Counting the cost of debt - where has the money gone?

Article Category: Finance  |   

This article is the second of a 2 part feature about calculating international debt, in which we take a look at the different types of debt and try to define what international debt means for all of us who aren't in charge of the nation's finances:

Part Two: Counting the cost of debt

The credit crunch began in 2007 - photo

The 'credit crunch' that began in late 2007, with its toxic mix of disappearing assets, tumbling tax revenues, bank bail-outs and 'quantitative easing' (printing of money), dramatically increased public debt for most advanced economies, with the consequences we saw in Part 1.

What's particularly worrying is that this trend has affected not only notorious spendthrifts such as Greece, Italy, Spain and Japan but also countries where debt seemed well under control before 2008, such as the UK, France, Portugal and Ireland.

Spiralling Debt

If you look at The Economist's Global Debt Clock, which covers 99 per cent of the world economy, you will see that the grand total of international debt is getting on for 56 trillion dollars and rising at more than a million dollars every ten seconds. How much money is that? Well, take a look at our article How Big Is a Billion? and multiply that 56,000 times.

To put it in terms we can all understand, the debt works out at around $10,000 for every man, woman and child on the planet. Given that well over half those people effectively have no taxable income (under $1,000 per year gross), this makes it clear how difficult it will be ever to pay down that debt.

Still, do we really need to? Does it really matter if we theoretically owe all that money?

The Real Cost of Debt

Why does global indebtedness matter? In theory, after all, this should be a zero sum game, with every debtor balanced by a creditor. All that money's still in our world somewhere, right?

Cut the debt, cut the money

Well, that's a matter of debate and so we'll come back to that. The primary issue is that governments need to keep their debt under control lest money markets and rating agencies start to look at them askance. That debt has to be rolled over every so often, as bond issues mature and need to be replaced.

This money has to be raised in the international bond markets, which set interest rates according to calculations of risk. Where a nation's debt seems to be spiralling beyond its capacity to pay, rates start going up. This exponentially increases the cost of the debt, leading to yet greater indebtedness in a vicious cycle that can quickly lead to meltdown, as happened in Argentina and the South East Asian economies in the 1980s and to Greece, Spain, Italy, Ireland and Iceland over the past few years.

So part of the reason why the UK has ridden largely serene through the maelstrom, despite having public debt levels on a par with Spain, Italy and Portugal, is that it's operating on different rollover time cycles. Whereas most countries in the world need to renew their bonds every five years or so, UK sovereign debt enjoys an average life of 13.8 years to maturity. That's nearly double anyone else in Europe, even the Swiss, and means a lot less of Britain's debt comes up for renewal at any one time. This tends to insulate the UK government from any short-term jitters. Quite simply, the system cuts the Brits a lot more slack.

Reducing Debt

This is just as well for Cameron, Osborne et al., since reining back a rising debt requires two things: higher taxes or public spending cuts – probably both. This sucks money out of the 'real' economy of people actually earning money for goods and services, reducing GDP, and increasing the size of the debt by proportion. Again, it's a vicious circle.

This is why so many analysts see high levels of debt as being unsustainable in so many countries, with particular attention on the euro zone's fringes. While Portugal, Italy, Greece, Ireland and Spain (the spitefully acronymed PIGS) have monopolized the headlines, there are also quieter worries about France and Belgium. Even Germany has suffered rating agencies tweaking with credit ratings and threatening downgrades, bolstering fears that the euro could yet collapse under the debt burden, possibly pulling apart the entire European Union. Europe's painful austerity measures have caused political disaffection, polarization, instability and growing protests all over the union – all ramifications of debt.

Where has the money gone?

Just one question remains: where, if anywhere, has all that money gone? After all, if someone owes money then someone else ought to be owed money, right?

But that's to misunderstand how the global monetary system works and how governments pay their way. Debt has risen relentlessly since 1971, which was the year that something very fundamental changed. President Nixon took the USA off the gold standard. Before that, the dollar, like most leading currencies once upon a time, was theoretically backed by gold reserves. In other words, each dollar bill was a notional promise that if the owner wished, he or she could march up to the Federal reserve and exchange that greenback for a fixed amount of gold or silver equivalent to the face value.

Nixon and Churchill
Richard Nixon and Winston Churchill: opposite sides of the gold standard.

Of course this was a notional pledge, but it meant that the Federal Reserve had to maintain a gold reserve worth a prudent proportion of all the dollars in circulation, just as the Bank of England had once had to do with the pound before a former chancellor (one Philip Snowden) fixed Winston Churchill's 1925 mistake and took Sterling off the gold standard for good in 1931.

Nevertheless, it kept the dollar honest, since the printing of dollars had to be partly a function of the amount of gold in Fort Knox. Further, because so many other currencies were pegged by fixed exchange rates to the dollar, it kept the world monetary system honest, too.

Following Nixon's action, the dollar and all the currencies linked to it became mere fiat currencies, backed by little more than faith (along with global demand created by trade patterns).

It also meant that henceforth all issuing of new dollars would be as a function of increased debt. Every time the US Treasury wishes to increase the dollar supply, it raises a new bond – or IOU – that is bought by the Federal Reserve with dollars that it has just printed – or the digital equivalent.

The same thing happens in every other country in the world. Even Switzerland, which had resolutely backed its franc with gold all the way through the 20th century, finally surrendered in May 2000.

So it's a vicious circle. The central bank holds the IOU and the government has the money, which it then spends. When the government runs out, it raises a new IOU, the bank buys it and the merry go round continues.

Exactly the same happens with businesses and families. All the money is raised by debt. So that's where the money went – it was never there to begin with. The money was in debt and the debt is the money.

In the meantime, and for the foreseeable future, the world continues to pay interest on that debt at the equivalent of around $500 annually per person. This distorts international cash flows with consequent effects on economics, politics, and society. More than any other single factor, this might explain why the world seems in such a mess at the moment.

More worrying still, the debt is growing faster than world population or global GDP prosperity, which is the very definition of non-sustainability.

Eventually, something will have to change. But what? And when?

Written by Nick Valentine

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Last update: 09 March 2015

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