We have all read about the standard “fixes” for a governmental debt problem – (1) inflate your way out of the problem, (2) cut programs and/or raise taxes, and (3) restructure debt, perhaps delaying repayment and giving bondholders a “haircut” on promised payouts.
A fourth one seems to circulate through peak oil circles, namely “debt jubilee”. It seems to me that there is really a fifth option as well, and that is the one that may actually get used more this time around, at least in some parts of the world. The fifth one is “do a disappearing act.” The government in question folds up, and maybe a new government is formed, or maybe not. If debt is really a problem, the new government would not take on the obligations of the previous government.
The country that exemplifies the “do a disappearing act” is the Former Soviet Union, but there are other examples as well. Both Czechoslovak Socialist Republic and the Socialist Republic of Yugoslavia broke up as well, about the same time. In the case of Yugoslavia, a war was involved, but in the other cases the breakup was relatively peaceful.
It takes energy and money to maintain a country that covers a large area. If energy is cheap, then it is easier to provide needed services–economic growth is higher, costs of transporting goods long distances are lower, and collecting taxes works better. As long as a country is growing economically (especially if there is job growth to go with the economic growth), then it is easy to collect rising amounts of tax dollars, because the tax code that is in place provides rising tax revenues simply because of income growth, without formally raising taxes.
When an economy shifts to no growth or actual economic decline, with falling GDP, then it is much more difficult to keep tax revenue from falling. There are theoretical ways of fixing the problem (all of the ways on the list above), but if there is a major imbalance, then solutions (2) and (3) above don’t work well at all, and a government needs to resort to some other approach.
Example of the Soviet Union Breakup
If we look at the example of the Former Soviet Union (FSU), we find that they were faced with falling prices with respect to their major export, oil, and because of this were having major financial problems, prior to their break-up:
Figure 1. Former Soviet Union oil production and oil price (2010$) based on BP Statistical Data
The peak in oil prices came in 1980. The Soviet Union continued drilling. We don’t know what their cost of production was, but presumably, they could continue to make at least some profit at the lower prices in the early 1980s. Wikipedia tells us, “Although statistics of the Soviet economy are notoriously unreliable and its economic growth difficult to estimate precisely, by most accounts, the economy continued to expand until the mid 1980s.” In another Wikipedia article we read, “The dramatic drop of the price of oil in 1985 and 1986, and consequent lack of foreign exchange reserves in following years to purchase grain profoundly influenced actions of the Soviet leadership.”
In 1987, FSU production hit a peak of oil production, presumably reflecting the fact that there was less oil available that could be profitably pumped at the low prices. This would seem to tie in with the lack of foreign exchange reserves, mentioned above. Finally in 1991, four years after oil production fell, the FSU collapsed. It was only when prices started rising again in the 2000s that production began to rise.
Figure 2. Former Soviet Union Oil Production and Consumption, based on BP Statistical Data.
When we look at FSU oil consumption (Figure 2), we find that it did not fall until 1991–the year of the collapse. The actual collapse came in December. Prior to that, oil consumption had remained level, despite falling oil production since 1987 and despite falling revenue from oil production, starting even earlier.
After the collapse of the Soviet Union, both production and consumption fell further. In fact, production and consumption of natural gas and coal fell as well. Even today, consumption of oil is low. Natural gas consumption has risen somewhat, but the FSU uses much less fossil fuels than it did prior to its breakup.
Why a Government Needs to Keep Tax Revenues Growing
A government exists to provide services to its citizens. Some of these services are things that take place on an ongoing basis–road building and repair; operation of schools; police and armies; issuance of patents; operation of parks; and regulation of food and drugs, for example. Some of these are more long-term–for example, Social Security, Medicare, FDIC guarantee of bank accounts, and PBGC guarantee of pension payments.
Maintaining these programs depends on economic growth to a significant extent. Long-term programs especially depend on economic growth, to keep them properly funded. Pension plans are based on the premise that the stock market will keep growing, and that bonds will pay out according to plan. If this is not the case, the government gets left trying to make up the shortfall.
Even on a short-term basis, governments are hit doubly hit by the recessionary impact of high oil prices:
(1) Outgo is higher, because of stimulus costs, bailouts for organizations that need bail-outs, and higher benefit costs, directly or indirectly because of unemployment.
(2) Income is lower, because fewer people are employed and pay taxes. For local governments, there may also be the issue of falling home values making it harder to collect enough tax revenue.
Figure 3. Average quarterly oil price and US Federal External Debt
Governments find themselves quickly going into debt, when recession hits following an oil price spike. Figure 3 shows how quickly this happened for the United States, when oil prices spike in July 2008. It also shows that the increase in debt is continuing. Now we have a second oil price spike, and the possibility of another recession. If the government tries to provide stimulus as in the past, it faces the possibility of a widening gap between revenue and expenditures. If the government cuts benefits and lays off workers, it is likely to send the country further into recession. But sometimes there seems to be no other choice.
Considering Options to Get Out of a Debt Problem
Option 1. A country’s first choice for dealing with debt is to try to inflate its way out of debt. Ben Bernanke is known as “Helicopter Ben” for his speech in which he mentions Milton Freeman’s previous mention of using a helicopter drop of money to prevent deflation.
In order to allow citizens to repay their debts, it seems to me that what needs to be inflating is salaries. Also, enough people need to be working, so that most people are actually collecting the funds needed to repay debt. If salaries are inflating and enough people are working, then business revenues and government revenues will inflate as well, so that repaying debt plus interest won’t be too terrible a task. At this point, there is not even a hint that salaries are inflating, and that the unemployment problem has been solved.
Option 2. If a country has just a “little” debt problem, then option (2) above, raising taxes and/ or laying off workers/cutting programs might work. The downside is that it is likely to send the country further into recession, and will make many voters unhappy. A politician who wants to be re-elected may therefore find this approach objectionable. In most cases, it needs to be combined with cutting longer term programs, something else that voters are likely to find objectionable.
Option (3) above, restructuring debt, perhaps delaying repayment and giving bondholders a “haircut” on promised payouts, would be a shock to financial markets. Governments are accustomed to borrowing increasing amounts of money. Once restructuring of a debt of a major country starts taking place, that country is likely to have a hard time obtaining new debt, except at very high interest rates.
If a country defaults using this approach, the action is likely to be looked down upon by both governments of other countries and by voters. Unless the revenue/expenditure problem was really tiny prior to the default, the government will still faces a major need for austerity–cutting programs and raising taxes, in order to match revenues and expenses, and have enough to repay the debt on the more generous terms. Option (3) only works if the country is in a fairly good financial state prior to the default–that is, on an ongoing basis, can pay for its programs, and still have money left over to pay back debt. There are many OECD countries not doing this well.
Option 4. A debt “jubilee” of some sort, in which all debts are forgiven. I have a difficult time seeing any agreement to this kind of thing happening, because there will always be winners and losers, and the losers will be unhappy. There are assets underlying some of the debt, and the question will be, which of the several possible claimants should get the underlying asset. For example, if a person has paid for 25% of the value of his home, should he get to keep it, or should one of the various owners of the mortgage on the home get possession of the home? Some of these debts will be international. What is to prevent retaliation, in the form of a grab of property of some other property-owner, if there is a default in a foreign country?
There is also the problem that the debt jubilee doesn’t really help with all of the long-term programs that cannot really be funded with declining resources.
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Figure 4. Two views of future growth
When programs such as Social Security, Medicare, and guarantees of banks, insurance companies, and pension funds were established, the view was that resource growth /economic growth would continue forever, as in Scenario 1 of Figure 4. If the real situation is more like Scenario 2 of Figure 4, there is a need to rework the whole system–reduce promised benefits, and probably forget the bank and pension guarantees. It is hard to see that these ideas would “sell” well with voters.
Option 5 looks like the easy way out. Just give up, and let a new government come in, and start with new programs and a blank slate. Or a revolution or civil war might produce this same result.
There seems to be a chance that if Option 5 occurs, there will never be a replacement for some governments. No replacement central government came into existence in the case of the Soviet Union break up, or the breakups of Czechoslovak Socialist Republic and Socialist Republic of Yugoslavia.
There are many locations where such break ups would seem to be possible. The European Union is one entity that would seem to be at risk of break up, if things continue to go badly with respect to the debt of individual members. The United States seems solid, but when a person looks at its debt situation, there would seem to be at least a small chance that at some point in the future, it will cease to exist. Canada doesn’t have quite the debt problems of the United States, but it has huge disparities among regions that increase tensions, especially if the US should break up.
There would even seem to be the possibility of breakup at a lower level than country. If the United States should break up (with perhaps some states regrouping to form new unions), it seems as though a state with huge debt problems, such as California or Illinois, could also break up, leaving counties to regroup as they choose.
There are no doubt many countries around the world where this pattern could hold. Many countries were put together by combining people of various ethnic backgrounds. If things go badly financially, and transportation becomes more difficult because of fuel problems, these countries too could be at risk of break up.
Obviously, if this pattern of break-up were to occur, there would be huge ramifications for international trade, for international businesses, and for lives of individual citizens. We can hope that I am wrong, and that our current systems for handling debt problems will somehow work provide solutions for most.
By. Gail Tverberg
Gail Tverberg is a writer and speaker about energy issues. She is especially known for her work with financial issues associated with peak oil. Prior to getting involved with energy issues, Ms. Tverberg worked as an actuarial consultant. This work involved performing insurance-related analyses and forecasts. Her personal blog is ourfiniteworld.com. She is also an editor of The Oil Drum.
