The current rise in inflation calls for a reassessment of the policy approach to public debt. As interest rates rise around the world, we need to reassess which types of debt should be considered stabilizing and sustainable, and which are most likely to cause economic and political instability.
In June, the Bank of England and the Central Bank of Turkey raised interest rates sharply. But if the Bank of England increased the rate by 0,5%, then the Turkish central bank acted much more harshly, almost doubling the discount rate - from 8,5% to 15%. It is interesting that these decisions did not lead to a significant strengthening of the exchange rate, which usually occurs after an increase in interest rates. And yet the management of these central banks will almost certainly be blamed for the economic pain caused. And monetary policy is at a standstill in both countries due to concerns about fiscal stability and debt levels.
Over the past 40 years, much of the government's attention has been focused on the burden created by external debt. And it's not hard to see why: the most shocking crises of the 20th century were always linked to foreign borrowing. There is a common thread linking the Barings Bank crisis of 1890 (the Argentine bankruptcy nearly brought down a major British bank) with the Great Depression, the Latin American debt crisis of the early 1980s, the Asian crisis of the late 1990s, and the Argentine crisis of the early 2000s- them. All of these panics were associated with government borrowing that proved unsustainable, either because the prices of key commodities fell (as during the Great Depression) or because international interest rates rose (as in the early 1980s).
The response to this type of crisis has usually been debt restructuring in one form or another. Significant financial claims accumulated by foreigners at a time of intoxicating optimism about the chances of economic growth of the borrower countries had to be reconciled with reality.
However, the current debt crisis looks different. While the UK and Turkey bowed after further interest rate hikes, world leaders gathered in Paris on June 22 and 23 for the "Summit for a New Global Financial Pact" to discuss ways to reduce the debt burden of low-income countries, which struggling with a whole range of shocks, including the covid-19 pandemic, disruptions in production chains and Russia's attack on Ukraine.
For decades, the main lesson of recurring debt crises has been that external debt is inherently dangerous. It seemed necessary to avoid short-term capital inflows, caused by a temporary mania, in order to protect the well-being of both the borrower country and the international economic order as a whole. Fortunately, there was a more sustainable and healthier alternative. Unlike external debt, domestic debt has traditionally been considered a useful tool that allows citizens to participate in the country's political system. Lenders, it was thought, were bound by civic and patriotic duty.
This model originated in Italian city-states at the end of the Middle Ages, especially in the great trading city of Genoa. The public bank Casa di San Giorgio, founded in 1407, which consolidated the city's debts on behalf of a large number of citizens, was praised even by Machiavelli.
By the end of the 17th century, England had adopted the Genoese model of Genoa's municipal government on a much larger scale, thanks to which the Bank of England was created. As noted by contemporary political scientists and economists (from Douglas North and Barry Weingast to Daron Acemoglu and James Robinson), in England the national debt was held by an institution owned by citizens who were also represented in parliament. Their elected representatives could vote on exactly how the revenues should be distributed, and guarantee them that the government would regularly service its debts to the central bank.
It turns out that the accumulation of internal debt is related to constitutionalism. Alexander Hamilton, America's first Secretary of the Treasury, was inspired by the Bank of England when he declared that the national debt was "a mighty force to cement our Union."
Viewed from this perspective, external borrowing appears to be a reserve that governments and countries resort to when they need resources that their citizens are unwilling or unable to provide. According to this logic, the development of domestic financial markets allows governments to avoid the trap of external debt and to borrow primarily from their own citizens, in their own currency.
In recent years, some proponents of modern monetary theory have advanced a simple balance sheet concept in which all domestic national debt is considered useful. Since the state's liabilities are assets for citizens, the growth of debt allows everyone to get rich. However, two relatively recent events, indirectly related to the covid-19 pandemic, challenged the popular idea that domestic borrowing has no downside.
The first event was the debt mini-crisis that rocked Great Britain in September 2022. Liz Truss, who was Prime Minister at the time, decided to abolish the highest rate of income tax (45%). The cost of this later abandoned plan was estimated at £45 billion, which seemed a small amount compared to the country's total debt. However, this plan caused interest rates to rise and the cost of long-term government debt to fall, which in turn caused a sell-off in government bonds. A vicious circle was created as financial institutions, especially pension funds, began to divest themselves of their financial assets.
The second event was Ghana's bankruptcy at the end of 2022. Unable to deal with debt servicing, as budget revenues fell and expenditures rose due to the pandemic, the country launched an external debt restructuring as well as an internal debt replacement program. However, as interest rates and inflation rose, so did the amount of local currency debt, increasing the amount of the country's tax revenue dedicated to servicing the debt. Three-quarters of these payments were received by Ghanaians, so the government's plan to drastically reduce the payments caused great public dissatisfaction.
Rising global interest rates have shattered the great illusion that domestic borrowing is less polarizing and dividing society than foreign borrowing. Although Hamilton may have viewed debt as a means of strengthening state power, his cement metaphor can be interpreted differently. Like cement, excess debt can become extremely politically burdensome, paralyzing governments and straining economies.
The author is a professor of history and international affairs at Princeton University
Copyright: Project Syndicate, 2023. (translation: NR)
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