Paper Promises

Debt, Money, and the New World Order


By Philip Coggan

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Winner of the Spear’s Best Business Book Award

Longlisted for the 2012 Financial Times and Goldman Sachs Business Book of the Year Award

For the past forty years western economies have splurged on debt. Now, as the reality dawns that many debts cannot be repaid, we find ourselves again in crisis. But the oncoming defaults have a time-worn place in our economic history. As with the crises in the 1930s and 1970s, governments will fall, currencies will lose their value, and new systems will emerge. Just as Britain set the terms of the international system in the nineteenth century, and America in the twentieth century, a new system will be set by today’s creditors in China and the Middle East. In the process, rich will be pitted against poor, young against old, public sector workers against taxpayers and one country against another.

In Paper Promises, Economist columnist Philip Coggan helps us to understand the origins of this mess and how it will affect the new global economy by explaining how our attitudes towards debt have changed throughout history, and how they may be about to change again.


To Helena and Catherine,
with apologies for the debts left by my generation

In the midst of life, we are in debt. We must borrow to pay for our education, for our consumer durables and for our houses. And as nations, we borrow money because the taxes we are willing to pay rarely match the public spending we wish to see.
Another name for debt is credit, a word derived from the Latin credere, to believe. When we borrow or lend money, it is an act both of trust and of confidence. Lenders have to trust the borrower to pay the money back. Homebuyers take on a mortgage, rather than rent, because they are confident houses will rise in price. Banks allow their customers to run up credit-card debts because they are confident that they will pay back both the capital and interest.
For much of the past forty years in the Western world, that confidence has been well placed. The economy has grown, recessions have been rare and incomes and asset prices have risen. It has paid to borrow, and to lend, and we have done a lot of it. In many Western countries, the total value of debt is three to four times the value of annual economic output.
But all that has changed. Like a cartoon character that has run off the edge of a cliff, we have made the mistake of looking down. We have realized how much debt we have taken on and started to worry about how we will pay it back. We have realized that asset prices do not always go up, not even if we wait for a decade or more. Europe has an ageing population and will have fewer workers with which to grow its economy. The US, so long the dominant power, is watching nervously in its rear-view mirror as China catches up. In August 2011, America lost its coveted AAA rating that had signified its status as the world's safest borrower. In short, the confidence needed to borrow and lend is diminishing.
The result is a mess. This book is about this mess and how it will affect the global economy and the relationship between generations. But it is also about how our attitudes to money and debt have changed through history, and may be about to change again.
The massive debts accumulated over the last forty years can't be paid in full, and they won't be paid. The debt crises of Greece, Ireland and Portugal are just the start. The economic outlook for some countries, particularly in Europe, is weak thanks to deteriorating demographics: the number of retirees is growing relative to the number of workers. As a result, these countries' incomes will not grow fast enough to service their debts. Either there will be formal defaults, under which debtors pay back only a proportion of their loans, or there will be effective defaults, in which the debts are repaid in money that has lost its purchasing power through currency devaluation or inflation. Economics and politics for the next decade and beyond will be dominated by this issue, as social classes and countries debate where the brunt of the pain will fall.


The Democratic presidential candidate was young, with just four years in Congress under his belt. He electrified his party with his powerful oratory and outshone his opponent, a military veteran, on the campaign trail. He represented a mid-west state although he had not been born there. He toured the country appealing to the common man against the interests of big business. 'The day will come when corporations will cease to consider themselves greater than the country which created them,' he declared. But, despite drawing more votes than the previous Democratic candidate, he lost. For this was not Barack Obama in 2008. This was William Jennings Bryan in 1896.
Bryan campaigned on an issue that may seem obscure now – he believed in bimetallism, the use of silver as well as gold as backing for the dollar. But Bryan was in fact championing an age-old cause: the interest of debtors against their creditors. Bryan spoke in favour of farmers, who had taken on debts to buy land and machinery and then had seen crop prices plunge. The farmers wanted higher prices and believed that adding silver to the currency would deliver them. He was opposed by bankers, who believed that sound money could only be based on gold.
In the late nineteenth century, most developed economies were governed by the gold standard, a system that tied the amount of paper money in circulation to the stock of gold. Since governments could not magic more gold out of thin air, the standard did not allow continuously rising prices. Safeguards also prevented governments from debasing the currency, the ancient trick of adulterating coins with base metal.
Between 1896 and 1908, Bryan ran for President three times and lost on each occasion. He was unlucky. Just as he was complaining about the lack of money, gold deposit discoveries in Alaska and South Africa were expanding supply. The 'American century' was about to dawn in which his country was to become the dominant economic and military power.
But the defeat of Bryan's ideas was only temporary. Within six years of Bryan's last defeat the gold standard was suspended, and the attempt to resuscitate it after the First World War failed. A world saddled by wartime debts found the constraints of the gold standard too hard to bear.
The world now operates with a system where money can be created at will or by decree ('fiat money' as it is known in the jargon). The last link to gold was severed in 1971. There is a fundamental difference between this paper money system and the metallic standard it replaced. Gold is no one else's liability; you can own it outright. Paper or electronic money is always a claim on someone else, whether a bank or a government. Modern money is debt and debt is money.
It is no coincidence that debt levels have exploded in the last forty years, culminating in the credit crisis of 2007 and 2008 from which the world is still recovering. In response to that crisis, new money was created via a tactic called quantitative easing (QE) – central bankers created money to buy government bonds (and other assets). The creation of money to finance government deficits is something that would have horrified the sound-money men of Bryan's era. But such tactics are hardly a surprise, now that governments and not just farmers have huge debts. The philosopher John Stuart Mill warned in The Principles of Political Economy, published in 1848, that 'the issuers may have, and in the case of a government paper always have, a direct interest in lowering the value of the currency, because it is the medium in which their own debts are computed'.
America is now the world's biggest debtor nation and the state of its finances is once more the subject of heated debate. The problem is that America is both the world's largest economy and the issuer of its most widely used currency, the dollar. The policies that the US has pursued to escape from the crisis (such as QE) are far from popular with its creditors, most notably the Chinese government.
In 2008, the US authorities feared a repeat of the Great Depression of the 1930s, when economic output plunged and unemployment soared. So they used all their available weapons, both monetary policy (the quantity of money and the level of interest rates) and fiscal policy (the balance between government spending and revenues), to ward off the threat. In addition, the banks were rescued with the government assuming some of their risks. Public debt replaced private debt.
The debate on the rescue has been highly political. The economists who follow the teachings of John Maynard Keynes have argued that such stimulus is essential to maintain demand and thus keep workers in jobs. Those Americans in the conservative 'tea party' movement counter that such a strategy expands the role of government, burdens future generations with high taxes and risks high inflation. The two sides clashed in the summer of 2011, when Congress debated a proposal to increase the debt ceiling, the amount the US government could legally borrow. Some in the tea party believed that the ceiling should not be raised under any circumstances; had they won the day, the US would have defaulted on its debts, causing chaos in the global economy.
Each camp has traditionally appealed to different constituencies. The debts of a country are ultimately those of its taxpayers, and the biggest taxpayers tend to be the wealthiest in the society. A government which runs a large and prolonged deficit will eventually raise taxes to pay for it, eating into taxpayers' income (or it will default on its debts, penalizing savers). On the monetary side, a government that expands the money supply at a rate in excess of economic growth will eventually erode the real value of taxpayers' wealth via inflation. Either way, the wealthy lose. The gainers will be the poorest, who benefit from increased public expenditure or who pay little tax.
Similarly, when a government decides to balance the budget by cutting public spending, or to eliminate inflation by raising interest rates, it is likely to penalize those employed by the public sector, those on benefits and those with debts. In short, one course of action tends to favour the creditor/rich class and the other favours the debtor/poor class. What is remarkable about the tea party is that a populist movement is taking the line normally associated with creditors, the complete opposite of the situation in the days of William Jennings Bryan. To complete the irony, the denizens of Wall Street, once firmly in the sound money camp, now favour the use of QE, since it props up the stock market and boosts their profits.
The argument is being fought across the developed world. In Britain, a Conservative/Liberal Democrat coalition is battling to bring down a huge deficit, inherited from a Labour government, in the face of trade union opposition to spending cuts. Their austerity programme is far more ambitious than anything planned by Mrs Thatcher.
But the crisis has been most intense in continental Europe. The region has conducted an historic experiment in monetary policy, replacing their individual currencies with the euro. In effect, the smaller countries hitched a ride on the reputation of the German Deutschmark, one of the world's strongest currencies in the second half of the twentieth century. In the early years of the euro, this seemed to bring nothing but benefits to the peripheral countries. Their borrowing costs fell, converging with those of Germany, while they avoided the exchange rate crises that had marked the 1970s and early 1990s.
However, the Europeans were running the monetary policy of Germany without the Germans' penchant for thrift or competitive industries. The result was either credit-fuelled construction booms (in Ireland and Spain) or repeated trade deficits (in Greece and Portugal). Debts built up. And even though the Irish government had a good fiscal record for many years, this was the result of an artificial banking and construction boom which boosted consumer spending and thus tax revenues; when the crisis hit, and the banks had to be rescued, excessive private-sector debts became a burden on the public sector.
As countries struggle to rescue their banking sectors, and cope with the rising debt burden, the future of the euro has been called into question. Will the most indebted European nations decide that default, or leaving the single currency, is a better option than years of austerity? Or will the Germans decide that they are unwilling to foot the bill for other countries' debts?


Conflict between creditors and debtors is almost as old as money itself. John Taylor, an early nineteenth-century American thinker, said that the banking industry 'divides the nations into two groups, creditors and debtors, and fills each with malignity towards the other'.1 One can see all of economic history through this prism – a battle between those who lend money and those who borrow it. The former want to be paid back with interest in sound money; in times of crisis, the debtors cannot afford to do so.
History suggests that periods of growing economic activity are accompanied by an expansion of the money supply and a widening of the definition of money. Confidence is high because trade and incomes are growing. Businesses are happy to accept the extra money, often in the form of debt – extending credit to customers, for example. Then something happens to shatter confidence and the definition of acceptable money narrows, which means that the willingness to extend credit declines.
In the twentieth century, each successive economic cycle tended to end with more debt being added. In 1981, Ronald Reagan managed to persuade some Republican Congressmen, rather against their will, to vote in favour of an increase in the government debt ceiling beyond $1 trillion, or one with twelve zeroes after it. It was assumed that a conservative President, who referred to government as the problem, would bring the deficit down. By the end of Reagan's time in office in 1989, the debt was $2.6 trillion.
That sum inspired a property developer named Seymour Durst to set up a debt clock in New York's Times Square to highlight the growing debt burden. By 2008, the clock had to be refurbished to add an extra digit because the debt total had reached $10 trillion. Just three years later, debt reached the previously agreed ceiling of $14.3 trillion, thanks to the massive fiscal deficits that followed the 2008 – 09 recession. This additional debt was more than the amount that originally alarmed Seymour Durst; indeed more debt than the US had accumulated in its first 212 years of existence.
The headline totals of government debt are only part of the picture. Politicians have also made promises to fund the retirements of ageing workers, in both the private and public sectors, to meet the cost of healthcare for the elderly and to guarantee the debts of banks and other companies. Beyond the obligations of the government, debt has also been accumulated by consumers on their mortgages and credit cards, by companies seeking to expand and by banks, seeking to speculate in the financial markets.
As these debts become due, rich creditors will be pitted against poor debtors; private-sector taxpayers against public-sector workers, young workers against the retired, domestic voters against foreign bondholders. It is impossible to forecast who will win each of these battles but one thing seems certain: not all these debts will be paid in full.
The crisis has also resulted in a debate about how to control the supply of money. In the 1970s, when money lost its link with gold, the result was much higher inflation; some thought we were heading for ruin. But the period of rapid money expansion since 1971 has also been accompanied by significant economic growth and the spread of capitalism to large parts of the ex-communist world. If these two developments are related (and it is not clear that they are), people might regard this as an acceptable trade-off. After all, credit is essential to make a modern economy function. Without it, businesses would be unable to grow and create jobs. More sophisticated societies seem to develop more complex financial systems. Banks may be the subject of much public opprobrium, but without them modern life would become incredibly cumbersome. Imagine if every prospective homebuyer had to raise the finance from their friends and acquaintances, or if we had to haul bags of gold or silver every time we went on an overseas trip.
Nevertheless, the modern monetary system creates some inherent dilemmas. When does the amount of bank lending become excessive? When does the financial system become too complex for the good of the economy? It is hard to define the 'right' level but it seems clear it was breached at some point in the last twenty years.
Credit can be used to finance trade but it can also be used to fuel speculation. By allowing banks to become so large and so central to the modern economy, the Western world acted like a parent who allowed his teenager to go on a credit-card-fuelled spending-spree. Banking turned from a rather dull profession into a glamorous world that the best and the brightest of the world's youth wanted to join. As money was lent to buy assets, asset prices soared. Trading on the financial markets became the route to riches. It is no coincidence that hedge funds and private equity companies, two industries that profit from easy credit and rising asset prices, have flourished in the last few decades. Whereas the new billionaires in the developing world still earn their fortunes from industry and natural resources, the developed world's plutocrats increasingly come from the world of finance. Luck and leverage can turn a trader into a genius.
Asset prices could not go up for ever. The crisis of 2007 – 08 overwhelmed the banks and governments felt obliged to step in for fear of widespread economic collapse. This has happened many times in the past. A government (or its agent, the central bank) is often the lender of last resort, since it can pay its debts out of taxes, or by printing money.
But a government's ability to fund itself is not infinite. In Greece, late in 2009, the sudden revelation of the dire state of the government's finances (after years of fudged statistics) soon sparked a funding crisis. The yield on Greek government debt rose sharply, making it more expensive to fund the government's huge deficit. The new Socialist administration announced several packages of austerity measures to try to close the gap, including an increase in the pension age and a cut in civil service benefits; the workers responded with strikes and violent protests.
The markets were unconvinced by the Greek plan and the cost of Greek borrowing rose alarmingly. So the Greeks turned to their richer European neighbours to fund a bailout plan and agreed an austerity plan with their new paymasters. This merely bought the Greeks time. They still had a debt bill that was too large – around 150 per cent of their annual economic output or GDP. Paying off that bill required the Greeks to run many years of surpluses – for the government to take in more tax revenues than it spends (before interest payments, at least) and for the country to export more than it imported. The implication was higher taxes, lower spending on benefits, lower wages and lower consumer demand: a massive dose of castor oil for the Greek population.
It was no surprise that a year later the Greeks were back asking their neighbours for more money. Investors had made their opinion clear: Greek two-year bonds were yielding 25 per cent, a level that indicated the fear that the debt would not be repaid in full. Default would bring down Greek debt to a more manageable level; say 70 to 80 per cent of GDP. But the EU was dead against default for fear that it would spread panic across the region. After a tense stand-off between the Greek parliament and demonstrators, a deal was agreed in June 2011 under which more money was lent in return for further budget cuts. But few people believe the deal was any more than a temporary reprieve, and the package was being renegotiated by October. What makes life so difficult for Greece is its membership of the euro-zone; the old trick of devaluing the currency and thus paying back foreign creditors less in real terms is not available.
Governments across the developed world may face the same choices as the Greeks in the next few years. Do they make the sacrifices needed to keep creditors satisfied? Do they default on their debt, at the risk of alienating the financial markets for a generation? Or do they try to ease the burden by devaluing, a trick not open to all governments (if one currency falls, another must rise)? For domestic creditors, the same effect can be achieved by the creation of inflation.
None of these tricks is new. Monarchs have been debasing their currencies (inflation by another name) for thousands of years. Modern history is littered with examples of default by developed and developing countries. Creditors have retaliated by demanding higher interest rates or by imposing agreements to tie down the value of currencies, for example by fixing monetary values in terms of gold.
This book will argue that we have reached another of the great crisis points in history. Borrowers will fail to pay back their debts, either through outright default or by encouraging their governments to inflate the debt away. The creditors, who are increasingly found in the developing world, will demand a new system to protect their rights. This might involve a commitment from the Western indebted countries to support their currencies and balance their budgets.


In 1971 President Richard Nixon abandoned the obligation for the US Federal Reserve to exchange dollars for gold at a set rate. At that time, gold was valued at just $35 a troy ounce; by August 2011, it was trading at $1,900 an ounce. That shift illustrates what those who believed in sound money feared would happen – paper money has an inherent tendency to lose its value. Some would say it is bound to decline to its intrinsic value: zero. In the critics' view, paper money is about as solid as air miles; the kind of currency that you accumulate but can never really cash in.
Nixon's decision also ushered in a new era in currency markets. From that point, most countries in the developed world let their currencies float, that is move up and down every day on the markets. The old constraints imposed by fixed exchange-rate systems, which forced governments to slam on the economic brakes when the currency was under threat, have been removed. It is no coincidence that this period has been marked by huge trade surpluses and deficits, booming asset markets and rising debts.
To be strictly accurate, the world of floating rates consists of the big economies (America, Japan, continental Europe, Britain) that let their currencies fluctuate against each other. However, economic power has been shifting to the countries of the developing world, led by China, which tend to manage their exchange rates – typically by pegging them to the dollar – rather than let them float. In recent years, that has often involved the use of policies to prevent their currencies from rising too fast and making their exports too expensive. China, for example, ensures that its currency, the renminbi, trades in a very narrow range against the dollar on a daily basis.
That policy has added to the potential for economic conflict. On one side you have the US, which is creating money to boost its economy; on the other, China, which is managing its exchange rate to keep its workers in employment. As a result the newspapers were full of talk of 'currency wars' in late 2010.
In a sense, this is just another version of the creditor/debtor battle being played out on a global stage, with China in the creditor camp and the US as the debtor. What is new this time around is that so many countries are facing debt problems at the same time, without the trigger of a world war to create them. The world is also enjoying interest rates that are lower than at any time in history, even though the risks of default and/or inflation seem high. We have interest rates fit for a gold standard era, but no limit to the ability to create more money.
This crisis follows a long period when attitudes towards debt have changed profoundly at the individual, corporate and national level. In the 1980s and 1990s, borrowing money was seen as a sign of economic shrewdness, rather than a matter of necessity. The developed world built an economic model on debt; consumers borrowed to finance their lifestyles, companies borrowed to enhance their returns, financial institutions borrowed more money to play the asset markets, countries borrowed money to tide economies over recessions. It may well be that the credit crunch of 2007 – 08 showed that this model had been tested to destruction. But what will replace it?


The Buddhists use a wheel of life to symbolize the cycle of life, death and rebirth. Religious scholars say that humans see everything from their own frame of reference, from their own point in the circle. Similarly, the economy flows in a circle, with money spent by one actor being received by the next. Arguments about economics tend to depend on the starting point in the circle chosen by the debater.
To some, the answer to the crisis is simple. We must abandon our spendthrift ways and start to live within our means. Saving is needed to finance investment. Only by investing in new technology and new equipment can the developed world hope to grow its economy over the long term. But the circular nature of the economy means that such individual decisions have collective consequences. As Keynes pointed out, money saved, rather than spent, reduces demand for goods and thus employment. The economy can be trapped in a circle where too much is saved, too little spent and too few jobs are available. What is true at a domestic level is also true internationally; if Western countries spend less, the economies of the developing world will sell fewer goods.
The same debate arises when governments opt for a fiscal stimulus, boosting an economy by cutting taxes or raising spending. Such a stimulus, say the Keynesians, will create a virtuous circle when an economy is in recession, boosting demand and creating jobs. As the economy recovers, tax revenues will increase and spending on unemployment benefits will decline, eliminating the budget deficit.
Nonsense, say the critics; government spending must come from somewhere else in the circle. In the short term, the government borrows the money, so diverting capital from businesses that might have created jobs on their own. And in the long run, deficits mean higher taxes which take spending power out of the wallets of consumers.
The international economic debate is also bogged down, because each country's perception of the issues is dictated by its starting point in the circle. Within Europe, the Germans think that other countries should adopt their export-led model. But if the Germans are exporting, someone must be importing. Those European nations currently facing a debt crisis incurred some of their debts buying German goods. If they stop buying, German industry will suffer.
In the China/America relationship, the Chinese see themselves as the virtuous party, with an economy based on manufacturing and the export of goods to other countries. They save and invest to lift their population out of poverty. Americans, in contrast, are seen to lack discipline, spending money they do not have on luxuries like widescreen TVs. To the Americans, however, it is the Chinese who must change. The Chinese only maintain their export competitiveness by holding their currency at artificially low levels. The West acquires cheap goods (but loses manufacturing jobs) while the Chinese get IOUs in return, which may or may not be repaid. This does not seem like a stable arrangement.


On Sale
Jan 17, 2012
Page Count
304 pages

Philip Coggan

About the Author

Philip Coggan writes the Bartleby column for The Economist and is the former writer of the Buttonwood column. Previously, he worked for the Financial Times for twenty years. In 2009, he was voted Senior Financial Journalist of the Year in the Wincott awards and best communicator in the Business Journalist of the Year Awards. Among his books are The Money Machine, The Economist Guide to Hedge Funds and Paper Promises.

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