From ZeroHedge,with some [comments] from us
Imagine a country whose public debt has rapidly climbed to around twice the national income and whose currency has fallen by half on the foreign exchanges. Against the advice of the nation’s most celebrated economist, the government decides to embark on a policy of extreme deflation. This results in a 45% overall decline in the general price level. There is a severe depression. Unemployment soars, accompanied by labor unrest and bloody riots. By the time the deflation is over, the real value of the national debt has climbed to more than 250% of GDP. What happens next? A default on the government debt? A bond market crash as investors shun this junk sovereign credit? A burst of inflation? The prolonged stagnation of an economy crippled with excessive debt? Political collapse?
[Do we recognize this situation? Oh yes. Those deflationary policies are exactly what some, including ZeroHedge are advising. Note that apart from the resulting savage depression, debt actually increased as a result.. ]
The answer is none of the above.The country in question is Britain in the aftermath of the Napoleonic Wars. An enormous debt had been incurred fighting the Corsican upstart. During the war, Sterling convertibility was suspended. Once hostilities ended, the government
planned a return to gold, against the recommendation of the great economist and MP, David Ricardo. The subsequent depression prompted widespread workers’ protests, resulting in the Peterloo Massacre (August 16, 1819) in which 15 people were killed and several hundred injured.
By the early 1820s, the British national debt relative to the national income was far larger than any country had ever experienced. Yet there was no default and no attempt to inflate away the debt. The economy didn’t suffer much from the large public debt and was booming by the middle of the decade. Sterling remained on the gold standard and the price level remained stable. The real purchasing
power of British government bonds quadrupled between 1815 and the end of the century. By the advent of the First World War, the national debt had shrunk to below 40% of GDP.
[Economic growth and mild inflation are the best ways to deal with debt burdens, this is what the UK and the US did with the considerably higher debt levels than today after WOII. Austerity should only be embarked on in emergencies (Greece) or when the economy is on sounder footing]
The US isn’t on the verge of default. As we have seen, there’s a long history of commentators fretting about an impending public debt implosion that never arrives. It’s true that several countries, including the US and UK, have large structural fiscal decits and huge unfunded contingent liabilities. But it’s a mistake to extrapolate current fiscal deficits indefinitely into the future and point to “inevitable” bankruptcy. In time, welfare and pension obligations will be reduced and taxes will rise. We are already witnessing the first round of fiscal tightening in the UK and elsewhere. As long as inflation remains quiescent and bond yields are low, the share of GDP consumed in servicing the government debt remains manageable. Furthermore, large industrial economies, such as the US and UK, have in the past carried large public debt burdens without defaulting. They have deep financial markets and domestic banking systems that are capable of absorbing vast amounts of government debt. Most importantly, unlike Greece and the other stricken Eurozone members, public debt is issued in their own currency and they maintain control over their central banks and foreign exchanges. Given these institutional characteristics, default is extremely unlikely.