We continue to live in hope, seizing upon the occasional piece of economic data offering some upside surprise. Last Friday, we discovered that the US economy had created 200,000 new jobs at the end of last year– a gain modestly ahead of market expectations – and that the unemployment rate had dropped to 8.5 per cent. All good news, of course but, frankly, not good enough. In previous economic upswings, the US had no difficulty in creating 300,000 to 400,000 jobs per month.
Hope is not the same thing as good policy. We have been living in hope for too long, yet our hopes are not being met. Government budgetary positions are in danger of spiralling out of control. Investors are already well aware of the fiscal risks in southern Europe: bond yields in Italy and Spain are painfully high, while the Greek government debt market has gone beyond the point of no return. Fiscal risks are not, however, confined to the eurozone.
The US and the UK have the advantage of seeing their central banks manning the printing press: the newly created money is used to buy government bonds, thus keeping yields lower than they might otherwise be. It's a useful wheeze in the short term, but it's not clear it can continue indefinitely: too much money chasing too few goods doesn't sound like a recipe for success, particularly if the low level of yields allows governments to delay and defer ultimately necessary fiscal retrenchment. And, in the event of another recession – leading to yet another shortfall of tax revenue – US and UK government debt could spiral out of control even with quantitative easing.
The broad sweep of history demonstrates all too clearly that government debt in the western world has reached levels relative to income impossible to sustain over the medium term. The Liquidation of Government Debt, an important paper written last year by Carmen Reinhart and Belen Sbrancia, shows that there have been only a handful of occasions over the last century when government debt as a share of GDP reached levels even close to where we are today: after the First World War, through the Depression years and immediately following the Second World War. In each of these cases, government debt eventually came back down, at least as a share of income. The key question is: how?
There is no reason to think that high levels of government debt necessarily threaten the fabric of economic life. After all, the 25 years following the end of the Second World War saw rapid economic expansion accompanied by very low interest rates and sustained reduction of government debt. This was a period now frequently labelled as "financial repression". Interest rates were kept artificially low, capital and exchange controls were used to prevent funds from heading abroad, and banks constantly had to cope with the vagaries of changes in reserve requirements and other "macro-prudential" policies. Meanwhile, although inflation was hardly running out of control, it was high enough to ensure that interest rates were often negative in "real", inflation-adjusted, terms, ensuring that savers (as opposed to debtors, including governments) ended up with pathetically low returns.
Those who wish for renewed financial stability are often, at least implicitly, demanding a return to these kinds of conditions. And if growth at the time was so good, is it such an unreasonable ambition?
In truth, there are objections aplenty. Not least, we no longer live in a world of cross-border capital controls. It's difficult to see, in the West at least, any enthusiasm for their return. It's not just the inevitable opposition from multinationals: we have all, whether we like it or not, become a lot more cosmopolitan, no longer regarding national borders as a barrier to either business or pleasure. Yet, with the return of capital controls, national borders would suddenly become a lot more relevant again: not so much an iron curtain as a regulatory force field preventing international economic relationships from being sustained.
Growth in the 1950s and 1960s was strong arguably in spite of – and not because of – financial repression. Through successive GATT (General Agreement on Tariffs and Trade) rounds, trade barriers came down rapidly, providing a massive stimulus to world trade growth. And the 1950s were, of course, the decade of post-war reconstruction, involving huge international government transfers linked, most obviously, to the Marshall Plan. Those transfers wouldn't have happened had the Americans not been so exercised about the spread of Soviet Communism throughout Europe.
Put another way, growth in the 1950s and 1960s owed a lot to unrepeatable one-offs which simply cannot play any kind of role today. Financial repression now is, thus, much more worrisome, as anyone in the UK will know, having compared the low level of interest rates with what has proved to be a stubbornly high rate of inflation.
But is financial repression enough to solve government debt difficulties? In the absence of a return to 1950s and 1960s-style economic growth, would a combination of low interest rates, higher inflation and increased private sector holdings of government bonds (for "macroprudential" reasons) be enough to bring government debt as a share of income back down again? It seems unlikely.
That leaves us with a number of awkward options. After the First World War, some heavily indebted countries – most obviously Germany – succumbed to hyper-inflation. During the 1930s, many countries were forced to default through one means or another. Today, devaluation offers a useful escape route for those nations who've borrowed heavily in their own currency from others (the US and, to a lesser extent, the UK fit into this category). And then there's the austerity option, which imposes a huge burden on the current debtor population, allowing the (typically foreign) creditor to be absolved of both blame and pain.
All of the above would help deal with high levels of government debt, but none is palatable. Yet unless there is a decisive shift in government debt dynamics, history suggests we should prepare ourselves for the worst.
The obvious means of escape – as we saw in the 1950s and 1960s – is to find another source of economic growth. That means fostering closer linkages with the faster-growing emerging nations, keeping global trade routes open, pursuing productivity gains wherever they can be found and accepting that, without hard work (and that includes raising retirement ages), we'll be faced with hard times. Hope alone will not triumph over painful experience.
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