Debt and Democracy

The rotating presidency of the EU is about to shed a spotlight on one of these countries. Hungary’s turn at the EU helm comes at a time of fierce debate over Prime Minister Victor Orbán’s alteration of constitutional law and suppression of press freedom, as well as a new round of worries about the country’s financial sustainability.

Hungary has many reasons to be sensitive to the issue of the political consequences of debt. After all, Hungary still holds the world record for hyperinflation, with the currency debased by 1027 in the 1940’s, paving the way for the imposition of Communist dictatorship.

The EU’s debt arithmetic is uncertain and precarious. Fiscal consolidation in the Mediterranean countries might just do the trick, and allow – at great cost – a return to normal financing arrangements. But if market nervousness persists and interest rates remain high relative to rates for secure German debt, the debt burden will rapidly become unsustainable. So it might be a good idea for the EU to prepare a mechanism that spells out how debt can be trimmed.

Many economists have argued this case on the basis of arithmetic calculation. But the European Central Bank, notably by ECB board member Lorenzo Bini Smaghi, has elegantly spelled out the case against debt reduction – a case that is politically significant and deeply moral. Indeed, the principle of not reneging on public debt is deeply intertwined with the development of legal security, representative government, and modern democracy.

In the wake of the Glorious Revolution of 1688, when Britain revolted against the spendthrift Stuart dynasty, the British government adopted a new approach to debt. Voting on budgets in Parliament – a representative institution – ensured that the people as a whole were liable for the obligations incurred by their government. A constitutional approach limited the scope for wasteful spending on luxurious court life (and on military adventure), which had been the hallmark of early modern autocratic monarchy.

The lesson of 1688 was reinforced by the next European revolutionary wave. In the aftermath of the French Revolution and Napoleon, France was heavily in debt, and the revolutionary regimes had discredited themselves through paper-currency (assignat) inflation. After the Congress of Vienna returned King Louis XVIII to the French throne, his advisers debated whether or not to recognize the debt incurred by Napoleon. The decision not to default contributed to the legal security needed for the French economy to catch up with Britain’s industrial revolution.

The experience of wartime inflations and de facto defaults in the twentieth century made the theme of responsible finance a crucial part of a new European consensus. A foundation of the European integration process was recognition of the importance of a stable currency to political legitimacy.

Indeed, the EU’s critical French-German axis was held together by the conviction that political order in a democracy depended on the security of debt. In Germany, the expropriation of two generations of middle-class bond holders was seen as the outcome of the Kaiser’s war, and then of Hitler’s war – in other words, a result of democratic failure.

After inflation and unstable government, Charles de Gaulle rebuilt the French political system, but also the idea of the French nation, by championing currency stability. He explicitly went back to the legacy of Napoleon, and argued that France could be stable only with a strong currency.

The financial revolution that swept the world over the last two decades seemed to sever the link between representative government and public finance. Derivatives and other complex financial instruments seemed to offer a way to circumvent citizens’ responsibility for expenditure to which they had consented.

In other words, modern government finance had come to resemble sub-prime mortgages, which created the illusion of universal home ownership; rules and limits no longer applied. Countries could practice generosity on the never never. The apparently hard rules of the EU’s Maastricht Treaty and its Growth and Stability Pact, which impose a 3%-of-GDP ceiling on fiscal deficits and 60% on government debt, encouraged ingenious accounting to shift expenditure for purely cosmetic purposes.

The financial revolution went in parallel with the effective disenfranchisement of Europeans. For the past 20 years, it looked as if power was being shifted to a technocratic elite. Behind-the-scenes accounting tricks were accompanied by behind-the-scenes political tricks. Citizens, unsurprisingly, complained about the declining legitimacy of EU institutions.

Similarly, in guaranteeing the debt of Irish banks in September 2008, the Irish government did something that no responsible government should have contemplated. It took responsibility for obligations that amounted to a multiple of Ireland’s national income, driving up government debt to more than 1,300% of GDP. Prime Minister Brian Cowen, who still defends this action, is likely to be massively punished in the next elections.

But Cowen’s actions were symptomatic of a broader failure: the fundamental link between the liability of citizens and taxpayers and the responsibilities of government had been broken.

The idea of shifting some part of EU members’ existing government debt to a European bond may be technically appealing, but it will work only if there is a return to the British principles of 1688 (or the principles of the American Revolution). Taxpayers across the EU must have the sense that they control what they owe – and that they will not be held responsible for the mistakes and frauds of the unholy alliance between irresponsible finance and irresponsible government.