Europe is now haunted by the specter of debt. All European leaders quail before it. To exorcise the demon, they are putting their economies through the wringer.
It doesn’t seem to be helping. Their economies are still tumbling, and the debt continues to grow. The credit ratings agency Standard & Poor’s has just downgraded the sovereign-debt ratings of nine eurozone countries, including France. The UK is likely to follow.
To anyone not blinded by folly, the explanation for this mass downgrade is obvious. If you deliberately aim to shrink your GDP, your debt-to-GDP ratio is bound to grow. The only way to cut your debt (other than by default) is to get your economy to grow.
Fear of debt is rooted in human nature; so the extinction of it as a policy aim seems right to the average citizen. Everyone knows what financial debt means: money owed, often borrowed. To be in debt can produce anxiety if one is uncertain whether, when the time comes, one will be able to repay what one owes.
This anxiety is readily transferred to national debt — the debt owed by a government to its creditors. How, people ask, will governments repay all of the hundreds of billions of US dollars that they owe? As British Prime Minister David Cameron put it: “Government debt is the same as credit-card debt; it’s got to be paid back.”
The next step readily follows: In order to repay, or at least reduce, the national debt, the government must eliminate its budget deficit, because the excess of spending over revenue continually adds to the national debt. Indeed, if the government fails to act, the national debt will become, in today’s jargon, “unsustainable.”
Again, an analogy with household debt readily suggests itself. My death does not extinguish my debt, reasons the sensible citizen. My creditors will have the first claim on my estate — everything that I wanted to leave to my children. Similarly, a debt left unpaid too long by a government is a burden on future generations: I may enjoy the benefits of government extravagance, but my children will have to foot the bill.
That is why deficit reduction is at the center of most governments’ fiscal policy today. A government with a “credible” plan for “fiscal consolidation” is supposedly less likely to default on its debt, or leave it for the future to pay. This will, it is thought, enable the government to borrow money more cheaply than it would otherwise be able to do, in turn lowering interest rates for private borrowers, which should boost economic activity. So fiscal consolidation is the royal road to economic recovery.
This, the official doctrine of most developed countries today, contains at least five major fallacies, which pass largely unnoticed, because the narrative is so plausible.
First, governments, unlike private individuals, do not have to “repay” their debts. A government of a country with its own central bank and its own currency can simply continue to borrow by printing the money that is lent to it. This is not true of countries in the eurozone. However, their governments do not have to repay their debts, either. If their (foreign) creditors put too much pressure on them, they simply default. Default is bad, but life after default goes on much as before.
Second, deliberately cutting the deficit is not the best way for a government to balance its books. Deficit reduction in a depressed economy is the road not to recovery, but to contraction, because it means cutting the national income on which the government’s revenues depend. This will make it harder, not easier, for it to cut the deficit. The British government already has to borrow ￡112 billion (US$172 billion) more than it planned when it announced its deficit-reduction plan in June 2010.