Financial Times

Bankruptcy could be good for America

By Gideon Rachman

Published: January 11 2010 19:47 | Last updated: January 11 2010 19:47

Pinn illustration

In Winnie-the-Pooh, there is a significant moment when the bear is asked whether he wants honey or condensed milk with his bread. He replies “both”. You can get away with this sort of thing if you are a much loved character in children’s literature. But it is more problematic when great nations start behaving in a childish fashion. When Americans are asked what they want – lower taxes, more lavish social spending or the world’s best-funded military machine – their collective answer tends to be “all of the above”.

The result is that the US is piling up debt. A budget deficit of about 12 per cent of gross domestic product is understandable as a short-term reaction to a huge financial crisis. What should worry Americans is that, with entitlement spending set to surge, there is no credible plan to bring the budget deficit under control over the medium term.

The US has formidable strengths that will allow its government to be profligate for far longer than other nations could get away with. But if the US keeps running huge deficits, sooner or later the country will start flirting with bankruptcy. Oddly, it might be best if the crisis came sooner rather than later. For a surprising number of countries, running out of money has been the prelude to national renewal.

The two biggest and most beneficial geopolitical stories of the past 30 years – the spread of democracy and of globalisation – were driven by a succession of states finding their coffers empty.

The background to Deng Xiaoping’s liberalisation of the Chinese economy in 1978 was a fiscal and foreign exchange crisis. Finding itself desperately short of cash, the Chinese government was much more willing to embrace heterodox economic ideas that promised to deliver faster growth and higher revenues. The rest is history.

It was the same story when India embraced economic reform in 1991. The Indian government found itself with foreign reserves that were worth just two weeks’ worth of imports. The Indians had to send gold to London to secure an emergency loan from the International Monetary Fund. But Manmohan Singh – then finance minister, now prime minister – urged his colleagues to “turn this crisis into an opportunity to build a new India”. They succeeded triumphantly.

Or take Latin America in 1982. When Mexico defaulted on its debts in that year, it triggered an economic crisis across the whole continent. But the long-term consequences of that crisis were beneficial. As Michael Reid, author of a recent history, has pointed out, “dictatorships buckled under the opprobrium of economic failure”. The Argentine junta fell in 1983; Brazil moved to democracy in 1985.

Disastrous problems with government finances also played a huge role in provoking the reforms that eventually did for the Soviet Union. When Mikhail Gorbachev came to power in Moscow, he was faced with a national debt that almost doubled in his first three years in office. It was those financial pressures that helped to persuade him that economic reform – perestroika – was unavoidable.

By 1989, the whole of the Soviet bloc was struggling under the weight of rapidly increasing foreign debts. Why did the East German government not shoot demonstrators in the streets in October 1989? In large part, it was because it could not afford to. East Germany was on the verge of bankruptcy and desperately negotiating with West Germany for a loan.

These salutary brushes with national bankruptcy do not only happen to under-developed Asian nations, flaky Latin American dictatorships and crumbling communist regimes. The British still shudder at the memory of the UK government having to go “cap in hand” to the IMF in 1976. It was humiliating – but it served a useful purpose. Britain’s brush with bankruptcy helped to convince the voters that things really needed to change, and prepared the ground for Thatcherism. France had a similar experience in the early 1980s – when capital flight from the country and collapsing tax revenues forced the government of François Mitterrand to abandon its hard-left policies.

Sometimes, if a government is truly rotten – East Germany in 1989 or France in 1789 – it is a good thing if a fiscal crisis leads to political collapse. But for most normal countries, it is much better to get close to the edge of national bankruptcy than actually to go over the Niagara Falls of sovereign default. As Britain discovered in the 1970s and India found in 1991, looking over the edge can create the atmosphere of crisis that allows governments to win the arguments for economic reform. An actual sovereign default, however, can destroy confidence and trust among citizens and investors for years.

Perhaps the most memorable thing said so far by an official in Barack Obama’s administration was the remark by Rahm Emanuel, the White House chief of staff, that “you never want a serious crisis to go to waste”. Mr Emanuel was widely condemned for flippancy and cynicism. But an examination of world history over the last 30 years suggests he was definitely on to something. Those much discussed emerging powers, the Brics (Brazil, Russia, India and China) all needed a fiscal crisis to set them on the road to economic reform and national resurgence. America may one day be lucky enough to experience its very own national fiscal crisis. Let us hope it is not wasted.

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