POLITICIANS across the rich world are quarreling over how to deal with public debt. Yet the most important actors in the drama may be unelected central bankers, according to a study by the International Monetary Fund, published in its latest economic outlook. The IMF looked at 26 episodes since 1875 when debt topped 100% of GDP, to determine how those ratios got back down.
- Growth, spending cuts and tax increases did their bit, but the make-or-break factor was monetary policy. Low or falling nominal interest rates and inflation were crucial to reducing the debt-to-GDP ratio. When interest rates were high and deflation rife, consolidation failed. This is mildly positive news for America and Britain, whose central banks are determined to keep monetary policy easy as austerity bites. But it suggests a bleak future for countries locked into the monetary straitjacket of the euro, in the absence of easier monetary policy by the European Central Bank.
- Britain emerged from the first world war with debt at 140% of GDP and prices more than double their pre-war level, but it was determined to pay off its debt and return the pound to its pre-war value against gold. This required excruciatingly tight fiscal and monetary policy. The primary budget balance (which excludes interest) rose to a surplus of 7% of GDP. The Bank of England raised interest rates to 7%, and deflation meant that real interest rates were even higher. The results were awful: output was lower in 1928 than in 1918. And the debt ratio actually rose, to 170% of GDP in 1930 and 190% in 1933, as high real rates and declining output wiped out the benefits of a primary surplus.
- This experience may be similar to what peripheral euro-zone countries such as Spain and Italy now face. They can restore competitiveness only through domestic deflation, not devaluation, and reduce debt only through austerity, not inflation. This combination is likely to hold back growth for years. Debt ratios may actually rise.
- Belgium in the 1980s and Canada and Italy in the 1990s are more relevant. Consolidation began with structural cuts in spending and higher taxes, and was then helped by falling real interest rates.
Joining the Euro may not be so desirable for the poorer SE European countries such as Romania and Bulgaria. And isn’t Greenspan accused of keeping the rates low for too long, causing the current dementia?