The debt problem ignored
- Low interest rates and government intervention swelled debt that set off the subprime crisis
- Irresponsible fiscal expansion has created an enormous sovereign debt problem in Europe
- The use of monetary policy to guide the economy can put off – but not prevent – another meltdown
The January 2019 edition of the Global Debt Monitor, published by the Institute of International Finance, reports that the accumulated global debt of governments, businesses and private households reached $244 trillion in the third quarter of 2018. That was more than 300 percent of the value of that year’s economic activity on our planet.
One does not need much economic imagination to know that debts of such size will never be repayable. It is also hard to believe that the practice of constant rollover (converting debt obligations that are about to mature into new debt), which in the present macroeconomic situation means increasing total indebtedness, is in any way sustainable. We are now living in an economy that functions on ceaseless injections of new money, which can only be generated by incurring debt.
How has the world fallen into this trap?
The problem really surfaced during the financial crisis of 2007-2008. Its immediate cause, the subprime crisis in the United States, emerged from an underlying problem that is worth analyzing. Largely thanks to Reaganomics, the U.S. economy was in good shape in the early 1990s. This allowed President Bill Clinton’s administration (1993-2001) to even reduce the federal debt. At the same time, an attempt was made to further stimulate the economy through looser monetary policy.
Lower interest rates helped reduce debt service costs for the federal government, while allowing households to pile up more debt. The two federal credit agencies, Fannie Mae and Freddy Mac, churned out mortgages that regularly exceeded the value of the houses used as collateral. The money created through this enormous injection of liquidity went into consumption. With cheap credit so easily available, commercial banks began to follow the example of government agencies, incentivized by their policies.
The system became a vicious circle, multiplied by repackaging of mortgage debt into securities that infected the global financial system. This bubble, called the subprime crisis, burst in 2007/2008 and dragged the financial sector down with it. It posed an existential crisis in the U.S., but had an even stronger impact in Europe.
Federal deficits in the U.S. had widened after the 9/11 attacks due to a necessary increase in defense and security spending.
A similar fiscal expansion can be observed in Europe in the 1990s and early 2000s, though here the cause of rising government expenditures was the need to fund an ever-expanding public sector and a bloated, inefficient welfare state. This resulted in increasing sovereign debt, though corporate and household indebtedness was less of a concern than in the U.S.
With the introduction of the euro, another problem started – less of the currency itself than of the political and fiscal framework that accompanied it. The Maastricht Treaty established a set of fiscal and monetary criteria with which members of the eurozone were expected to comply. The same criteria would also be applied to all future applicants for eurozone membership.
This paved the way for a successful launch of the single currency, which eased trade inside the Union by reducing transaction costs and increased the currency bloc’s power and stability in global competition. The eurozone’s architects also intended the European Central Bank (ECB) – as the first supranational central bank – to be independent of politics, along the lines of Germany’s Bundesbank. This would leave it free to concentrate on its sole responsibility for monetary policy and currency stability. The autonomous ECB’s involvement in fiscal policy was excluded.
So far, so good. But the difficulties began just a year after the euro’s rollout in 2002, when the currency bloc’s two largest members, Germany and France, broke the budget deficit limit, set at 3 percent of gross domestic product in the Maastricht Treaty. As then German Chancellor Gerhard Schroeder remarked, “the Maastricht Treaty does not interest me.” As far as he was concerned, the fiscal criteria were just a piece of paper.
This opened the door to expediency. Unfortunately, subsequent events proved that this irresponsible German politician was correct in his conclusion. When Greece used faked economic data to gain admission during the eurozone’s first enlargement, all criteria were ignored.
Many members of the euro area, especially in Southern Europe, were used to high interest rates. Now the euro gave them a low-interest currency, creating an incentive for businesses, households and especially governments to incur high debts. At the same time, unfortunately, the ECB became more politicized, helping member states service their growing debts through a policy of easy money.
All over Europe, governments opted to keep voters happy through runaway, debt-financed spending. In these “complacent democracies,” welfare states devoured more and more resources, not just for the needy but also to cover increasingly irrational bureaucratic costs.
Europe’s sovereign debt bubble started to surface with the Greek crisis of 2010. Policymakers feared that a Greek default would create a domino effect. Thanks to their intervention, Greece’s internal problems were not solved; instead, billions of euros were spent to keep the Greek government solvent. This policy was clearly a breach of the EU treaty’s “no-bailout” clause, but it was backed to the hilt by senior officials, especially German Chancellor Angela Merkel. Instead of allowing Greece to leave the euro area and create a national currency that could be devalued, the EU forced Greece to adopt an austerity program that inflicted enormous suffering on its people.
Sovereign debt was hardly an isolated Greek problem; it had become an issue for the whole euro area. In complacent democracy, however, politicians – especially weak ones – find it exceptionally difficult to curb costs and reduce public spending. It is much easier to incur more debt and demand lower interest rates to service it. Tax increases were also tried but proved ineffective. Since taxpayers were already squeezed, additional fiscal pressure simply damaged economic growth.
Bank financing had always been an easy way out for eurozone governments, as by law, government debt was considered triple-A, and carrying such debt did not require commercial banks to add equity to their balance sheets. This created another vicious circle between eurozone lenders and governments. In the wake of the Greek crisis, as triple-A ratings became doubtful, commercial banks could not provide more money to governments until they had fixed the severe equity problem on their own balance sheets.
This was the moment when the ECB started to abandon its principles and subordinated monetary to fiscal policy. Interest rates went from zero to negative and huge bond purchasing programs started. As the dam broke, the monetary authorities in Frankfurt began printing money. Debt could be incurred without limit.
Sovereign debt was not the only reason that the ECB deemed its new policy expedient. We know from experience that big government and its inevitable consequences – high sovereign debt and overregulation – are very damaging to the economy. This is not just a European problem. Needing to stimulate the growth without resorting to tried-and-tested remedies – reducing government spending and streamlining regulations – cheap money was pumped into the economy to boost consumption. At the same time, more regulations were introduced, ostensibly to stabilize the financial system.
Against all better judgment, easy credit was used as a short-term fix for the economic malaise caused by big government. This was the second reason monetary policymakers in Europe and the U.S. decided to lower interest rates and punish savers. Household savings were regarded as damaging to the economy, because they restrict consumption.
This idea of using monetary policy to guide the economy has a clear kinship with the socialist concept of central planning. Both Karl Marx and Vladimir Lenin observed that the way to crush capitalist entrepreneurs is to destroy their savings. In fact, it is easier for governments to control the spending of people in debt than those with savings. A person with financial resources is free, while debtors are hostage to their creditors.
Seen in the cold light of economic efficiency, all these policies of guiding and planning amount to kicking the can down the road. They only make things worse. Since the people in charge have easy access to economic expertise or are economists themselves, why have they chosen this course? Is it just blindness, combined with irrational hope that a miracle will happen? It would not be the first time that politicians have tried to buy time until the next election. But there is also a more disturbing possibility: some people may be pursuing a political and ideological agenda to create a planned economy and controlled citizens.
The foregoing account leaves out some essential elements of the fiscal picture – especially future retirement pension and healthcare costs in an aging society. No national accounts have created adequate reserves for these future obligations.
Even without taking such liabilities into account, the global debt of governments, businesses and households almost certainly surpassed $250 trillion at the end of last year. As mentioned above, this is more than three times the annual economic output of our entire planet. Europe has contributed more than its fair share to this shaky construction.
No government in the world, and certainly not Europe on the Union or national levels, has a plan for how to address this situation. The pending financial meltdown can be pushed a bit further into the future, but it will eventually occur.
Convergent policies pursued by like-minded crisis managers around the world have led us to this predicament. Sound policies have been avoided. These leaders have been kept in charge under the pretext that “we need experienced politicians” to manage the situation. Under this not-so-visionary slogan, French President Emmanuel Macron is now trying to block a younger, more dynamic conservative, Manfred Weber, from becoming president of the European Parliament.
And so the sleepwalking continues.