The West’s Day of Fiscal Reckoning, Part III

Politicians might conclude that debt restructuring is inevitable.

October 16, 2013

Author

Daniel Stelter

Daniel Stelter is the founder of the German think tank Beyond the Obvious and former member of Boston Consulting Group’s Executive Committee. Follow him @thinkBTO

As discussed in part 2 of this paper, financial repression will not be easy to achieve and will take many years. Inflation would have to be significant, raising the risk of getting out of control.

Daniel Stelter
The Western World’s Day of Fiscal Reckoning
Part I
Part II
Part III

If the overall debt load continues to grow faster than the economy, politicians might conclude that debt restructuring is inevitable. Such a course of action would not be new.

Option 4: Debt restructuring

In ancient Mesopotamia, debt was commonplace and individual debts were recorded on clay tablets. Periodically, upon the ascendancy of a new monarch, all debts would be cancelled. In other words, the clay tablets were destroyed.

The challenge facing today’s politicians is how to implement a similar debt cancellation given the size of the debt overhang of approximately $11 trillion (67% of GDP) for the U.S. and €7.4 trillion (78% of GDP) for the eurozone.

Cyprus was the first case where politicians tried a debt restructuring. Savers with more than 100,000 Euros in a given bank account lost their savings above that level when the bank where they held their funds was either closed or merged, and the losses written down.

In spite of many politicians’ claim that this was a one-off decision not to be repeated in other countries, it is reasonable to assume that it will be repeated, given the size of the problem.

The Cyprus solution can be criticized mainly for the fact that only bank accounts were affected, not the other financial or real assets of the investors.

This leads to an economic imbalance, as no rational saver will have more than 100,000 Euros in a bank account. A proper debt restructuring would need to be paid by a tax on all financial and real assets.

Assuming a one-off tax on financial assets to reduce the debt load to 180% of GDP, between 16% (Germany) and 80% (Spain) of private financial assets would have to be taxed away.

In Ireland, however, all financial assets of private households would not be enough to deal with that country’s debt overhang! This underscores the dimension of the Irish real estate and debt bubble.

These write-offs would have to lead to a real reduction of the debt burden of the debtor, and not just to an adjustment on the creditor’s balance sheet.

If governments chose this course of action, only true debt relief (and thus an end to the painful deleveraging process) could lay the foundation for a return to economic growth.

To follow this path, they would need to convince themselves that the overall benefit of an economic restart outweighed the risk of moral hazard.

A debt restructuring would not be very popular, although taxing the wealthy could well garner populist support. Moreover, the reduction of debt alone would not be sufficient to ensure future stability. Any debt restructuring would need to be accompanied by some additional measures.

Debt ceilings, Eurobonds, control of private sector growth

A clear commitment of governments to stick to the 60% debt ceiling and the 3% maximum annual budget deficit going forward. There could be pressure to make such commitments part of the constitution of the member states, with EU institutions having the power to enforce compliance.

At that stage, the funding of all European government debt would be done with eurobonds. (In contrast, EU-wide eurobonds would not be a solution today, as they would only postpone the problem and reduce the pressure to adjust public deficits in the countries of the periphery.)

A government could borrow only via the European Stability Mechanism, thereby ensuring compliance with the 60% rule.

In that brave new world, a mechanism would need to be established to control the growth of debt in the private sector to avoid new debt bubbles in the future. This would probably be achieved with differentiated interest rates and capital requirements.

The head in the sand era is over

Either way we look at the issue, not addressing the issue of ever growing debt levels is no option. Growing out and saving and paying back are not realistic, and inflation seems to be difficult to generate and control.

Therefore, an organized debt restructuring might well be the least damaging approach. After all, we have to keep in mind that the losses have already occurred. The creditors have only not yet recognized them.

Having dealt with the overhang of official debt, governments will have to address the issue of unfunded liabilities as well. This includes the following steps:

Increase the retirement age. As unpopular as this measure will be, it is the most important lever to reduce future costs. In an era of shrinking workforces, the current retirement math simply doesn’t work.

The sooner the public knows what to expect, the sooner it will be able to plan for this scenario. In this light, recent political initiatives towards even earlier retirement, as we are currently witnessing in France, are extremely counter-productive.

Reduce social insurance payments. Even with a higher retirement age, it will also be necessary to reduce the expected future payouts, at least in some developed countries. Again, the sooner the public has a clear picture of what the changes will be and when, the sooner it can begin to prepare for them.

Manage health care systems for efficient impact. In many countries, especially the United States, health care is the primary driver of increased government spending. But higher spending on health care is not necessarily a sign of better health outcomes.

Although the United States spends 17.6% of GDP on health care (compared to only 9.6% in the UK and 11.6% in France and Germany), U.S. life expectancy is between 1.7 and 3.0 years less than it is in these countries. The health care systems of the developed countries — and not just the United States — offer huge potential for more efficiency without losing effectiveness.

Kicking the can down the road does not work anymore. Everyday the problem grows bigger and the damage of an unwinding of excess debt and unrealistic promises gets bigger – for all of us.

Editor’s note: This is the final part of a three part series. Return to part I.

Takeaways

An organized debt restructuring might be the least damaging approach to address the ever-growing debt levels.

Restructuring would not be popular and the reduction of debt alone would not suffice to ensure future stability.

Cyprus was the first place where politicians restructured the debt. That could be repeated in other countries.

A proper debt restructuring would need to be paid by a tax on all financial and real assets.

In Germany, 16% and in Spain 80% of private financial assets would have to be taxed away.

In places like Ireland, the write-offs would have to lead to a real reduction of the debt burden of the debtor.

Governments must increase the retirement age, reduce social insurance payments and manage health care systems.