In 2008 the global financial crisis began to morph into a global debt crisis. That’s because the massive money printing and bailouts undertaken by many of the world’s largest economies dramatically increased their debt burdens.
Today the global debt crisis is perhaps the single biggest threat to our economic future and therefore understanding how it might be resolved is vital. This article examines six options for resolving the global debt crisis.
Option one: Grow our way out
Normal levels of economic growth simply wouldn’t be sufficient to grow our way out of such unprecedented debt. In order to get the kind of phenomenal growth rate required, governments around the world would need to adopt radical economic policies. The problem however, is that far from implementing radical economic reform, the world’s most indebted nations continue to pursue loose monetary policy, big government and bailouts.
Another thing that could bring about extraordinary economic growth is a major technological breakthrough. A breakthrough in the area of energy generation, for example, could create new industries, put millions of people back to work and reduce the cost of energy. The problem here is that such advancements typically take many years, or even decades.
Option two: Major interest rate cuts
With interest rates already close to zero there is little or no room for more cuts, and certainly major cuts are out of the question.
Option three: A bailout
An indebted nation can be bailed out if it is small enough, and if there are sufficient solvent nations willing to provide the funds. The problem today is that the world’s most indebted nations, which include the US, the UK, Japan and France, are far too big to bail out.
It is also not just one or two countries that are suffering from chronic indebtedness. Take the eurozone for example. The Maastricht Treaty requires that member countries maintain a budget deficit of no more than 3% of GDP. Today however, only 6 of the 17 member nations meet that requirement and all 17 are running a budget deficit of some description.
When so many nations are in trouble, providing bailouts for the likes of Greece, Portugal and now Spain simply reduces the solvency of the eurozone as a whole. Therefore bailouts are not a long-term option for resolving the debt crisis.
These first three options are the easy ones that cause little or no economic and political pain. Unfortunately these options are either no longer available to us, or, in the case of option three, they provide only short-term relief from the crisis whilst making the eventual outcome worse. The three remaining options are all difficult and painful.
Option four: Default
When a nation defaults on its debt it is those holding that debt that incur the losses. Typically this will include other governments, pension funds, and bond/ mutual fund investors.
Due to the interlinked nature of today’s markets, an outright default by even a small country would send tremendous shockwaves throughout the global financial system. Having had a taste of this kind of financial chaos with Lehman Brothers, we can be confident that this is one option that politicians will do their best to avoid.
Option five: Austerity
Austerity is designed to cut the budget deficit, reduce government spending and ultimately reduce the level of outstanding public debt. However, as we have seen in Greece and Spain, when government spending is cut aggressively it plunges nations into a depression, especially if those cuts are not accompanied by the appropriate policy reforms.
Austerity is a painful option which typically brings about higher unemployment and lower economic growth for many years.
Option six: Money printing & inflation
In order to understand how money printing and inflation can be used to help resolve the debt crisis it is first necessary to understand what inflation is and how it’s created.
It’s a commonly held belief, even among many economists, that inflation describes rising prices. This is misleading however, since rising prices are a symptom of inflation rather than the cause. The true cause of inflation is an increase in the supply of money and credit.
When you increase the amount of money in an economy, but don’t increase the amount of goods, you end up with more money chasing the same quantity of goods. Sooner or later this leads to inflation as new money competes with old in bidding up prices. Money printing, for example through Quantitative Easing, simply reduces the value of the money already in circulation. However, as governments print new money they not only destroy the nominal value of paper money, they also destroy the nominal value of debt.
This is by far the most politically palatable option. For example, if a government can maintain an average inflation rate of 4% for a period of seven years, it will have eroded nearly 25% of its debt.
The bottom line
Over the next few years I expect to see more nations default on their debt. I also expect more countries to adopt austerity measures. Above all however, I expect governments around the world to take the easy way out and embark on more massive money printing in an attempt to inflate away a good portion of their debt.
In this environment preservation of wealth is paramount, therefore those invested in paper assets such as cash, government bonds and bank CDs, should monitor this key macro story closely. If inflation begins to pick up they should consider moving a portion of their wealth into tangible assets such as gold and silver which have a history of maintaining their purchasing power over the long-term.
This is the subject of an excellent book by Claus Vogt.