DEBT WEIGHT / PROJECT SYNDICATE

Debt Weight

For decades, countries around the world borrowed heavily from their own citizens under the false impression that this approach was less dangerous than issuing debt denominated in foreign currencies. The surge in global interest rates has shattered this illusion.

Harold James

PRINCETON – Today’s inflationary surge calls for re-evaluating the politics of public debt. 

With interest rates rising around the world, we must reassess which types of debt are viewed as stabilizing and sustainable, and which are likely to cause economic instability and political volatility.

In June, the Bank of England and Turkey’s central bank dramatically increased their interest rates. 

While the BOE raised its rate by 0.5%, the Turkish central bank was even more aggressive, nearly doubling its policy rate from 8.5% to 15%. 

Interestingly, these actions did not result in the major exchange-rate recoveries that typically follow interest-rate hikes. 

Nevertheless, central bankers will most likely be blamed for the subsequent pain. 

In both countries, however, monetary policy has been stymied by fears about fiscal stability and debt levels.

Over the past 40 years, much of policymakers’ attention has centered on the burdens resulting from foreign debt. 

It is not hard to see why: the most spectacular debt crises of the twentieth century all had to do with external borrowing. 

There is a common thread that connects the 1890 Baring crisis – an Argentine default that nearly brought down a large British bank – to the Great Depression, the Latin American debt crisis of the early 1980s, the East Asia crisis of the late 1990s, and Argentina’s default in the early 2000s. 

These panics mostly involved sovereign borrowing that proved to be unsustainable, either because major commodity prices fell, as in the Great Depression, or because international interest rates surged, as in the early 1980s.

The response to this type of crisis typically involved some sort of debt restructuring. 

Ultimately, the substantial financial claims accumulated by foreigners in moments of heady optimism about borrower countries’ growth prospects had to be reconciled with reality.

But the current debt crisis seems to be different. 

As the United Kingdom and Turkey were reeling from the latest interest-rate increases, global leaders gathered in Paris for the June 22-23 Summit for a New Global Financing Pact to discuss ways to reduce the debt burdens of low-income countries grappling with a confluence of shocks, including the COVID-19 pandemic, supply-chain disruptions, and Russia’s invasion of Ukraine.

For decades, the lesson from recurring debt crises was that foreign debt was inherently dangerous. 

Avoiding short-term capital inflows driven by temporary mania, it seemed, was necessary to protect borrowing countries’ well-being and that of the international economic order. 

Fortunately, there appeared to be a much more sustainable, healthier alternative. 

In contrast to foreign debt, domestic debt has traditionally been viewed as a virtuous tool giving citizens a stake in their country’s political system. 

Lenders, the thinking went, were bound by civic obligation and patriotism.

This model originated in Italian city-states during the late Middle Ages, particularly the prominent trading city of Genoa. 

The Casa di San Giorgio, a public bank established in 1407 to consolidate the city’s debts on behalf of a large number of citizens, was even praised by Machiavelli.

By the late seventeenth century, England adopted the Genovese model of municipal governance and implemented it on a much larger scale, resulting in the establishment of the BOE. 

As modern political scientists and economists from Douglass North and Barry Weingast to Daron Acemoglu and James Robinson have observed, the national debt was held by an institution owned by citizens who were also represented in Parliament. 

Their elected representatives could vote on how revenues were allocated, ensuring that the government regularly serviced its debts to the central bank.

The accumulation of domestic debt was thus linked to constitutionalism. 

Alexander Hamilton, the United States’ first Treasury Secretary, drew inspiration from the BOE when he proclaimed that public debt constituted “the strong cement of our Union.”

From this perspective, foreign borrowing is a fallback option that governments and countries resort to when they require resources that their own citizens are unwilling or unable to provide. 

According to this logic, developing domestic financial markets would enable governments to escape the trap created by foreign indebtedness and borrow mainly from their own citizens, in their own currency.

In recent years, some advocates of Modern Monetary Theory have proposed a simple balance-sheet view that considers all domestically held national debt beneficial. 

By making the liability of the state the asset of the citizen, more debt could make everyone richer. 

But two relatively recent events – distinct but related to the COVID-19 pandemic – have challenged the increasingly popular notion that domestic borrowing has no downsides.

The first event is the mini-debt crisis that shocked the UK in September 2022. 

At an estimated cost of £45 billion ($57 billion), then-Prime Minister Liz Truss’s aborted plan to abolish the 45% top income-tax rate may have seemed small relative of debt. 

But it led to a surge in interest rates and a fall in the value of longer-term government debt. 

This, in turn, triggered a sell-off of government bonds, which spiraled into a vicious cycle as institutions, primarily pension funds, offloaded their assets.

The second event is Ghana’s default in late 2022. 

Struggling to service its debts after the pandemic caused revenues to fall and spending to rise, the country initiated an external debt restructuring and a domestic debt exchange program. 

But as interest rates and inflation rose, so did local-currency debt, resulting in more and more of the country’s tax revenues going toward servicing it. 

Given that three-quarters of those payments went to Ghanaian citizens, the government’s initial plan to impose a drastic haircut understandably triggered an intense public backlash.

The rise in global interest rates has shattered the grand illusion that domestic borrowing is less polarizing and divisive than foreign debt. 

While Hamilton may have viewed debt as a means to solidify a state’s authority, the cement metaphor is apt in more ways than one. 

Much like cement, an excess of debt can become politically burdensome, immobilize governments, and weigh down economies.

Harold James is Professor of History and International Affairs at Princeton University. A specialist on German economic history and on globalization, he is a co-author of The Euro and The Battle of Ideas, and the author of The Creation and Destruction of Value: The Globalization Cycle, Krupp: A History of the Legendary German Firm, Making the European Monetary Union, and The War of Words.