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Forgive Us Our Debts?

The war between lenders and borrowers.

May 28, 2012, Vol. 17, No. 35 • By IRWIN M. STELZER
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Yes, if default were to become the solution to the world’s problems—in essence a transfer of wealth from creditors to debtors—moral hazard would rear its ugly head. Pardon illegal immigrants, and millions more will troop across our borders in the hope of another pardon. Pardon debtors, and those capable of repaying their debts might decide that remission beats repayment as a financial strategy. But that is a risk the possible cost of which must be weighed against the social cost of existing policies that favor creditors: wide-scale unemployment, impoverishment, the scuppering of democratic governments in favor of “technocracies,” to mention a few. In this difficult policy area, elevating the fear of moral hazard to the sole policy criterion surely is not the answer, as John Maynard Keynes recognized in 1923 when he recommended debt cancellation to “avoid general disorders and unrest.”

So consider default—as a thought experiment if nothing else. In Europe that would take the form of refusal by sovereign governments to repay their debts, followed by negotiations with disappointed creditors. It has been done dozens of times before and, if recollection serves, without ever permanently freezing the defaulter out of world credit markets. If Greece defaults and exits the euro, it will in a stroke become free to craft its own economic policy rather than wait for the latest edict from Berlin: Harder times are ahead either way, but surely the home of democracy would rather have its voters choose their own form of suffering than wait to learn what Germany has in store for them. A “Grexit,” as it has come to be called, would leave Greece no poorer than it now is, and freer to decide how to live within its straitened circumstances rather than be told how to do so by a foreign power or an unelected technocrat imposed on it by a foreign power.

Of course, there are alternatives to widespread default. One such, alluded to above, is inflation. So desperate are the Germans to keep Greece in the euro, and to prevent a fracturing of the eurozone, that inflation-phobic Berlin is sending signals it will tolerate a bit of inflation—a tiny bit, driven by wage increases, something that Germany’s iron chancellor, Angela Merkel, cannot help but find attractive as she faces a tough reelection campaign. 

Such a move would make other eurozone countries a bit more competitive with German manufacturers, although my guess is not by enough to affect the relative performance of the German and southern European economies. It is, instead, a bone thrown to those who are demanding greater flexibility on the part of Merkel, and might make it possible for France’s new Socialist president, François Hollande, to claim he has won the pro-growth concession he promised voters. With that under his belt, he can raise tax rates on the rich to 75 percent, lower the retirement age, and adopt other sops that his Socialist colleagues find attractive, proving their imperviousness to both experience and economic logic.

In America, the government could reduce the real debt burden by printing it away. Poof! and the real burden of what we owe China is reduced. Yes, incomes would be redistributed internally from creditors to debtors. And yes, that would affect the price lenders would demand of borrowers in the future. But a policy of inflation-as-default would merely be an explicit and one-shot application of what the Fed is now doing gradually and by stealth.

Does this mean I am recommending massive defaults? No: There are alternative policies that might result in more tolerable sharing of the pain of debt repayment, more tolerable than austerity alone. One such alternative would be to complete what advocates of a united Europe call the European Project: Add fiscal union to monetary union. Germany can make its high credit rating available to the troubled nations by agreeing to a eurobond. Future borrowing would be guaranteed by the eurozone as a whole, aka Germany. Investors, secure in the knowledge that they will be repaid, would make funds available at interest rates far below those being demanded of Spain and Italy, but somewhat above those offered to Germany. This is a covert transfer of income from Germany southwards, but if Germany really fears a breakup of the eurozone, it might be willing to pay this price, especially since it would be more or less invisible to most voters. To prevent Greece and others from returning to their profligate ways on the back of this German guarantee, the eurobond might apply only to some portion of the borrowings of individual countries, leaving them dependent on their own credit standing and the capital markets for the balance.

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