Senior Research Fellow
Eight historical examples
In a previous paper, the author conducted analysis based on historical examples on how certain countries were able to trim enormous fiscal deficits (FRI Research Report No. 158, March 2003: “Resolutions to the Amassment of National Debt: A Historical Analysis”). Though published seven years ago, this paper has recently been generating questions as sovereign risks rise around the world. After introducing the essence of this paper, the positioning of Greece and Japan’s current fiscal problems are examined.
The original paper highlights eight cases in which the GDP ratio of outstanding government debt increased: the US (after World War I, World War II, and in the late 1980s); England (after the Napoleonic Wars); Germany (after the World War I); Italy (early 1990s); Sweden (early 1990s); and Japan (after World War II).
Currency system and fiscal discipline
First, the eight cases are basically divided between their implementation of a gold standard or currency control system, and the functioning of fiscal discipline depends on the system.
Under the gold standard, governments generally manage finances tightly to curb domestic inflation and maintain the currency peg. In terms of currency supply, central banks cannot issue currency in excess of gold reserve limits. As a result, central banks cannot finance government spending by absorbing government bonds.
Central banks have discretion over the amount of issued currency under a currency control system, making it easier for currency to bloat compared to the gold standard. In some cases central banks can finance government spending. These differences between the two systems strongly impact the processes of increasing and eliminating government debt.
Even in the era of the gold standard, however, the system was not strictly maintained. It was common practice to temporarily pull out in unique circumstances, such as in times of war when increased war spending was unavoidable. Even under currency control, the pressure to maintain fiscal discipline varies between a currency peg and floating rate system. In general, governments trying to adopt a currency peg have an incentive to maintain fiscal restraint, but this incentive is weak in a floating rate system.
In this way, though the gold standard and currency control are polar opposites as systems, in practice their differences are modest. Even the currency peg that was adopted first under a gold standard has not always been maintained, and, when difficult, fiscal discipline has often been temporarily discarded. In such cases, governments have depreciated the currency when unable to return to the original exchange rate. The difference between the two systems ultimately comes down to whether the source of currency trust in is gold or the central bank.
Has currency confidence been maintained?
Looking at these eight cases, pressure to curb rising government debt has often stemmed from difficulties in maintaining currency value, regardless of the currency system. In other words, serious concerns over maintaining currency value have pressured governments to limit rising debt.
The end of war marked a fiscal turnaround for post-Napoleonic War England and post-World War I US, where war spending had bloated fiscal deficits. In both cases, the need to strengthen or return to the gold standard provided incentives to quickly restore fiscal discipline.
Plummeting currencies raised a national sense of crisis in Italy and Sweden in the early 1990s, providing a strong impetus for fiscal restructuring. The imminent monetary union in the EU served as strong external pressure for Italy in particular, which would be left behind if it failed to meet the fiscal conditions for participating in the single currency. In both cases, the market pressured governments towards fiscal restraint when further deficits would have shattered currency confidence.
In the late 1980s, the US was saddled with both fiscal and current account deficits which damaged confidence in the dollar. Here again, determination to protect currency value served as strong pressure to restore fiscal discipline.
In this way, the pressure to preserve currency value helped curb rising government debt in these six cases. Italy, Sweden, and the US ended up seeing currency adjustments in the early 1990s (currencies plunged in Italy and Sweden; the dollar was devalued in the US after the Plaza Accord), but strong pressure to avoid decisive damage to currency confidence served as impetus for fiscal reform.
In contrast, in some cases maintaining currency value placed no pressure on governments to limit debt. For example, the America’s status as the key currency country was unquestioned after World War II, and it was also a creditor country boasting a vast current account surplus. The US had no need to quickly trim debt to maintain currency value, as this value was unaffected by higher government debt. The US stopped issuing new bonds, and the central bank gradually reduced debt by implementing policy to support bond prices. This policy resulted in mild inflation in the US economy.
Lastly, post-World War I Germany and post-World War II Japan are cases where, from the perspective of maintaining currency value, complete loss in currency confidence led to hyperinflation and, as a result, elimination of government debt. Germany covered its war reparations by issuing currency; Japan financed surging war and other expenditure through the Bank of Japan’s absorption of government bonds. Both moves damaged confidence in the central bank and invited hyperinflation.
War financing or big government?
The eight cases can also be classified by the factor behind increased government debt: war financing, or big government from expanding public works and social welfare costs.
War financing spurred higher government debt in England (post-Napoleonic Wars); the US (post-World War I and World War II); and Japan (post-World War II). In contrast, Italy (early 1990s) and Sweden (early 1990s) saw rising debt because of high expenditure that follows bigger government.
Under the Reagan Administration in the late 1980s, the US adopted supply-side policy to stimulate the economy through lower taxes while also ramping up military spending to counter the Soviet Union: these were the factors behind accumulating debt. The US was able to cut military spending after the end of the Cold War, paving the way for fiscal reform—in this sense the US in the late 1980s exhibits elements of the former cases. The US, which saw fiscal deficits grow in its pursuit of a small government from lower taxes, is different in character from the cases where higher expenditure invited debt, but similar in that it depended on borrowing for its financial resources.
In the former cases where war and military financing led to fiscal deficits, the end of war marked a fiscal turnaround. In these examples, therefore, the opportunity for fiscal reconstruction was readily available: when war is a factor behind higher government debt, the end of war itself becomes the first step towards fiscal reform.
In the latter cases of big governments, however, it was difficult to reign in expenditure that had ballooned over years of fiscal management. This is because parties with entrenched interests in government expenditure opposed spending cuts. Moreover, domestic pressure to change policies was weak in countries lacking strong opposition to the ruling party, making fiscal reform even more cumbersome from a political perspective.
In these cases, therefore, embarking on fiscal reform was difficult in times of peace. As evidenced by the examples of Italy and Sweden, in the end the pressure towards fiscal reform comes from the market, such as plunging currencies or bond markets, or externally, such as currency unification. In these cases citizens shared a sense of crisis, creating an environment favorable for fiscal reform. In other words, market pressure became a powerful, big bang-type force that made reform possible.
In contrast, the US in the early 1990s was different in that market pressure in the form of sagging dollar confidence was clearly an opportunity for reform, but the domestic political climate also played a role. The Bush and Clinton Administrations were able to curb fiscal deficits that had ballooned under the Reagan Administration.
From a political economics perspective, the US is a rare case in which domestic politics also functioned alongside external forces such as market pressure to promote gradual reform. Viable political forces keeping each other in check as they vie for domestic power, such as in a two-party system, create a sense of tension that makes it possible to promote reform through internal pressure. On the other hand, Italy and Sweden had no alternative but to ride market pressure towards quick reform. In these cases, political leadership towards fiscal reform finally emerged as a result of external pressure.
Factors behind falling government debt ratios
The eight cases can be classified by the strongest factor behind the falling government debt ratio: reduced outstanding debt (net debt redemption); real economic growth; or inflation. Germany after the World War I and Japan after World War II are cases where lower government debt was mostly attributable to hyperinflation.
In contrast, lower outstanding debt and real economic growth factored equally in the US after World War I, with government spending cuts and real growth pushing down the debt ratio. The US then saw its debt ratio after World War II fall because of both real growth and inflation. The Federal Reserve’s policy to buy government bonds generated mild inflation, which played a role in decreasing the government debt ratio.
Real growth also drove down the debt ratio in the US in the late 1980s, with inflation contributing to a lesser degree. In addition to military spending cuts, sustained economic expansion also contributed in this period. Meanwhile, Italy and Sweden also saw their debt ratios drop because of real growth and inflation in the early 1990s.
In this way, lower government debt ratios are achieved only when fiscal reform such as spending cuts and tax hikes is combined with economic growth and a degree of the inflation that follows. After World War II, natural growth-driven inflation coupled with government bond price policy that artificially maintained mild inflation contributed to lower a debt ratio in the US. Such examples indicate that a degree of growth and corresponding inflation are necessary to drive down the government debt ratio.
There is an extremely rare case, however, of the debt ratio falling during a period of deflation. In 18th century England after the Napoleonic Wars, prices generally began to fall primarily as a result of the gold standard. Yet, England’s economy maintained high real growth that more than offset this deflation. England underwent its industrial revolution early on in the 17th century, established its position as the world’s industrialized nation, and enjoyed the fruits of these achievements over the entire 18th century. Moreover, England’s remarkable rise in industrial power sparked a population surge which also greatly contributed to growth.
Of the eight cases, post-Napoleonic War England had the highest government debt ratio while also facing deflationary trends. Serious concerns over how to resolve the budget deficit should have been accompanied by a crisis in currency confidence. High growth and sufficient confidence in the globally dominant British pound, however, prevented such problems from surfacing. In cases like this, economies that maintain real growth robust enough to compensate for falling prices are able to trim fiscal deficits despite deflationary trends.
Patterns of trimming government debt
In summary, excessive government debt creates serious concerns regarding currency confidence which manifest in collapsing currency prices and government bond markets. Citizens begin to share a sense of crisis when such a critical situation emerges, creating momentum to quickly pursue fiscal reform. In addition to market response, institutional constraints such as monetary union or maintaining the gold standard can also pressure governments to uphold fiscal discipline.
When mounting central bank-financed debt shatters currency confidence, hyperinflation can emerge that in effect reduces this debt.
In contrast, currency confidence can be preserved despite accumulating debt by holding enough foreign assets or financial assets; in this case, a “soft-landing” becomes possible where debt is reduced gradually. For example, the central bank buys government bonds and in effect decreases debt through mild inflation.
Realistically, reducing the debt ratio is difficult with only fiscal reform: the economy must also be on a growth path. Though rare, there are cases where economic growth is robust and the government debt ratio is lowered despite deflation.
Looking at political conditions necessary for fiscal reform, when debt increases because of government expansion it is generally difficult to find an opportunity to embark on reform. Reform usually becomes possible only under a heightened sense of crisis because of market pressure or institutional constraints. Reform can also be advanced, however, in the presence of strong domestic opposition to the ruling party.
Ultimately, three forces pressure governments to maintain fiscal discipline: the market (currency and government bond markets); institutional constraints; and domestic opposition.
Greece’s current case
With this in mind, we examine how the current situations in Greece and Japan are positioned historically.
Greece’s woeful financial condition can be attributed to, after the change of government in October 2009, the exposure of the previous administrations’ cover-up of the fiscal deficit and the resulting spike in long-term interest rates. This means that two of the three factors that push fiscal discipline (domestic opposition and the market) are in play. In addition, as part of the euro zone Greece currently has no choice but to reduce its fiscal deficit with austerity measures. In other words, the institutional constraint of membership in the euro zone has also pressured Greece to maintain fiscal discipline—all three of the factors are functioning.
It remains unclear, however, whether Greece can trim its fiscal deficit under such conditions. Countries facing current account deficits and the danger of financial collapse would typically see a sell-off and subsequent depreciation of the currency, which would restore competitive strength and facilitate economic restructuring. Greece’s membership in the euro zone, however, has from the start rendered it unable to ride currency depreciation to recovery. Greece must therefore cut costs to restore competitive strength under a Euro rate relatively high to Greece’s economic strength. This is the fundamental reason why Greece must implement tightening policy.
Greece’s current situation resembles cases where, under a gold standard, the currency peg becomes unsustainable following difficulties in maintaining fiscal discipline. As mentioned before, there are many instances of countries temporarily pulling out of the gold standard system when fiscal discipline becomes difficult, and depreciating the currency when unable to return to the original currency rate. If Greece were to withdraw from the euro zone at this stage, however, the market would begin to sniff out the next country to follow, putting the entire area at risk. This is not an option for the euro zone.
In addition the EU and IMF’s current support, it may also be necessary to forgive Greece’s debt at some stage to keep it in the euro zone. This is analogous to a country where the central government assumes the debt of a local government facing financial crisis. Such a situation in the euro zone would unify the area in terms of both fiscal policy and management, presenting an opportunity for deeper regional integration.
Because of the unified currency, Greece’s current fiscal crisis can be attributed to its inability as an economically weak country to revive the economy through currency depreciation. Greece’s troubles also raise a historically unprecedented problem of maintaining both fiscal discipline and currency confidence that could invite a crisis in the unified Euro.
Japan’s current case
As the fiscal deficit widens, the Bank of Japan is buying up a certain amount of government bonds to avoid disruption in the government bond market. In this sense, Japan resembles post-World War II America where the Federal Reserve long ago implemented bond price support policy.
Moreover, just as the dollar was unaffected by Federal Reserve’s move, the bond-buying trend in Japan has not lowered confidence in the yen. Like the US in that period, Japan is a creditor that enjoys a current account surplus. This shows that Japan also has the strength to ward off damage to its currency confidence despite the mounting government debt financed by the central bank.
The US policy after World War II was to buy government bonds but put a check on rampant debt, and leverage economic growth for a soft-landing of the debt ratio. Japan today is similar in that the Bank of Japan is buying a limited amount of government bonds, but differs in that it shows no signs of halting growing debt and is falling into deflation and economic stagnation.
Post-Napoleonic War England shows that fiscal deficits can be cut even under deflation. In England’s case, however, improved productivity after the industrial revolution and the subsequent population increase generated high growth that more than offset deflation and helped lower the debt ratio. Japan, however, suffers not only low growth but also population decline; reducing the debt ratio under deflation seems unrealistic.
Yet, there are some positives for Japan. First, citizens share a sense of urgency regarding Japan’s fiscal health. In a public opinion poll, 60% of respondents already think that “raising consumption tax is unavoidable to maintain the social security system” (“Yomiuri Shimbun”, November 2009 survey). Behind such opinion is the heightened sense of crisis concerning Japan’s deteriorating fiscal health following the Lehman shock; stronger understanding that new financial resources are necessary to improve child-rearing support and impoverished healthcare; and the reality that even “budget screening” will only produce marginal revenue. Recent media coverage juxtaposing Greece’s crisis with Japan’s fiscal situation may also be contributing to public awareness.
Japan’s 2009 government debt ratio is on par with post-Napoleonic War England (171%, accumulative long-term debt/GDP). The government bond market survives because almost all of the bonds are held domestically (about 95%), and there is significant room to raise taxes in the future. Japan’s current 25.1% tax burden ratio (fiscal 2008) is low compared to European countries (England 37.5%; France 37.6%; Sweden 51.5%: Ministry of Finance), and the possibility of a consumption tax hike is particularly high. If citizens recognize that their tax burden is low and accept a higher consumption tax there is no reason why the government bond market should collapse from worries over bond redemption. As society ages and the savings rate falls, however, Japan does face a gradual decline in its capacity to absorb government bonds.
Of course, to reduce the debt ratio Japan must not only raise taxes but also shake free from deflation and embark on an economic growth track (high nominal growth that yields a degree of inflation). Japan is fortunate to be in proximity of rapidly growing emerging markets such as China, affording it great potential to maintain growth by maximizing such demand. Whether Japan can really leverage this demand is unclear, but the potential leaves the door open to fiscal reform.
While Japan’s fiscal situation is therefore severe, there are paths towards improvement such as tax raises and growth. The issue is whether there is the political will to stanch further fiscal deterioration and make tax hikes and growth a reality. Absent a show of government will in this direction, the market will focus only on the negatives such as a falling capacity to absorb government bonds and difficulties in spurring growth and raising taxes. Japan will be expected to become a deficit country even if it enjoys a current account surplus at that point. Of the forces that pressure the government towards fiscal prudence, market pressure such as rising long-term interest rates should come into play.
Moderate pressure from the market notwithstanding, Japan will likely end up raising taxes and address the problems without inviting disturbance in the market. The Bank of Japan will then need to provide financial support to foster an environment favorable to realizing high growth.