Why Democracies Have A National Debt Problem

Published in Investing on 12 April 2012

Politicians promise public spending increases to gain popularity.

"There never was a democracy yet that did not commit suicide" -- John Adams

Every modern democratic state has a national debt because its voters like politicians who increase public spending. Most voters prefer it if other people's taxes are raised to pay for any new spending, but since this usually won't bring in enough revenue, then the state has to borrow to make up the difference -- and these deficits accumulate over time to form a very large sum.

The current French presidential election gives us a good example of this, as the favourite, François Hollande, is leading the polls because he is calling for huge spending increases, which would push France's national debt to levels that would damage its economy.

Once a country's debt reaches a certain size it starts to restrict economic growth, and if the debt then grows at a faster rate than the economy for too long, eventually it will be unable to service it. Then the country defaults on its debts, as Greece recently did, and it will enter a spiral of decline, which forces it to slash public spending.

I'm a big taxpayer, get me out of here

Nowadays, governments find it hard to make up the difference between spending and taxation because of competition from other countries. If taxes are too high, the high-earning companies and individuals who pay a substantial proportion of the income and corporate taxes can easily move themselves and/or their capital abroad to a country with lower tax rates.

During the last financial year the top 5% of British taxpayers paid approximately 47% of the total income tax take, so it wouldn't require many of them to emigrate in order to make a big dent in the government's income. The increasing mobility of high earners nowadays is a major reason behind the trend in many countries towards higher taxes upon land and consumption, as these are much harder to avoid.

California dreaming

It's often said that America is five years ahead of Britain, and this is certainly the case when it comes to the national debt. The US federal government owes about $15.6 trillion, which is almost 100% of the gross domestic product, compared to a mere 65% in the UK, and many states and cities have also built up huge debts as their spending commitments have continued to outstrip their income.

One of the best examples is California, which has been in serious financial difficulty for several years. The root cause of the problem is that, under Californian law, large groups of people are able to get single-issue proposals onto state election ballots. If these are then approved by the voters, they become binding upon the state government.

The use of single-issue referenda took off in the 1970s, and ever since then California's voters have used the ballot box to limit the state's ability to raise taxes while also passing laws to increase spending. The best-known of these is "Proposition 13", which amended the state constitution to stop property taxes from being raised above a certain level.

Borrow or print? Or both

An alternative to borrowing is to print money, though nowadays this goes by the name of "quantitative easing". Doing so pushes up inflation, which has the happy side-effect for the state, and other borrowers, of eroding the real value of their debts.

Eventually, lenders become wise to this 'inflation tax' and demand higher interest rates to compensate, but politicians nonetheless still keep on trying to buy votes. This leads to the situation we're currently experiencing in Britain where public spending is at an all-time high and where the government has to borrow even more money, while the Bank of England stokes inflation in order to debase the debt!

The investment angle

Investors must expect bouts of inflation as governments are easily tempted to periodically use it to reduce their debts. Furthermore, you should expect the less creditworthy nations such as Greece to periodically default. A good example of this is that the last few days have demonstrated that concerns remain as to whether Spain will eventually default.

The best protection against inflation is to own real assets, such as land, property, shares, gold (and other precious commodities) and index-linked bonds, as these tend to follow inflation over long periods of time.

Don't keep all of your assets in the same country and be wary of lending money to countries with a track record of defaulting on their debts, like Greece, which has spent half of its life as an independent country in default, unless you believe that the interest rate that you're getting more than justifies the higher risk that you're taking on.

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Comments

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goodlifer 12 Apr 2012 , 11:55am

Why Democracies Have A National Debt Problem

Don't ALL governments have a national debt problem?
For much the same reasons?

jegwe 13 Apr 2012 , 3:11pm

Government borrowing should be viewed in the same way as personal borrowing for a mortgage i.e. they should be allowed to borrow a certain multiple of their income and should be required to pay it back over 25 years. They will then reach the same situation as the older part of the population and will be debt free.

However, unlike the elderly they will still have their source of income. There is therefore no need for established economies to be borrowing at all. That way they can retain wealth and use it effectively.

It is up to the electorate to demand this and to stop electing governments with excessive borrowing requirements. It is also time that government was subject to the same sort of scrutiny and regulation that is imposed on financial institutions and the ministers responsible for maintaining state finances should be subject to the same penalties as the CEO's of financial institutions if they breach them.

This is a long term goal which I why I would allow borrowing for a few decades, but there should be a legally binding requirement that government borrowing was reduced year on year instead of increasing. It is the same principal as paying off a mortgage, and then being richer once it is paid off. A wealthy first world state with a long history and an established economy should not need to borrow.

longpod 13 Apr 2012 , 7:19pm

Governments/Local Councils who spend more than their income should by law have to impose fines on the individuals responsible.

brokebee 13 Apr 2012 , 8:14pm

I'm with jegwe but I wonder about going further - if national debt increases in any year, or unemployment increases in any year, then I why not cut all MP's salaries by, say, 10%?

goodlifer 14 Apr 2012 , 10:52pm

Hi jegwe,

"A wealthy first world state with a long history and an established economy should not need to borrow."
So why do they all borrow?

Answer: mainly to "create " jobs
If people don't spend, other people go bust - or so most economists seem to think.

It's a sad fact that most of us would rather have some sort of a job in a lousy economy than be unemployed in a brilliant one.

goodlifer 15 Apr 2012 , 10:50pm

I've just remembered walking through London, in my service days - around the 1950s - with an aristocratic brother-officer who explained to me, quite forcibly, that our prosperity wouldn't pick up till we saw a few more beggars and unemployed lining the streets.

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