap of losing control of the debt, when debt is used indeed to feed economic growth over many years – in clear, allowing the country to live above its possibilities. The amount of debt gets too high and it becomes impossible to pay back. The level that can be considered a non-return one, above which the country has no way to pay back, is more or less of 60% of GNP, depending of the individual position of each country, and of additional risks linked to the debt, for example its % libeled in foreign currency. Many countries are now far above such level (as a reminder : US 110% , UK 90%, Italy 125%, Greece 170%, France 90%, Spain 90%, Cyprus 90%, Japan 230% , Ireland 117% – compared for example to Russia with only 11%!).
To continue the comparison with households, the balance between revenues and budget is however much more tricky for a state than for a household. The reason is the correlation between revenues and expenses. For a household, expenses are mostly independent from revenue, and in theory, expenses could be reduced a lot in case of financial problem. For example sell a car and use public transportation, eat simple food , stop any unnecessary expenses… although terrible if implemented for a long time, such measures actually free resources to repay a too heavy credit, without impacting the salaries. For a state budget, this does not work, as reducing social costs (smaller jobless compensation, smaller pensions) or reduce investment in infrastructure shall immediately reduce the amount of taxes paid, increase jobless rate and indemnities, reduce consumption and thus reduce VAT revenues. This is the classical spiraling effect that we see today in Greece or Spain.
But states also have a way-out of overwhelming debt, that is impossible for household : decide to default and send creditors to hell. Households clearly cannot do that, as banks would sue them, have all assets confiscated and eventually have the individuals sent to jail. States can default, and did default many times (see previous letters) and nothing really happened. Investors may boycott the country in question for some time, but they forget fast! Force is rarely used by creditors – and Japan or China shall hardly send troops to New York to confiscate assets in case of a US default! Or States can go for inflation and repay in monkey money, like emperor Dionysius did in Syracuse four centuries before JC, who realized he could not pay back its debt to his citizens, took all coins of 1 Drachma he owned, coined them again with 2 instead of 1, and then paid his debt in full! This is power of statesmanship and it can be used anytime, never forget.