It is likely that there will soon be intense discussion, in most parts of the world, about ways to deal with out-of-control debt. After about three decades of mostly falling interest rates, which made it ever easier to increase leverage, global debt is over 300 per cent of the world economy. In Australia the pattern is mainly seen in the household sector because of two decades of soaring house prices and reckless bank lending. But the problem is everywhere, including in China. It is a centuries-old phenomenon that occurs because compound interest on debt increases geometrically while economic growth or income growth increases only linearly. As a result, sooner or later the debt burden becomes unsustainable. Hence the long history, over thousands of years, of either debt cancellation or debt relief.
Wholesale debt cancellation is not possible in developed economies for two reasons. Most of money in the system is credit with an interest rate on it (cash, which is interest free, is only a small proportion of the overall money supply). Cancelling credit too aggressively runs the risk of destroying the banks, triggering collapse. The only way to save the banks would then be to nationalise them, which may be possible in China where the banks are state-owned, but in the West is not viable because the banks are mostly private entities.
The second reason is that older civilisations did not have the dominant proportion of their human activity subject to financial transactions, as is the case now. The monetary/debt system would have applied to activities like farming, but not to the whole span of human activity. That is not the case now; modern society is monetised to an extreme degree. Making a change to how money works in modern societies would completely change the character and foundations of modern life.
We are seeing the end of what the economist Michael Hudson calls ‘financial capitalism’, as opposed to ‘industrial capitalism’ – the implication being that only the latter is genuinely productive. So what options are likely to be explored? One is to default on the debt by calling it something else, like a ‘restructure’. This has often been done, even by the United States, which likes to brag that it has never defaulted on its debt. In 1933 the US, during the first administration of president Franklin D. Roosevelt, did ‘restructure’ its debt unilaterally imposing a 41 per cent loss on investors. Those debts equated to almost 1.7 times the nation’s GDP.
Another possible strategy is to undertake what is called a debt-for-equity swap. This term was widely used during the Latin American debt crisis in the 1980s, which at the time imperilled America’s and Europe’s banking system. The Western banks had assumed that nations would never default on their sovereign debt. But they had not taken into account the behaviour of the Latin American senior bureaucrats and politicians, who pocketed a significant proportion of the funds, placing it offshore in their own names – in some cases in the same banks that made the loans in the first place.
A version of what amounts to debt-equity swaps has intermittently been happening since Covid, including in Australia. It is called quantitative easing (QE), a tactic devised by Japan when it went into a decades-long recession because of out of control indebtedness. QE involves central banks printing cash to fund conversions of the national debt, principally by buying back government bonds. It can be inflationary, which is probably one reason why inflation is soaring in the US and Europe (that did not happen in Japan because the country was in a severe deflationary spiral).
'We know, after thousands of years of evidence, that the debt-based system of money eventually self-destructs and this time the effects are likely to be felt around the world. One solution could be to convert debt to equity; make significant changes to the way that the capital in capitalism functions.'
QE is not really a debt for equity swap, though. It is just a way of shuffling debt around, or trying to make it go away. What would be far preferable is to actually start working out how to meaningfully make the conversion by massively deepening equity markets. In Australia’s farming sector, for example, swapping debt for equity would greatly enhance the sustainably of the nation’s oldest industry. Because farming income is so volatile, debt, which requires regular interest payments, is not suitable. If a proportion of it could be swapped for equity by creating a diversified vehicle to attract some of Australia’s burgeoning superannuation funds, and then inject equity capital into the sector, it would help protect farmers from their perennial risk.
There is extensive evidence that debt accumulation eventually destroys the financial system whereas equity (shares on the stock market or private shares) does not. With debt, when the interest on the debt cannot be paid, then the transaction fails. Similarly, a rapid repricing of the value of a debt instrument imperils the system: banks can only survive a comparatively small level of defaults on their loans.
With equity it is different. There are no regular interest payments, just dividends, which are paid in good times but need not be when things are difficult. Shares can be repriced – and routinely are – without putting stress on the system. Stock markets operate something like a shock absorber when the system is under stress.
If there is a financial crisis, swapping debt for equity may become involuntary. Some analysts think there is a possibility that stressed banks in some countries will force depositors to convert their savings into shares in the same bank.
Money is just a set of rules. What needs to be asked is: ‘What rules of money will best serve society and not cause crises?’ We know, after thousands of years of evidence, that the debt-based system of money eventually self-destructs and this time the effects are likely to be felt around the world. One solution could be to convert debt to equity; make significant changes to the way that the capital in capitalism functions.
David James is the managing editor of personalsuperinvestor.com.au. He has a PhD in English literature and is author of the musical comedy The Bard Bites Back, which is about Shakespeare's ghost.
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