A Socio-Economic Experiment on $ 58 Trillion

Historically most governments saddled with vast debt have removed them by default, devaluation or war.

Some Examples

• Greece: 5 major defaults in less than 200 years
• Germany : sovereign default(1948)
• Russia: sovereign default and devaluation (1998)
• Argentina: sovereign default and devaluation (2001)
  Reference Link

“When national debts have once been accumulated to a certain degree, there is scarce, I believe, a single instance of their having being fairly and completely paid.” – Adam Smith from the Wealth of Nations

In dealing with sovereign debt there are 2 major schools-of-thought.

School of Hard-knocks
This economic school of thought believes that once debt has blown out of proportion, the best way to reduce it is to rationalize government spending and increase taxes.

A study by consultants Oxford Economics has stated that most of the savings should come from the cuts in current government expenditure (spending on recurring items like pay-roll, amenities).The capital spending on infrastructure should continue. Furthermore the study goes on to state that If more than 30% of the savings come from tax rises then it can negatively impact economic growth
Some examples in history that have resorted to government cuts and been successful are: Sweden, New Zealand and Canada

School of Hard-rock

This school of thought believes that the party cannot stop. In other words the only way to reduce government debt is for the economy to grow faster resulting in higher tax collection to pay-off debt. Some of the common scenarios where it can happen are

• Technological advancement affecting productivity (for example the internet). When this advancement increases productivity it increases output and stimulates growth. Climate change even if proven and implemented, cannot provide this increase in throughput. The only way the west can benefit from it is if the west manages to sell this technology to the emerging markets.
  • An increase in consumer spending

IMF economist Oliver Blanchard and Carlo Cottarelli note:”strong growth has a staggering effect on public debt. A one percentage point increase in potential growth lowers the debt ratio by 10% within 5 years”.
Some common examples are QE1, QE2 and Japan. Their success is debatable / yet to be seen.
What both schools of thought have in common, Is that they have not been tested in a period of global weakness. In the past these corrective measures have been applied when the rest of the world was doing fine. This is like a large scale economic experiment on a 58 Trillion dollar economy (World GDP 2010).
Economics is a nascent science that is still learning from the past. I reckon there will be much learnt from this event. The most interesting battle is not “Emerging versus Developed Markets” or “China versus India”.
It is the battle of economic ideas – history will remember this as a time when 2 wounded titans were looking for a weapon in a battlefield drowned in dead-bodies
My personal opinion (probably not worth much) is that if I were the CEO of a company, in a recession I would prefer to become leaner and more efficient through cost cutting measures as opposed to hoping that customers will buy more because I am spending more on advertising. By extension – the captains of economy should also resort to cost-cutting. Financial and operational prudence would be the order of the day. – But that’s just me.