The History of Dealing with Excessive Government Debt: Monetary Policy

An article in The Economist reviews the findings of an International Monetary Fund (IMF) report that surveyed the past history of how governments dealt with excessive debt. The IMF study found 26 instances where a country had a debt that exceeded 100% of GDP. The data went all the way back to 1875.

What conclusions can be drawn from the IMF study?

"Growth, spending cuts and tax increases did their bit, but the make-or-break factor was monetary policy. Low or falling nominal interest rates and inflation were crucial to reducing the debt-to-GDP ratio. When interest rates were high and deflation rife, consolidation failed."

Note that that while growth, spending cuts, and tax increases can all contribute to lowering the debt, they can also be mutually exclusive. Growth is inconsistent with excessive spending cuts and large tax increases. Note also that a little inflation can be a good thing.

The article uses Britain’s austerity response to its debt after World War I as an example of how not to do things.

"Britain emerged from the first world war with debt at 140% of GDP and prices more than double their pre-war level, but it was determined to pay off its debt and return the pound to its pre-war value against gold. This required excruciatingly tight fiscal and monetary policy. The primary budget balance (which excludes interest) rose to a surplus of 7% of GDP. The Bank of England raised interest rates to 7%, and deflation meant that real interest rates were even higher. The results were awful: output was lower in 1928 than in 1918. And the debt ratio actually rose, to 170% of GDP in 1930 and 190% in 1933, as high real rates and declining output wiped out the benefits of a primary surplus."

Apparently, the lesson from Britain’s experience was not learned. A regimen of austerity is being imposed on the high-debt countries of Spain, Ireland, Italy, and Portugal by their wealthier Eurozone partners, and the option of currency devaluation is not available to them.

"This experience may be similar to what peripheral euro-zone countries such as Spain and Italy now face. They can restore competitiveness only through domestic deflation, not devaluation, and reduce debt only through austerity, not inflation. This combination is likely to hold back growth for years. Debt ratios may actually rise."

Paul Krugman has been arguing long and loud that austerity in a falling growth scenario is madness. He has been suggesting what is essentially a monetary policy response to ease the situation. A bit of austerity combined with a bit of growth and a little inflation is how to address the problem. Stimulus in the strong countries causes growth throughout the sector plus a little inflation. Applied for several years, this would bring down the debt costs and the debt in the affected countries without the severe disruptions caused by austerity alone. Krugman would seem to have history on his side—and also The Economist.

What does history tell us about countries like the United States?

"America after the second world war offers a different lesson. Bouts of inflation, and a ceiling on bond yields imposed by the Federal Reserve, chopped 35 percentage points off the debt-to-GDP ratio. Yet such tactics may be unavailable in today’s flightier financial markets."

The article suggests that the more recent experiences of Belgium, Italy, and Canada may be more relevant in this era.

"Consolidation began with structural cuts in spending and higher taxes, and was then helped by falling real interest rates. Low real interest rates in Britain and America can be similarly helpful to stabilise debt. Clearly, the two countries’ options are better than the euro zone’s."

A little growth, a little austerity, and a little inflation can do wonders.