In Praise of Debt Ceilings

In the end, the solution to this “redistribution battle” tends more often than not to be found in more government borrowing. For today’s democracies, the fact that those who will eventually have to pay the taxes to service the resulting debt cannot yet vote makes borrowing the most expedient way out of a messy political battle.

The lure of borrowing becomes irresistible if it can be assumed that the burden might be shifted to population groups other than those benefiting today from low taxation or higher public spending. That is, for example, the case with childless people: they benefit from public borrowing and manage to shift to other families’ descendants the part of the debt service that will fall due when they are no longer around.

Only insofar as parents, taking into account the interests of their children and grandchildren, participate in the political process can the borrowing addiction be kept in check. If this is what motivates the Republicans’ hardline stance in the ongoing US redistribution battle, then theirs is a worthy cause – that of attempting to protect their descendants from being exploited. From this perspective, the Republican sentiment underlying the recent debt-ceiling impasse might be just as commendable as, for example, the prohibition enshrined in the German Constitution against debt financing of any sort, which will take effect no later than 2016 at the federal level and in 2020 for Germany’s länder.

Another example is debt mutualization among countries, such as that being carried out now in the European Union. First, individual countries borrow far above any sensible level, knowing that they will be saved from insolvency by rescue operations financed by the other member countries. The rescue initially takes the form of intergovernmental loans, so that the fiction can be preserved that each country pays back its own debts. But, as soon as the loans are dished out, mutualization shows its real face, taking the form of debt forgiveness.

In the case of Ireland, €40 billion ($54 billion) in Emergency Liquidity Assistance loans from the European Central Bank were converted into long-term bonds at below-market interest rates after the collapse of the bank established to consolidate the failed Anglo Irish Bank’s non-performing loans. About a year ago, the maturity of the intergovernmental loans given to Greece was extended to around 30 years on average, at highly preferential interest rates; indeed, interest was waived for a full ten years. That move represented debt forgiveness, in present-value terms, of €47 billion.

And that is not the end of it. There is talk now of another maturity extension and a further lowering of interest rates for Greece.

In all of these cases, the debt burden is, for all practical purposes, being shifted onto other countries. As a result, eurozone countries’ appetite for borrowing remains unbridled, while at the same time the sanction mechanisms included in the European Union’s “fiscal compact” are quietly set aside. Instead of shouldering the burden of reducing expenditures or raising taxes, countries opt for borrowing, because they know that they can unload part of the burden onto others.

Jointly guaranteed Eurobonds are already waiting in the wings to be used as instruments of debt mutualization. If a country proves unable to service such bonds, the other member countries will have no option but to pick up the tab.

During the United States’ early decades, debt mutualization triggered an irresistible urge to borrow. After Alexander Hamilton, the country’s first treasury secretary, mutualized the states’ Revolutionary War debts in 1791 by turning them into federal debt, the states went on a borrowing binge to finance infrastructure projects. Canals were dug at huge cost – only to become obsolete not long after railroads started to operate.

The economic boom that borrowing ushered in turned out to be nothing more than a credit bubble that eventually burst (with the financial panic of 1837). By the early 1840’s, eight of the 26 US states then in existence (along with the territory of Florida) had gone bankrupt as a result, while several others teetered on the brink.

But further mutualization was no longer an option. In the end, mutualization led to nothing but strife and growing animosity. The festering debt question poisoned the atmosphere in the US for years afterwards and contributed to sectional tensions that were already inflamed by the dispute between the North and the South over slavery.

So, let us be grateful for strict debt ceilings, for they can help to nip disaster in the bud – even if bumping up against them can leave politicians slightly bruised.

Copyright: Project Syndicate, 2013.
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