Nick Silver: Forget the dogma, there is a way out of this financial mess

Meanwhile the US government hope that they have successfully kicked their fiscal debt-can down the road until after the Presidential elections. While these problems are indeed serious, nearly all Western countries are facing a sword of Damocles over their heads, probably rendering efforts to deal with the current crisis futile.

I recently calculated that the total UK public debt is £5.5 trillion, or nearly four times our total output. If I did these calculations for other western countries, even the supposedly frugal Germans, I would get similar numbers. The figure is much higher than the official government debt because it includes so- called implicit liabilities from unfunded pensions and social security systems.

Implicit pensions debt represents the total future expenditure that government has already committed to pay, in the form of future pension and other benefits payments.

It could be argued that these liabilities are affordable because they are covered from future tax revenues. But because all western countries have ageing populations, government expenditure will inexorably increase as older people require more health care and other benefits. It also means that the tax base will be lower as there will be less people of working ages. These combined with existing pensions’ commitments mean that governments will find it increasingly hard to reduce deficits.

Increasing government deficits could still be sustainable, providing the economy grows fast enough to outweigh the increase. But the very same problems render this virtually impossible.

With an ageing population and low birth rates, even if per capita GDP grows overall GDP growth will not, as the working population is declining. Secondly, as we are heavily indebted this means that future growth prospects are poor.

For example, the US’s leverage ratio, that is the economy’s total debt (not including pensions and social security liabilities) compared to GDP, is 3.6 compared to a historical 1.6. That represents years of de-leveraging and hence stagnation just to get back to normal.

My conclusion is that even if the euro governments manage to somehow stave off disaster, this will only be a temporary respite – if we’re lucky we’ll be wiped out by the next financial shock, otherwise we face a slow and painful economic death.

But there is a way out – we need a grand bargain between governments, financiers and the population.

Firstly, we have to accept that we can’t pay our debts off – the only way out is to take the lead from the ancient Babylonians and enact a debt amnesty. Obviously this will still cause a lot of disruption, but the choice is not if but when, and how to avoid the most pain.

Writing off debt alone is not sufficient – we have to ensure that we do not get back into the same mess and we have to restore confidence. There are three fundamental problems we need to address: firstly to make sure that governments live within their means, secondly we need to limit credit to avoid unsustainable debt-fuelled booms and finally we need to re-negotiate current pension promises and set up sustainable systems that are fit-for-purpose for ageing populations.

For example, sustainable pensions systems could involve mandatory personal accounts or be controlled by an independent body setting the pension level and retirement age based on life expectancy and the budget available for pensions spending. A statist approach to limiting credit would be to place strong regulatory limits on borrowing and capital controls. A free-market approach would be as advocated by the Austrian School which is to move away from fractional reserve banking towards asset backed or even privately issued money.

Finally governments could make sure that budgets cannot become unsustainable by having an independent body determine the spending limit – this leaves right and left wing parties to debate the merits of different levels of tax and expenditure. The point is that there is a technical not political level within which budgets have to operate.

I am not advocating any of these solutions per se but illustrating that there are many options that political parties could adopt without compromising their principles. It is right and proper for democratic institutions to decide on how these problems are addressed, but it is not right and proper to ignore financial reality.

Although it sounds far-fetched, this could even have the added benefit of re-invigorating political discourse. But that would probably be one ask too many.