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Excessive Debt or the Illusion of Wealth
on February 6, 2012
Philip Coggan explores with much clarity the different cycles in which money and debt have expanded. Mr. Coggan reminds his audience that money is concomitantly a medium of exchange, a unit of account, and a store of value. Two of these monetary roles - the means of exchange and store of value - lie at the heart of the ongoing struggle between creditors and debtors.
Starting in the United Kingdom in the late eighteenth century, the Industrial Revolution resulted into accelerated economic growth, significant population increase, and more trade across the developed world and its colonies. This burst of activity required more official money that remained based on precious metals until WWI. The United Kingdom led the way once again with the adoption of the gold standard among developed economies in the first half of the nineteenth century. The absence of universal suffrage allowed the upper or creditor classes to whom central bankers usually belonged, to favor a policy of sound currency backed by gold, regardless of the pain inflicted to the lower social classes. WWI resulted into the suspension of the gold standard and the massive increase in paper money.
Power shifted to debtors during the inter-war period due to the widespread adoption of democracy and the impossibility to restore the gold standard because of the burden of international debts, especially war reparations. During this period, the global money supply expanded, resulting in more paper money relative to gold. The crisis of 1931 resulted into a deflationary trap and the shift toward the modern welfare state to try to mitigate the effects of persistent mass unemployment in the 1930s. Widespread trade protectionism compounded the difficulty for governments of advanced economies to manage the economic cycle during this period.
Under the leadership of the U.S., the Bretton Woods system of fixed exchange rates was introduced in 1944 and remained in place until 1971. This system was built on the control of capital flows and the confidence of international investors in the U.S. economic policy. Currencies were linked to the U.S. dollar, which was itself linked to gold. Only central banks were able to convert paper money into the gold that the U.S. owned. During this period, economic activity far outstripped the supply of precious metals.
Confidence in the U.S. economic policy broke down in 1971. The final link with gold was removed by the U.S. The combination of paper money and the adoption of floating exchange rates, in the developed world at least, resulted into a massive increase in the volume of debt. Governments, mainly in the developed world, further fueled this debt bonfire by making more and more unfunded promises to their (ageing) electorates. The past decades witnessed first runaway inflation, then a series of bursting asset bubbles from the 1980s onwards. During the same period, the increase in consumer prices was constrained thanks to globalization, technological advances, and the greater role of women in the workforce.
The current global debt crisis, which started in 2007-2008, has witnessed the return of the problems associated with the 1930s, i.e., debt/deflation spiral and the paradox of thrift. Central banks have not hesitated to sacrifice the value of their currencies to protect the financial system.
To his credit, Mr. Coggan clearly articulates the likely long-term consequences of this debt crisis, i.e., inflation, stagnation, and default.
1. High inflation is very tempting to the central banks of heavily indebted countries. However, creditors will push back by asking for the same real rate of interest, regardless of the level of inflation. Furthermore, quantitative easing (QE), which also sacrifices creditors' interests to the benefit of those of debtors, is an unproven tactic that is unlikely to work. As Mr. Coggan learns from Lee Quaintance and Paul Brodsky, two hedge fund managers, printing money and extending credit do not create wealth. QE at best redistributes wealth; at worst may temper its creation.
2. Low interest rates, which reward debtors at the expense of creditors, and low growth, go hand in hand. The cost of capital and the return of capital tend to be at the same level. Therefore, if this is the case, the Western world is following a deeply flawed strategy. Electorates will push sooner or later their representatives to erode the debt, in real or nominal terms, to try to escape from stagnation. Nonetheless, creditors will push back as it was noted previously.
3. The temptation to default is also high. The political unpopularity involved in paying "greedy" (foreign) creditors will overwhelm any other issue associated with a default. The best that creditors can do is to cut off (temporarily) the defaulting debtors from access to further borrowing.
It does not matter which of these three scenarios ultimately gets the upper hand, writes Mr. Coggan. Debt is unlikely to be repaid in the form of money with the same purchasing power as when it was lent. Breaking these paper promises will damage the interests of both debtors and creditors.
Many developed Western economies are unlikely to escape from this crisis by achieving high growth due to population and productivity constraints as well as higher energy prices. Some developed countries will be able to muddle through; others will be ensnared into a debt trap. The developing countries will have to review their options under these circumstances.
Mr. Coggan concludes his examination of the history of money and debt by looking at the outlines of a new international currency system resulting from a world economy in crisis. The U.S. and China are at odds with each other about the outlines of this new system. China prefers a system of fixed exchange rates, the U.S. a system of floating exchange rates.
In summary, Mr. Coggan does a great job in making a complex subject accessible to a wider audience.