interest rates will impose an increasing burden.
We will discuss these in turn.
1. Borrowing from Abroad
We have already discussed the problems that servicing foreign debt can create and, in view of these, it is hard to see why any country should ever borrow abroad at all. Foreign capital creates problems when it enters a country and further problems when it leaves. When it comes in, it boosts the country’s exchange rate, thus hurting firms producing for the home market by making imports cheaper than they would otherwise be. It also hurts exporters, reducing their overseas earnings when they convert them into their national currency. As a result, when the loan has to be repaid, the country is in a weaker position to do so than it was when it took the loan on — its imports are higher and its exports reduced. Foreign borrowing is so damaging that it has even been claimed that the Chinese policy of pegging its currency to the dollar at a rate which makes its exports very attractive and keeping that rate by lending a lot of the dollars it earns back was designed by military strategists to destroy America’s manufacturing base.2 The strategists are said to have argued that no superpower can maintain its position without a strong industrial sector, so lending back the dollars China earned was a handy way to destroy the US ability to fight a major war.
For a country with its own currency, the alternative to borrowing abroad is to allow the value of its currency to float so that its exports and imports are always in balance and it never need worry about its competitiveness again. As eurozone countries no longer have this option, they have very few tools to keep exports and imports in balance. Indeed, it’s hard to know what they should do to deter foreign borrowing because, while the state may not borrow abroad itself, its private sector may be doing so. In Ireland, for example, the net indebtedness of Irish banks to the rest of the world jumped from 10% of GDP in 2003 to over 60% four years later, despite the fact that some of the state’s own borrowings were repaid during these years. All the state could have done to stop this borrowing would have been to restrict lending that was based on the overseas money. For example, it could have placed a limit on the proportion of its loans that a bank could make to the property sector, or stipulated that mortgages should not exceed, say, 90% of the purchase price and three times the borrower’s income. This would have dampened down the construction boom and limited the growth of incomes and thus import demand. But such indirect methods of control are not nearly as potent as allowing the market to achieve balance automatically. Their weakness is a very powerful argument for breaking up the eurozone.
Although one might accept that borrowing abroad for income purposes comes at the cost of undermining its domestic economy, it could be argued that capital inflows for use as capital will allow a country develop faster than would otherwise be the case. Let’s see if this argument stands up.
The danger with bringing capital into a country with its own currency is that part of it will become income in the ways we discussed and thus boost the exchange rate and undermine the domestic economy. So, if we restrict the capital inflow to the actual cost of the goods that the project will need to import, is that all right? Well, yes, it might be. It depends on the terms on which the capital is obtained, and whether the project will be able to earn (or save) the foreign exchange required to pay the investors. If the world economy shrinks as we expect, it is going to be harder to sell the product and its price may fall. This might mean that interest payments would take a greater share of the project’s revenue than was expected, causing hardship for everyone else. So, as we will discuss later, the only safe approach is for the foreign investor to agree to take a fixed portion of the project’s foreign revenue, whatever that is, rather than a fixed sum of money based on the interest rate. This would ensure that the project never imposed a foreign exchange burden on the country as a whole. The foreign capital would be closer to share capital than a loan. This should be the only basis that any country should allow foreign capital in.
At present, however, so much foreign capital is moving around that its flow might need to be limited to prevent destabilizing speculation. As Rein hart and Rogoff point out, “Periods of high international capital mobility have repeatedly produced international banking crises, not only famously as they did in the 1990s, but historically.” One solution to this, again for countries with their own currencies, is to have two exchange rates; one for capital flows, the other for current (i.e. trading) flows. This would mean that people could only move their capital out of a country if others wanted to move theirs in. Rapid, speculative flows would therefore be impossible. Ireland had this system when it was part of the Sterling Area after World War II until Britain abandoned it around 1979. It was known as the dollar premium. South Africa had a capital currency, “the financial rand,” which gave it financial stability throughout the apartheid period. It dropped it in 1995.
Keeping capital and current flows apart would greatly reduce the power of the financial sector. After they were divided, no one would ever say as James Carville, President Clinton’s adviser, did about the bond markets in the early 1990s when he realized the power they had over the government, that they “can intimidate everybody.”
Of course, the threat to its power will mean that the financial sector opposes capital-flow currencies tooth and nail. Yet its power, and income, must be reduced, especially if incomes in other sectors of the economy are going to fall. According to the OECD, the share of GDP taken by the financial sector (defined as “financial intermediation, real-estate, renting and business activities”) in the United States increased from 23% to 31% between 1990 to 2006. The increase in the UK was over 10% to about 32% and around 6% in both France and Germany.
The rise in the sector’s share of corporate profits was even more striking. In the United States, for example, it was around 10% in the early 1980s but peaked at 40% in 2007. Mentioning these figures, Már Gudmundsson, the deputy head of the Monetary and Economic Department of the Bank for International Settlements, told a conference in the US in 2008 that the financial sector needed to become smaller and less leveraged: “That is the only way the sector can be returned to soundness and profitability in the environment that is likely to prevail in the post-crisis period.” I would put it much more strongly. The British sector’s income is bigger than those of agriculture, mining, manufacturing, electricity generation, construction and transport put together, and the sector’s dominance in other economies is similar. It is a monstrous global parasite that needs to be cut down to size.
The Financial Tail Wags the Societal Dog
GRAPH 5. The financial sector in five rich-country economies, the US, Japan, the UK, France and Germany, has been taking an increasing share of national income over the past twenty years, in part because of the increasing debt burden. The sector is now bigger in each country than all the productive sectors put together. Source OECD.
2. Allowing Inflation to Correct the Debt-Income Imbalance
As the amount of energy in a liter of petrol is equivalent to three weeks’ hard manual work, having power at one’s disposal can make one much more productive. A country’s income is consequently largely determined by its direct and indirect energy use. So, whenever less energy is available, incomes fall and debt becomes harder to service unless an inflation is allowed to increase money incomes and reduce the real burden imposed by the debt.
This has been demonstrated by two real-world experiments. After OPEC’s first oil-supply restriction in 1973, the world’s central banks allowed the inflation created by the higher oil prices to go ahead. By reducing the burden of existing debt, this made room for the commercial banks to lend out the money that the oil producers were unable to spend. The US came out of the recession quickly and Britain did not have one at all. Developing countries did well too even though they were paying more for their oil, because the prices of their commodity-exports increased more rapidly than the rate of interest they were being charged on their external debts and, although they borrowed from
