Guest Post: Europe Needs Debt Relief And Structural Reforms, Not Hyperinflation

Submitted by Philip Stive and Dennis Buitendijk

Europe Needs Debt Relief And Structural Reforms, Not Hyperinflation

Most developed economies are suffering from excessive debt burdens and are struggling to cope with this issue. The amount of debt is often so large that growth itself is hampered and the effect of any additional debt (to serve as a stimulus) is close to zero, or even negative. For governments and households to be in better shape in the future one part of the solution is to purge most of this debt from the system. There are various ways to accomplish this, but two are often being discussed lately.

The first option is to default on much of the debt. This will wipe out the current owners and management of most of the financial institutions providing a great opportunity to reform this sector to be beneficiary to society again, instead of merely extracting interest from credit that went to unproductive uses. Also it will be a long over due lesson that lending out money bares risk and that risk needs to adequately assessed by the creditorl only this way capital can be allocated to more productive uses and realise sustainable growth. And last but not least it will be beneficiary not only to debtors (which are relieved of much of their debt burdens), but also to savers. Since reducing the amount of credit outstanding is per definition deflationary, their savings will become worth more, and their prudent behaviour will finally be rewarded instead of the punishment they have been suffering for years by paying taxes on their savings, contrary to all the tax deductions available to interest payments. Critics of this approach say that this will lead to a deflationary spiral. However, GDP growth has been unsustainable for decades and we have just come out of the biggest credit boom in history which served to extend this unrealistic growth as long as possible. So, actually debt deflation is what we need: it is time to snip back to reality while avoiding the deflationary spiral. Allocating the previously mentioned savings productively can help to avoid this downward spiral. For instance reforms towards productive allocation of capital will open up opportunities for investment of these savings, especially if interest rates will no longer be manipulated through policy and investors are not ‘directed’ towards highly volatile and insecure markets.

Obviously there will never be a “good time” to purge the debt from the system, however, doing this at the top of a credit boom might actually not be a bad moment as it provides countries and households with a situation were they have more freedom to adjust to changes in the economy. For instance they can move closer to where there is work (because they can actually sell their house without being stuck with a huge amount of negative equity) or re-educate (because they are not burdened with student loans that prevent them from taking on new education), which should provide stimulus on its own to avoid a deflationary spiral. A study by the McKinsey Global Institute (Debt and deleveraging (2010)) shows that deleveraging through default is tough in the beginning, but that growth will quickly pick up at an increased rate and the subsequent 10 year GDP growth is the highest compared to all other solutions (and it will also yield the largest increase in GDP 15 years later, compared to when the deleveraging began). Worries about a deflationary spiral are mostly based on memories of the Great Depression, but the evidence of other default episodes shows that the outcome of the 1930’s is not the de facto result.

Another method is to turn on the printing presses. This will also relief most of the debtors from their debt burdens, because the real values of these loans will drop significantly. However, it leaves the current status quo and financial system intact, does not provide the much needed lesson on productive capital allocation, provides no incentive for governments to put in real structural reforms because of tighter credit conditions and it will only benefit debtors and not savers. Savers will be punished greatly, especially since there is no limit to printing currency and the central bank could carry on undisturbed for a long period of time. This will continue to ease the burden on debtors due to inflation, but looming hyperinflation will be devastating for everyone.

Until now both of the above options are off the table for politicians, and they have been kicking this choice down the road for a very long time now. They will, however, have to make this choice in the future as it is the only way out of the current situation. At the moment austerity combined with monetary policy that is supposed to spur growth is still believed to be the solution that can get us out of this mess. Only Swaziland in 1985 was able to actually grow its way out of an excessive debt burden (see ‘This Time Is Different’ by Reinhart and Rogoff). Assuming that Europe is like Swaziland and we can grow our way out of this mess, monetary policy actually seems to be the wrong tool to kick start it. Lose monetary policy is a supply side tactic that only sometimes works in cyclical down turns, however this is not a cyclical problem. This is a structural problem of too much debt and a lack of aggregate demand (especially for credit). On the other hand the austerity measures are aimed at short term revenue increases and expenditure cuts, which are unsustainable. This brutal form of austerity will send the economy in a downward spiral, making the debt problem even worse.

What is needed, in combination with the debt relief we talked earlier about, are structural reforms. The austerity or structural reforms should have the goal of preventing that countries will in the future end up in the same situation as they are now, but should not try to solve the current debt problem. Strong changes to entitlement programs are needed, as well as health care and housing overhauls, but these structural changes should be gradually implemented alongside a long term plan to reform. This gives society time to adjust, employees to re-school, homeowners and house prices to adjust and families time to switch to a more debit financed system of health care and education instead of one based on credit and student loans.

These structural reforms will require hard work, a long-term vision and a lot of patience, because they differ greatly from the often applied strategy of 'temporary palliatives' to keep citizens satisfied in the short run (e.g. tax breaks, 'cash for clunkers' and other such temporary stimulus-programs). Also the political climate in the United States and most countries in the European Union is limiting the pace of these reforms greatly. Congress in the USA has been gridlocked for months now over all kinds of legislation and the lead-up to next year's elections only shows more and more polarisation and extreme views being expressed. The advent of populist parties in Europe (most notably in Denmark and the Netherlands) leads to more extremist views and legislation there as well, but additionally the multi-party system in Europe is slowing down progress even further. Recent parliamentary votes in Greece, Italy, Slovakia and Germany showed the ongoing bargaining and discussion between parties on for instance the EFSF contributions: these deals were ratified months after the original plans and reforms were drawn up and have become almost obsolete already in the process. This shows how fragile the system is and it can (easily) lead to government break-ups even in times when strong leadership and swift reform is needed the most. So there seems to be an ongoing conflict between the limited time span of elected (multi-party) governments (say 4/5 years) and the horizon needed for structural reforms (beyond 5 years and most likely beyond 10 years).

A technocratic government could be very well suited to implement these structural reforms. However, technocratic can have different meanings, from the one-party China model to the technocratic-military hybrid-model in Egypt where strong military power is coupled with civilian expertise with respect to social and economic issues (The Economist, 19/11/11). These models are far from desirable in Europe of course, citizens simply would not accept them. Technocratic governments could however be successful for short periods of time and the situation as described in the previous section might be one: technocratic governments might be the tool to overcome the difficulties of implementing structural reforms and give countries a good fresh-start and long-term vision for the coming decade. This would be a very noble cause for any technocratic government, but as ever things are not so simple, since even technocratic governments have an "agenda".

The current governments in place in Italy and Greece are puppets of the banking system, making sure that countries do not default and pay as much interest for as long as possible by implementing short term austerity measures. This is not the type of technocratic government these countries need. They need a technocratic government that sees that the current debt burden is unsustainable and cannot be serviced, acknowledging that defaults are necessary. They should seize this opportunity to change the financial system and implement structural reforms, while exercising their powers to facilitate orderly defaults for both governments and household debt. This way countries will be able to start from a situation where there is breathing room to implement much needed structural reforms throughout society.