Uncontrolled public debt threatens to rupture society as older generations thrive at the expense of the young.
Critics of Western democracy are right to discern that something is amiss with our political institutions. The most obvious symptom of the malaise is the huge debts we have managed to accumulate in recent decades, which (unlike in the past) cannot largely be blamed on wars.
According to the International Monetary Fund, the gross government debt of Greece this year will reach 153 per cent of GDP. For Italy the figure is 123, for Ireland (Xetra: A0Q8L3 - news) 113, for Portugal 112 and for the United States 107.
Britain’s debt is approaching 88 per cent. Japan (EUREX: FMJP.EX - news) a special case as the first non-Western country to adopt Western institutions is the world leader, with a mountain of government debt approaching 236 per cent of GDP, more than triple what it was 20 years ago.
Often these debts get discussed as if they themselves were the problem, and the result is a rather sterile argument between proponents of “austerity” and “stimulus”. I want to suggest that they are a consequence of a more profound malaise.
The heart of the matter is the way public debt allows the current generation of voters to live at the expense of those as yet too young to vote or as yet unborn. In this regard, the statistics commonly cited as government debt are themselves deeply misleading, for they encompass only the sums owed by governments in the form of bonds.
The rapidly rising quantity of these bonds certainly implies a growing charge on those in employment, now and in the future, since even if the current low rates of interest enjoyed by the biggest sovereign borrowers persist the amount of money needed to service the debt must inexorably rise.
But the official debts in the form of bonds do not include the often far larger unfunded liabilities of welfare schemes like to give the biggest American programmes Medicare, Medicaid and Social Security.
The most recent estimate for the difference between the net present value of federal government liabilities and the net present value of future federal revenues is $200 trillion, nearly 13 times the debt as stated by the US Treasury. Notice that these figures, too, are incomplete, since they omit the unfunded liabilities of state and local governments, which are estimated to be around $38 trillion.
These mind-boggling numbers represent nothing less than a vast claim by the generation currently retired or about to retire on their children and grandchildren, who are obligated by current law to find the money in the future, by submitting either to substantial increases in taxation or to drastic cuts in other forms of public expenditure.
To illustrate the magnitude of the problem, the economist Laurence Kotlikoff calculates that to eliminate the federal government’s fiscal gap would require either an immediate 64 per cent increase in all federal taxes or an immediate 40 per cent cut in all federal expenditures.
When Kotlikoff compiled his “generational accounts” for the United Kingdom more than 12 years ago, he estimated (on what proved to be the correct assumption that the then government would increase welfare and health care spending) that there would need to be a 31 per cent increase in income tax revenues and a 46 per cent increase in National Insurance revenues to close the fiscal gap.
In his Reflections on the Revolution in France (1790), Edmund Burke wrote that the real social contract is not Jean-Jacques Rousseau’s contract between the sovereign and the people or “general will”, but the “partnership” between the generations. He writes: “SOCIETY is indeed a contract… The state … is … a partnership not only between those who are living, but between those who are living, those who are dead, and those who are to be born.” In the enormous intergenerational transfers implied by current fiscal policies we see a shocking and perhaps unparalleled breach of precisely that partnership, so brilliantly described by Burke.
I want to suggest that the biggest challenge facing mature democracies is how to restore the social contract between the generations. But I recognise that the obstacles to doing so are daunting. Not the least of these is that the young find it quite hard to compute their own long-term economic interests.
It is surprisingly easy to win the support of young voters for policies that would ultimately make matters even worse for them, like maintaining defined benefit pensions for public employees. If young Americans knew what was good for them, they would all be in the Tea Party.
A second problem is that today’s Western democracies now play such a large part in redistributing income that politicians who argue for cutting expenditures nearly always run into the well-organised opposition of one or both of two groups: recipients of public sector pay and recipients of government benefits.
Is there a constitutional solution to this problem? The simplistic answer which has already been adopted in a number of American states as well as in Germany is some kind of balanced-budget amendment, which would reduce the discretion of lawmakers to engage in deficit spending, much as the practice of giving central banks independence reduced lawmakers’ discretion over monetary policy.
The trouble is that the experience of the financial crisis has substantially strengthened the case for using government deficit as a tool to stimulate the economy in times of recession.
Last year, following a German lead, continental European leaders sought to solve that problem by resolving to limit only their structural deficits, leaving themselves room for manoeuvre for cyclical deficits as and when required. But the problem with this “fiscal compact” is that only two eurozone governments are currently below the mandated 0.5 per cent of GDP ceiling; most have structural deficits at least four times too large, and experience suggests that any government that tries seriously to reduce its structural deficit ends up being driven from power.
It is perhaps not surprising that a majority of current voters should support policies of intergenerational inequity, especially when older voters are so much more likely to vote than younger voters.
But what if the net result of passing the bill for baby boomers’ profligacy is not just unfair to the young but economically deleterious for everyone? What if uncertainty about the future is already starting to weigh on the present? As Carmen Reinhart and Ken Rogoff have suggested, it is hard to believe that developed country growth rates will be unaffected by mountains of debt in excess of 90 per cent of GDP.
It seems as if there are only two possible ways out of this mess. In the good but less likely scenario, the proponents of reform succeed, through a heroic effort of leadership, in persuading not only the young but also a significant proportion of their parents and grandparents to vote for a more responsible fiscal policy. As I have already explained, this is very hard to do. But I believe there is a way of making such leadership more likely to succeed, and that is to alter the way in which governments account for their finances.
The present system is, to put it bluntly, fraudulent. There are no regularly published and accurate official balance sheets. Huge liabilities are simply hidden from view. Not even the current income and expenditure statements can be relied upon. No legitimate business could possible carry on in this fashion.
Public sector balance sheets can and should be drawn up so that the liabilities of governments can be compared with their assets. That would help clarify the difference between deficits to finance investment and deficits to finance current consumption.
Governments should also follow the lead of business and adopt the Generally Accepted Accounting Principles. And, above all, generational accounts should be prepared on a regular basis to make absolutely clear the intergenerational implications of current policy.
If we do not do these things then I am afraid we are going to end up with the bad, but more likely, second scenario. Western democracies are going to carry on in their current feckless fashion until, one after another, they follow Greece and other Mediterranean economies into the fiscal death spiral that begins with a loss of credibility, continues with a rise in borrowing costs, and ends as governments are forced to impose spending cuts and higher taxes at the worst possible moment.
There is, it is true, a third possibility, and that is what we now see in Japan and the United States, maybe also the United Kingdom. The debt continues to mount up. But deflationary fears, central bank bond purchases and flight to safety from the rest of the world keeps government borrowing costs down to unprecedented lows. The trouble with this scenario is that it also implies low to zero growth over decades.
As our economic difficulties have worsened, we voters have struggled to find the appropriate scapegoat. We blame the politicians whose hard lot it is to bring public finances under control. But we also like to blame bankers and financial markets, as if their reckless lending was to blame for our reckless borrowing. We bay for tougher regulation, though not of ourselves.
This is an edited extract from the first of Prof Niall Ferguson’s four Reith Lectures, to be broadcast today on Radio 4 at 9am