The Promises Must Be Broken
15 June 2010
Many governments, including those of the US, Japan, and most euro-zone countries, have made extremely costly promises to provide entitlements to their citizens and to repay their creditors. These promises must be broken, firstly because they cannot be kept and secondly because they should not be kept.
It should be blatantly obvious to anyone with a basic knowledge of finance that the promises cannot be kept. The government of Japan, for example, has amassed liabilities to bondholders amounting to two-times the country's annual gross domestic product (GDP), and on top of the debt that has already been issued there is an unknown (to us) -- but undoubtedly large -- quantity of "unfunded" (off-balance-sheet) liabilities associated with various entitlement programs such as social security. Taking another example, within the next 12 months the liability to bondholders amassed by the US federal government will exceed one-times GDP, but when the so-called "unfunded" liabilities are added to the equation it can be seen that the total present value of all US government promises to pay is already more than 5-times GDP. Considering other examples, the debt-related predicaments of the "PIIGS" governments are well known, but less well known is that the governments of both France and Germany have total (on- plus off-balance-sheet) liabilities exceeding 4-times GDP. So, what's the point of pretending that these liabilities will ever be covered?
There is not only no point pretending, it is dangerous to pretend. It is dangerous because attempting to keep alive the illusion of solvency necessitates theft on an increasing scale, either directly via more taxation or indirectly via more inflation. A case in point is the plan put together by Europe's political leadership with the aim of preventing the Greek government from immediately defaulting on its debt. This plan involves higher taxes in Greece, the transferring of Greek government obligations from private bondholders to other governments, and debt monetisation (inflation) by the ECB, but leaves the overall debt burden the same. It therefore wastes resources, confiscates savings and reduces economic growth for the sole purpose of delaying the 'day of reckoning'. Another case in point is the claim made by a famous economist (Joseph Stiglitz) to the effect that the large and rapidly-growing debt burden of the US federal government won't lead to a default thanks to the government's ability to print whatever amount of money it needs. It is true that the US government could turn to the printing press (with the help of the Fed), but it is vital to understand that an attempt by the US government to use monetary inflation to cover the bulk of its liabilities would, in effect, be an attempt to surreptitiously transfer tens of trillions of dollars of wealth from the most productive parts of the economy to bondholders and the recipients of entitlements. This type and scale of wealth transfer would destroy the dollar and devastate the economy, all for the sake of maintaining an illusion.
It is argued that the direct default by a government would eliminate that government's future access to the debt market, which is true. But that would be a huge positive rather than a negative. The world would be a better place if governments were not able to access the debt market. For one, there would be much less chance of war.
It is also argued that government promises must somehow be 'made good' because many people have come to depend on these promises. In particular, many people have paid taxes and social security contributions throughout their working lives on the understanding that the government would provide them with certain payments and other benefits after they retired. The problem with this argument is twofold. First and as explained above, it is not possible to make good on the promises. The promises will eventually have to be broken, the only question relates to how much more damage will be done in the period between now and when default is confirmed. Second, a wrong cannot be made right by committing another wrong. To be more specific, while it is certainly wrong that promises were made that could never be kept, this wrong cannot be corrected by stealing more money from savers and current taxpayers.
Some governments now appear to be coming around to the realisation that their debt situations are untenable, and are introducing "austerity measures" in response. However, while such measures could prevent the debt problem from worsening in the short-term they don't address the main issue, which is that current debt levels are already so high that default or major restructuring is both essential and inevitable.
The bottom line is that the promises made by governments will have to be broken and should be broken, the sooner the better.
Above is an excerpt from a commentary originally posted at www.speculative-investor.com on 13 June 2010.
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