The Impossible Level of Debt and the Improbable Way It’ll Be Repaid
The first book about finance I ever read was about the US government debt. It’s unsustainable and will lead to a crisis if we don’t reform, the book informed me.
About 15 years later, with a zero tacked onto the end of the problem, there still hasn’t been a reckoning. Heck, interest on US government bonds is extremely low.
Perhaps the markets were banking on some sort of return to fiscal sanity, at some point. And that’s what kept government bond markets in places like the US, UK, Italy, and Japan tranquil.
But COVID-19 has made your usual fiscal reform impossible for government debt around the world. Deficits have blown out and GDP is crumbling.
Just consider UK budget forecasts, which came out this week. The ratio of government debt-to-GDP is set to hit 418.4% in 2070 according to the government’s own accountants. Second World War levels were about 270%…
Japan, Italy, and a long list of other countries are in dire straits too.
So, what’s keeping a lid on government bond markets now? Why aren’t we seeing a rerun of Greece and Argentina in Italy and the UK?
Well, the market must still be pricing in some sort of escape mechanism for government debt. And so, today, we look at the solutions for this lost cause.
And I use that word ‘solutions’ very loosely. Because what’s a solution for tax collectors is very unlikely to be a solution for you…
Of course, Australia’s debt-to-GDP ratio is comparatively under control. Even while The Australian explains ‘Australia facing “biggest fiscal hole” in 75 years’. 75 years takes you back to…oh boy.
But even starting from a lower base, Australia will get into fiscal trouble. And our economy will be far from immune to the crisis unleashed by fiscal ‘solutions’ elsewhere. Because there’s no easy way out of the global government debt-to-GDP trap.
But what are the options?
Option one for dealing with deficits is of course tax hikes. Those may or may not be in the works in different countries according to several media reports.
Option two is of course tax cuts.
Yes, I know, welcome to the wonderful world of economics, where you can have it both ways, or neither, depending on which economist you’re talking to about which particular topic. They’re worse than epidemiologists.
The idea of tax cuts solving the problem of too much debt is that the economy grows faster, thereby growing the GDP and even tax revenue, eventually.
Now economists and media pundits love to debate this point. Do tax increases raise or lower revenue? And the same for tax cuts.
The idea is usually shown as a chart with something called the Laffer Curve on it. It’s more of a hill — the sort the Grand Old Duke of York spends his time on, going back and forth, discovering neither option works as well as theory suggested.
Why the hill shape for the Laffer Curve? According to President Reagan’s advisor Art Laffer, at low rates of tax, a tax hike probably raises revenue. But at high rates of tax, a tax cut has such a good effect on the economy that it also raises revenue. Perhaps by bringing black market economic activity back into the fold, for example.
The point of the Laffer Curve is to illustrate that there is an optimal level of tax rates, to collect the maximum amount of tax revenue. Because that is of course a good thing…
My own views on the matter are best displayed by how every computer game handles this trade-off. Because computer game engineers keep the blatantly obvious simple.
Higher taxes raise more revenue in the short run, but at the expense of economic growth. Eventually, that lack of economic growth leaves you with less tax revenue than you would’ve had by keeping tax rates low.
The result is a strategic trade-off, in the game. Where time is the key consideration. Something the Laffer Curve ignores.
If you can make your computer game civilisation function with low taxes, your economy will outgrow your competitor’s over time. And you will win. But there is a risk…
In games, this trade-off is of course all about how much you can spend on raising an army to slay your opponents. Tax too low and you get wiped out by other players’ higher military spending early in the game. Tax too high and your economy will be stunted as the game goes on. When your enemies turn up with superior expensive tech, you get wiped out too.
Back in reality, it’s all about political parties being able to bribe the swing voters instead of slaying the other player. But it’s all a game there too.
Option three for dealing with the deficit is practically tradition. A tradition that was ended by central bank independence and inflation targeting. Because it’s not a very nice option.
Inflation reduces government debt burdens. At least, it can. That’s how governments got over their war and welfare debts in the 60s and 70s. That’s the last time we faced frightening debt burdens and did manage to pay them off, sort of.
But inflating away government debt only works under certain conditions. And those are called financial repression.
Essentially, interest rates must remain below inflation. That’s a simple idea, but thinking it through is crucial. And terrifying for investors.
Normally, when inflation breaks out, central bankers and bond markets raise interest rates. The interest spike makes government debt more expensive. And so, inflation in and of itself doesn’t solve the problem of government debt.
But if central bankers give up on pretending, they become independent and collude with politicians to allow inflation to surge without hiking interest rates, then inflation really does cut debt. Inflation reduces the value of the debt while interest rates don’t rise to make the debt more expensive.
This leaves the bill at the feet of those who rely on assets for income. That means you, the investor.
Bond holders cop it especially badly. Their interest income doesn’t keep up with inflation. The value of their wealth slowly disappears.
But inflation undermines equity returns too. Adjusted for inflation, the Dow Jones Industrial Average was back at its 1916 level in the 1980s. After capital gains taxes on the inflated prices, you were deeply in the hole.
So, inflating away government debt comes at the expense of return on investment. That’s why inflation is known as a stealth tax. I think this is the most likely course of events for our future.
But I want to leave you with option four. Something that hasn’t been done for hundreds of years. And it reads more like a science fiction novel than a fiscal strategy…
But there is a precedent.
Back when the French king was a few years old, the Duke of Orleans was the Regent, and a Scotsman named John Law ran the French public finances (into the ground), a similar scheme was attempted.
Back then, France was in fiscal trouble too. They tried a bit of option two (above) first. But the tax cut caused political trouble in ways Art Laffer had failed to predict hundreds of years later.
And so, John Law came up with a solution. France had acquired the Mississippi Valley in the US. By which I mean that the French government owned the place. And nobody was allowed to trade with it, unless by Royal Assent. Which could be bought.
And that sort of agreement is actually what created the weird and wonderful world of joint stock companies like the ones you own in your pension fund today. Investors got together, formed a company, and bought trading rights off the government. Hence the names East India Trading Company and Mississippi Company.
Law’s idea was to sell the trading and mineral rights of Louisiana to such a company. In exchange for that company buying the French national debt. A type of debt for equity swap, if that doesn’t confuse you. The company gets the benefit of being allowed to trade with Louisiana and the French government gets fiscal stability.
To make the scheme work, there had to be a speculative mania which would make Elon Musk blush. There had to be such a clamouring for Mississippi Company shares that it would make the French government debt disappear into the Mississippi Company’s coffers.
And that worked surprisingly well. In ever-increasingly creative ways. Until the bubble burst and the Mississippi bubble managed to ruin both the public and private financial affairs of France — a decent achievement for a bubble.
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How is this relevant to today?
Well, I was reading the biography of the man who managed to become a Mississippian, meaning millionaire, from speculating in Mississippi stocks, and escape with his fortune too. He did it again with another bubble in the UK shortly after, while also founding the science of economics, if it is a science, on the side. But that’s another story.
I was thinking about how it’s a shame we don’t have a new North America to discover. We could send the navy off to colonise it and then sell it off like John Law did, thereby solving the problem of the national debt.
And then it hit me. The world does have such a place. A source of vast future wealth which governments have effective ownership of, or at least control of, but to which they could sell the economic rights today. And the technology we need to begin reaping the economic rewards of such a place is approaching realisation.
Look up and you might see it.
Until next time,
Editor, The Daily Reckoning Australia