Toward a Return to the Post-World War II Financial World

Some in Europe, particularly leaders in Germany and France, have called upon private creditors to cough up for the drama unfolding in Greece.

German and French financial institutions intend to heed the call by rolling over part of Greece’s government debt, which will help to buy more time for officials to avert a full-blown crisis.

But there is a more appealing and simultaneously more radical way of making the financial sector pay — as the British and the Americans did after 1945, when they paid off their gigantic war debts. They did so by keeping interest rates low and increasing the pressure to buy government bonds.

This is more subtle and would probably be more efficient than a vain attempt to slash deficits via radical consolidation measures, talk of cutting debt or expressing threats to investors. After all, it is not only the Greeks who have a huge debt burden to eliminate.

Post-war period as a good example

There is something grotesque about the enthusiasm with which the EU Commission and the German government still urged the Greeks to reduce their debts via even more tax increases along with even sharper pension and public spending cuts.

If anything, the Greek crisis has shown that, even in the case of a highly indebted country, trying to lower the deficit with short-lived reductions and tax increases is a plain disaster. It initially does nothing other than intensify the recession, resulting in lower tax revenues. It’s a vicious circle.

Two prominent U.S. economists, Carmen Reinhart and Belen Sbrancia, also have their doubts as to whether it is possible to outgrow one’s debt in such conditions by means of robust economic growth. They believe it would be better to follow the lessons that helped the British and the Americans after 1945, referred to as “financial repression” by the experts. It’s an almost forgotten concept by now.

At the end of World War II, the British had piled up government debt that was more than twice as high as their GDP, much more than the Greeks’ public-sector debt today. The Americans’ debt reached almost 120% of GDP. Ten years later, the percentages were only about half as high — an absolutely breathtaking reduction.

According to Reinhart and Sbrancia, economic growth alone could not have been responsible for this. After all, the level of economic growth was not that high in those days. There were no calls for debt forgiveness either, of the kind demanded by quick-fix economists especially for a frequently cited southern European country. No hyper-inflation either, with which government debt is to be eliminated by inflation, a strategy that does not exactly have solid public support.

The trick was in the stringent process of regulation that the Americans and the British had embarked on. Part of the strategy was to introduce interest rate caps on bank deposits. That made it appear more attractive to buy government bonds bearing only moderate interest rates from the state. Another measure was to keep key interest rates low.

In addition, strict conditions were imposed on transfers of funds abroad, preventing savers from trying to escape low interest rates. Another step was for governments to impose rules forcing pension funds to add a certain volume of government bonds to their portfolios, which also helped alleviate debt service.

As the two U.S. experts convincingly demonstrate, the result was that interest rates in this period were considerably lower than in (later or earlier) years of highly liberalized financial markets — with only moderately higher inflation rates.

Each year of negative interest rates reduces the level of government debt. And the effect is enormous. Measured in terms of GDP, the United States saved well over 3% in interest payments per year in this period. That alone caused the volume of debt to decline by at least 30-40% of GDP in ten years. The few countries that achieved comparable reductions in an environment of more normal interest rates required a few decades to do so — or a permanent boom.

However, it is clear that interest rates that are kept down by the state are a hidden tax on savings and income of the financial sector, which the state uses to reduce sovereign debt. This is not an ideal outcome. The question, however, is whether there are practical alternatives.

This recipe would not impede the level of economic activity as much as endless cuts imposed on pensions and investments. Low interest rates are also beneficial in this context. And it forces the much-beleaguered private sector to play a role in lowering the level of public-sector debt, for which it is also responsible.

The return to the post-World War II financial world might even be the only way of cutting the level of government debt at all, which has soared worldwide. In addition, such a path would help foster economic growth. After all, it cannot exactly be said that conditions were so bad from 1945-1980 that the financial sector was prevented from making really big money.