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Fiscal Caution Thrown To The Wind


THE list of top ten countries with the highest debt to GDP ratio as compiled by the International Monetary Fund has three European nations (Greece, Italy and Portugal), and the number one slot belongs to Japan, whose ratio is nearly 240 per cent. Contrary to conventional expectations, these highly indebted countries are not among the poorest nations, or identified as reckless and spendthrift. Of course, there are also other countries such as Lebanon, Yemen and Sudan in the top ten. Argentina, which recently was granted the highest ever loan from the IMF of $50 billion, is ranked 94 in the debt to GDP ratio, even below fiscally conservative nations like Germany and Austria.

Debt As Financier

The larger point, however, is that sovereign debt of nations is at record highs. How this debt is ever going to be paid back is an unanswered question. Countries like Japan and India have been prudent, in the sense that most of their sovereign debt is issued in their own currencies, and owed largely to their own citizens. So the risk of an international default is minimal (in case of India, almost nil). Some may say that unlike human beings, nations do not ever have to repay their debts. They can simply issue new debt to repay old debt, and keep this rollover ad infinitum. At some time, this may affect the credibility of such nations and their governments, but that day of reckoning can be postponed. The fact that a rich country like Japan has been able to sustain high levels of debt is testimony to such a strategy.

But not all countries enjoy the A+ rating of Japanese sovereign bonds. Hence to protect their rating and credibility, countries like India enforce fiscal responsibility through legislation.  It is as if the hands of the government are tied by limits set by law which prohibits deficits and debts beyond a legally determined ceiling. This is the same approach taken in the Maastricht Treaty of 1992, signed by the members of the European Union. Alas, that treaty was breached by the biggest members of the EU within four years of its signing. Legally enforced fiscal rectitude falls by the wayside when the business cycle turns adverse, or voters demand higher government spending. Indeed, unlike the prescription given to the Asian countries in 1997, the IMF itself abandoned advising fiscal caution when it came to the European debt crisis of 2011.

Private sector debt

The problem of private sector debt is equally serious. The global financial crisis of 2008 was triggered mainly by excessive debt, combined with lax regulation, pliable rating agencies, greedy bankers and reckless borrowers. India escaped mostly unhurt from that crisis, due to proactive tightening of lending norms, increasing risk weights on housing and similar loans (this making it more difficult for banks to lend), and regulatory vigilance in general. It also helped that most real estate transactions in India had a substantial undeclared owners’ equity (also called ‘black money’) making it more difficult to trigger a sub-prime loan crisis like in the USA. But escaping the debt induced financial crisis of 2008 does not mean that the world, India included, is safe from another crisis. Indeed the world today is awash in liquidity and debt levels are the highest ever.

The central banks of US, EU and Japan, for almost a decade, followed a policy of printing money, and kept interest rates near zero so as to induce more lending by banks and more credit growth. Banks create money supply by a process of credit creation. Ballooning debt also means rapid increase in money supply. That may lead to inflation, but it also leads to economic growth as per Keynesian economics. If however consumers and investors lack confidence about the future, then the money printing may not be as effective.

Rising bad loans

Unfortunately, we are also seeing unprecedented bank failures, and rising levels of bad loans i.e. non-performing assets (NPAs). The burden of bank failure falls on the depositors who put their money in the bank, or on taxpayers, whose money is used to infuse more capital into state owned banks (as in India or China). How then to prevent such episodes of excessive lending, and eventual excessive credit creation leading to bad loans and burden on depositors and taxpayers? There is no easy solution or a magic bullet. It calls for regulatory vigilance and strict enforcement, strong governance standards in lending, adequate collateral against loans, an efficient bankruptcy resolution process and a strong credit culture. That seems like a tall order but there is no other option if we want to prevent bank failures or excessive debt.

But the Swiss thought otherwise. It is one of the richest nations, nowhere near any banking crisis. Indeed, Switzerland has been known for centuries as a country of discreet and very conservative bankers who will happily safeguard the assets of the rich and wealthy from all over the world. But the people were concerned about indiscriminate increase in money supply through credit creation. So they forced their lawmakers to hold a referendum earlier this month, asking whether bank lending should be prohibited from creating money supply. In effect, the referendum was whether Swiss banks should have 100 per cent cash reserve ratio. Every incremental deposit could not be loaned out. The only way banks could create new loans, was to enforce repayment of old loans.  The intention was to prevent bankers from reckless lending other people’s money (savings).  This initiative is called “Vollgeld” or sovereign money.  Only the central bank would be allowed to “create money” and make it much harder for commercial banks to “create credit”.  This radical initiative would change the face of commercial banking totally. Senior bankers were aghast at this initiative and were alarmed that it had reached referendum status. Economists were divided, but mostly sceptical. Lawmakers simply bowed to the public sentiment but would not have hesitated to put this into law. Luckily for now, the idea of “Vollgeld” was defeated by more than a two-third majority. For now, it is too extreme and idiosyncratic. But this may be the canary in the coal mine. Look out in the future for more such legal initiatives to curtail the juggernaut of exploding debt.

The Billion Press


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