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States, Debt, and Power'Saints' and 'Sinners' in European History and Integration$

Kenneth Dyson

Print publication date: 2014

Print ISBN-13: 9780198714071

Published to Oxford Scholarship Online: August 2014

DOI: 10.1093/acprof:oso/9780198714071.001.0001

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The Dynamics of Public Debt in Historical Perspective

The Dynamics of Public Debt in Historical Perspective

The Limitations of Formal Economic Reasoning

Chapter:
(p.191) 7 The Dynamics of Public Debt in Historical Perspective
Source:
States, Debt, and Power
Author(s):

Kenneth Dyson

Publisher:
Oxford University Press
DOI:10.1093/acprof:oso/9780198714071.003.0008

Abstract and Keywords

This chapter looks at public-debt dynamics in a long historical perspective. It uses historical analysis to raise questions about reliance on formal debt sustainability analysis, suggesting the value of narrative synthesis as practised by Hume and Smith. It then provides a set of detailed historical case studies, analysing historical data. They include Austro-Hungary, Belgium, Britain, Ireland and Scotland, Italy, the Netherlands, Prussia and Germany, Spain, and the United States. Finally, the chapter seeks to draw some general lessons from history. These lessons relate to war and the threat of war; welfare-state development; and financial crises. Historical analysis suggests the pivotal importance of state capacity and ideological commitment to extract taxes and deliver infrastructural and social investment that helps generate economic growth and build social solidarity and political inclusivity. Formal debt sustainability analysis fails to capture this key insight.

Keywords:   debt sustainability, formal analysis, historical patterns, Austro-Hungary, Belgium, Britain, France, Germany, Italy, Spain

Qui numerare incipit, errare incipit.

Morgenstern (1950: 2)

Historical analysis of European public debt faces many difficulties, not least relating to the availability, accuracy, and comparability of very differently generated long-term data. These difficulties make historical data less suitable for systematic statistical meta-analysis than for narrative synthesis. David Hume and Adam Smith were past masters of narrative synthesis in political economy, treating history as a laboratory that yields a rich assortment of empirical observations. Narrative synthesis starts from the premise that data selection, data errors, and weighting of observations remain problematic in any attempt to think about public debt. The added value in historical analysis lies in revealing the context-specific and contingent character of public debt dynamics and in picking up the significance of low-frequency events. It induces scepticism towards formal economic and probabilistic reasoning about debt sustainability and sovereign creditworthiness. Historical analysis challenges their claims to provide a universal logic, their neglect of ‘off-model’ developments, their tendency to generalize from temporally limited data, and their proneness to extrapolate from past experience to future prospects.

Longer-term observation of public debt helps puncture the illusion that there can be a single, authoritative, and agreed optimal theory of debt sustainability, from which a simple firm fiscal rule can be derived. Sustainable debt is historically contingent on three factors. It depends on variations in potential gross domestic product (GDP) growth rates and in characteristics of economic structure that affect these rates, including their (p.192) degree of openness. It varies also with whether states borrow with or without their own currency, the capacity of their banking system to absorb public debt, and the degree of sophistication in debt financing and management techniques. Not least, debt sustainability is a function of political will and state capacity to extract taxes and to translate debt into productive investment in infrastructure and in building social solidarity and political inclusivity. This factor highlights the role of culture. The historical record offers too flimsy an empirical basis for claiming a causal theory that justifies an upper bound of a 90 per cent public debt/GDP ratio or a 3 per cent fiscal deficit/GDP rule. Historical analysis has an additional value. It highlights the precariousness of sovereign creditworthiness. In so doing, it subverts the naïve belief—at the heart of much financial regulation—that sovereign bonds are intrinsically a ‘safe’ asset.

The analysis of longer-term historical data also puts in question certain conventional beliefs about the accumulation of public debt and sources of threat to debt sustainability. One such belief is that the main source of this threat is to be found in the spread of the notion of social and economic entitlements and its embodiment in fiscally profligate welfare states. In contrast, historical observation shows that what matters is the nature and quality of public expenditure, above all social investment and infrastructure spending, in bolstering long-term economic growth. Political will and state capacity to sustain productive public investment in infrastructure and in building social solidarity have made vitally important contributions to long-term growth-maximizing debt sustainability (Aschauer 1989; Vandebroucke 2012). For this reason, over the period 1960–2010, Denmark, the Netherlands, and Austria, followed in rank order by Germany and France, were able to secure a comparative advantage in debt sustainability over Portugal, Belgium, Spain, Britain, and Greece (Checherita-Westphal, Hughes Hallett, and Rother 2012: 12).

Historically, risks to debt sustainability derived more from the illusion, hubris, and complacency that have been endemic in banking culture and in consumer culture. Financial crises proved a key driver of public debt dynamics, revealing the scale of implicit state guarantees of the largely opaque liabilities of banks. At the political level, the chief source of risks to debt sustainability has come historically from the privileging of the military in constructing external and internal security threats, from engagement in war, and from the prospect and experience of military defeat.

Despite their limitations, formal economic reasoning and formal debt sustainability analysis have an important role to play in enlightening narrative reasoning about what constitutes sustainable public debt. They show that issuing debt is not an alternative to cutting expenditure or raising taxes. Debt accumulation is only a way of deferring these steps. In the long or even short run, it can prove costly—even disastrous—to economic growth. It reduces the fiscal space to deal with emergencies and to absorb the costs of short-term opportunistic political behaviour as well as the capacity to invest productively in infrastructure and in social solidarity (Ghosh, Kim, Mendoza, Ostry, and Qureshi 2011; International Monetary Fund 2009c). Formal economic reasoning helps show how the European Union (EU) and its Member States might define a fiscal ‘safe zone’ that accommodates future shocks and the temptations of governing elites to self-interested, time-inconsistent behaviour (Checherita-Westphal, Hughes Hallett, and Rother 2012).

Formal debt sustainability analysis contributes enlightenment by showing how public debt dynamics are embedded in the complex interactions amongst a range of (p.193) macroeconomic variables and by warning of fiscal risks on this basis. However, immersion in formal modelling can produce intellectual amnesia. Many of the key variables that impact on debt sustainability evade precise and reliable measurement or probabilistic reasoning. They are subject to radical uncertainty. Formal economic reasoning and formal debt sustainability analysis neglect vital ‘soft’ indicators. They ignore governance standards and state capacity; poverty and deprivation; and environmental degradation and resource depletion. Moreover, formal economic reasoning tends to be preoccupied with short-term, not always reliable data; to be caught up in statistical squabbles and in the problems that stem from fiscal data misallocation; and to err towards universal, top-down solutions to context-specific problems of public debt. It is, in consequence, limited in its capacity to produce reliable country-specific estimates about debt sustainability. There is a risk of bias from ‘variable omission’ in estimation.

The limitations of formal economic reasoning and formal debt sustainability analysis matter because they play a constitutive role in public debt dynamics. They affect how the dynamics work. Their limitations as a camera might be less serious if they did not also function as engines of financial market sentiment (MacKenzie 2006). The formal debt sustainability analyses of the European Central Bank (ECB) and, above all, the International Monetary Fund (IMF) were basic to the design, operation, and redesign of the international bail-outs of Cyprus, Greece, Ireland, and Portugal. The risk was that they could impact negatively by contributing to vicious circles in sovereign creditworthiness (European Central Bank 2012a).

Debate about sovereign risk and creditworthiness is subject to intellectual capture by the formal debt sustainability analyses of official sources. They produce authoritative, technical knowledge about public debt, which is clothed in the mystique of precise measurement and which drives market and political expectations about sovereign creditworthiness. As later chapters show, there are two other engines that drive market and political expectations and mould debate about sovereign risk. Though both are less strictly anchored in formal economic reasoning, they share a fundamental commitment to probabilistic reasoning. Fitch, Moody’s, and Standard and Poor’s assign formal credit ratings to states and put them on positive or negative outlooks. Disaster risk is signalled once sovereign bonds lose investment grade status and are designated ‘junk’. In addition, credit-default-swap (CDS) spreads offer market-based, trading-oriented assessments of propensity to default. Disaster risk is signalled once sovereign CDS spread jumps above 200 basis points.

Credit ratings and CDS market spreads have the additional feature of being internal to the functioning of financial markets, whilst at the same time constructing the reality of fiscal normality that they seek to describe. Formal debt sustainability analysis, credit ratings, and CDS markets are by no means identical types of branding exercises. Credit ratings, for instance, explicitly recognize the role of qualitative variables. Nevertheless, they lean to probabilistic reasoning rather than recognize that radical uncertainty in public debt dynamics makes narrative reasoning about sovereign creditworthiness more intellectually appropriate. They incline to working with a discrete range of variables that can be suitably quantified to provide an objective basis for branding states. A few formal economic assessments of public debt dynamics achieved a seminal importance, notably Aschauer (1989) and Roubini and Sachs (1989). In particular, Reinhardt and Rogoff (2010) gained intellectual status as gurus of fiscal austerity in Europe.

(p.194) Formal Debt Sustainability Analysis

Conventional formal debt sustainability analysis involves an accounting exercise based on a standard debt accumulation equation. It rests on the implicit assumption that macroeconomic variables are the core drivers of public debt dynamics. Both the ECB and the IMF use similar types of analysis. They identify a set of key determinants of sustainable public debt: the existing public debt level (‘debt stock’ or ‘debt legacy’), the current budget position (the fiscal primary balance, after excluding debt servicing costs), the nominal interest rate, and the nominal GDP growth rate. The key difference is that the ECB adds the ‘deficit-debt adjustment’. This measure accounted for changes in the public debt/GDP ratio that are not reflected in the primary balance. Examples include effects from exchange-rate changes or acquisitions of shares in companies by government. Both equations assigned significance to the fiscal primary balance and to the ‘interest-growth differential’. High primary surpluses and GDP growth rates in excess of interest rate are identified as the keys to reducing the public debt/GDP ratio. The effects of inflation are incorporated in nominal GDP growth.

The IMF (2003) constructed a simple formula for debt sustainability, in which D* is the sustainable debt level; PS the primary surplus; r the interest rate; and g the GDP growth rate. Its equation provided an authoritative, technocratic logic of fiscal normality, which could serve as the basis for analysing and critiquing states and their political systems.

D* = PS/(r - g)

Using this equation, the IMF concluded that advanced industrial economies—like those at the core of Europe—required primary fiscal surpluses that rise from 2 per cent when public debt is 20 per cent of GDP to around 8 per cent when it climbs to 100 per cent of GDP. As public debt accumulates, primary surpluses need to rise to ensure debt sustainability. On this basis by 2011 Belgium, Greece, Ireland, Italy, and Portugal faced alarming challenges of debt sustainability. The ECB (2012a: 69) calculated that they needed to maintain primary fiscal surpluses of over 4 per cent of GDP for a prolonged period. In contrast, Norway combined a public debt/GDP ratio of 55.4 per cent with a primary fiscal surplus of 9.3 per cent (International Monetary Fund 2011b: 8).

According to the IMF in 2003, the main EU Member States had long-term sustainable public debt levels. However, Greece and Italy seemed much more vulnerable than many central and east European states, like Estonia and Slovakia, which had inherited relatively low public debts and—as ‘catch-up’ post-communist economies—had relatively high nominal GDP growth. The IMF model also suggested that public debt legacy is decisive in shaping ‘fiscal space’ or room for manoeuvre in the face of economic shocks. A high debt stock places the political onus of adjustment on the primary fiscal surplus because of the size of debt-servicing costs. It also increases risk of negative effects on nominal GDP growth and a debt/deflation spiral. In formal terms, debt sustainability depends on governments being able to generate future primary fiscal surpluses that are large enough to accommodate the cost of servicing current and future public debt obligations (European Central Bank 2011b: 64).

At the core of formal debt sustainability analysis is the argument that high public debt legacy has negative effects on nominal GDP growth and thus on public debt/GDP ratio. The appropriate policy responses are fiscal consolidation and structural (p.195) reforms. Given the nature of the general government debt ratio, the central macroeconomic drivers of debt dynamics are seen as nominal GDP growth, variations in unemployment, and the primary fiscal balance. If nominal interest rates exceed nominal GDP growth, a positive primary balance is necessary to prevent rapid debt growth. The higher the inherited public debt ratio, and the greater the difference between the interest rate and growth, the larger the primary surpluses must be. This last scenario faced Greece in an acute form post-2010. In the case of Italy, with its relatively low trend GDP growth rate and inflation rate and its large debt legacy, the 3 per cent fiscal deficit criterion of the Maastricht Treaty made little sense if debt was to be substantially reduced. Hence measures that would raise the trend rate of GDP growth and that would increase primary fiscal balances were central to reducing Italy’s public debt and securing creditworthiness. In such cases, the ECB and the IMF argued that the absence of structural reforms to product, services, capital, and labour markets—designed to raise trend growth rate—were a powerful indicator of debt risk.

The Limitations of Formal Debt Sustainability Analysis as Camera and as Engine

Conventional formal debt sustainability analysis suffers from various limitations. They accumulate into its potential to distort perceptions of sovereign risk, by either underestimating or exaggerating risk. Formal economic reasoning may not only fail to accurately picture sovereign risk. It may also destabilize expectations.

Some of the limitations of formal debt sustainability analysis are internal. It is vulnerable to data and calculation errors, particularly due to fiscal data misallocation in official sources (Checherita-Westphal, Hughes Hallett, and Rother 2012: 17). The value of formal debt sustainability analysis also depends on the choice and the realism of its assumptions, notably about GDP growth. In the Greek and Portuguese ‘bail-outs’, these assumptions proved ill-founded and were the source of later troubles. Moreover, formal debt sustainability deals with ‘official’ GDP. This measure is extremely narrow. It poses questions about whether national accounting offers a good camera of the economy. As traditionally conceived, official GDP figures were better at capturing tangible than intangible assets, like scientific research, cultural products, design, and branding. They were slow to adapt to the emerging ‘knowledge-based’ economy, treating research and development as a business cost rather than as investment. Part of the problem was that here were difficult challenges in capturing intangible assets, notably in measuring their productivity. Nevertheless, revision to measures of official GDP offered the inducement of adding to its size. It could also be justified by reference to harmonization with new international accounting standards.

The problems of extreme narrowness in measures of official GDP were more fundamental in that measures of environmental, natural resource, and social accounts were not included. Also, formal debt sustainability analysis captured neither the ‘hidden’ GDP of the black economy nor the ‘criminal’ GDP. Hence, in states like Greece and Italy, ‘official’ GDP offered a poor picture of national wealth. What made debt sustainable was not in the formal analysis.

(p.196) More generally, formal debt sustainability analysis is highly vulnerable to the radical uncertainties that surround medium-term debt trajectories. The problems are compounded by understatement of contingent and implicit liabilities. Furthermore, the analysis neglects net public debt. It does not account for public assets, in particular more liquid financial assets. Also, insufficient account is taken of short-term liquidity risks from financial market contagion and from refinancing requirements. Finally, and not least, questions arise about the adequacy and reliability of the underlying fiscal and economic statistics, coding errors, and weightings. These various problems can lead to results that prove fragile and potentially dysfunctional.

At a level more fundamental than calculation and data errors, formal debt sustainability analysis is only as persuasive as its core assumption that macroeconomic variables are central. Other factors matter more. This type of formal economic reasoning is intellectually averse to narrative reasoning about sovereign creditworthiness that foregrounds ‘softer’ indicators of governance standards, poverty and deprivation, environmental degradation, and resource depletion. Formal debt sustainability analysis fails to build in knowledge about state capacity to improve primary fiscal balances, to build an adequate ‘safe zone’ to manage unexpected shocks, and to enforce fiscal rules on deficits and, above all, debt. It is even less attuned to dealing with the culturally and ideologically conditioned willingness to invest productively in infrastructure and social solidarity. Governance standards, institutional competence and resilience, public trust, and inclusive political processes for managing debt reduction that address poverty and deprivation are ‘off-equation’. They are, however, fundamental and political.

Moreover, debt sustainability analysis fails to address two key contextual issues. It is severely limited in historical time period. It is also fails to take adequate account of the interaction of public debt dynamics with developments in the larger European and global economies. This interaction is fundamental in affecting debt sustainability and suggests that appropriate policy prescriptions will differ depending on whether the European and global political economies are experiencing ‘good’ or ‘hard’ times. In its enlightenment mission, debt sustainability analysis is dangerously prone to universalize, above all to prescribe fiscal contraction in all cases.

It is difficult to disentangle formal economic reasoning as applied to sovereign creditworthiness from subjective knowledge. Choices about the range of relevant variables, weighting of their individual significance, and interpretation of the available—often incomplete and unreliable—data are ultimately not objective. Other difficult questions arise. How much reliance should be placed on official definitions of the economic cycle in assessing compliance with rules on structural fiscal balance? How accurate are official fiscal data? Are they distorted by statistical manipulation? Credit ratings differ from formal debt sustainability analysis in involving complex, evolving contextual inference and synthesis, which is in part quantitative but ultimately judgemental. More generally, in formal economic reasoning there is a temptation to resort to short cuts and heuristics to resolve uncertainty. This process is a way of trying to elicit the ‘real’ preferences of governments and their competence to deal with uncertainties and extreme circumstances. Market-based processes of constructing sovereign creditworthiness are conditioned in subtle, often implicit and unconscious ways. They involve subjectively-laden images of state capacity, the honesty and integrity of elites, their governing competence, and their (p.197) willingness to comply with obligations. These images become more embedded once confirmed by formal debt sustainability analysis and the application of algorithmic skills.

In some respects, context plays a significant role in formal debt sustainability analysis. This type of analysis opens up some difficult and contentious issues of theory and empirical research within formal economics. One such issue is the role of sizeable welfare states in acting as automatic stabilizers during ‘hard’ times. Neo-Keynesian economists tend to welcome welfare states as mechanisms through which demand is automatically injected into the economy. In their absence, as in the United States, larger-scale use of discretionary fiscal measures can compensate. Hence, EU Member States are less likely to need to resort to discretionary fiscal action. The European Economic Recovery Programme, which was championed by the European Commission in 2008, added no substantial discretionary pan-European fiscal stimulus beyond the limited stimuli (compared to the United States) to which Member States were already making unilateral commitments. Neo-classical economists focused more on regaining fiscal flexibility through deep structural reforms to welfare states, with the adjustment being born on the expenditure side.

However, formal economic arguments of this kind risk overlooking another property of welfare states. They provide social investment in education, training, childcare, health care, and poverty reduction. Social investment remains indispensable to economic growth and, not least, social solidarity in the face of fiscal crisis. From this perspective, the economically and politically difficult challenge is to match short-term fiscal consolidation with strengthening long-term social investment (Vandenbroucke 2012).

Context is also an issue with respect to the role of fiscal multipliers in long-term sustainable debt. Attempts to formally model and give precise value to the effects of fiscal multipliers on economic growth and public debt/GDP ratios generated fragile and contested results. Neo-classical economists tend to argue that these effects are weak so that sharp and rapid fiscal consolidation will have limited, negative short-term impact on economic growth. This impact will be offset by fiscal and structural reform policies that have ‘full credibility’, lead to a decline in the sovereign risk premium, lower debt servicing costs, and stimulate private-sector investment. The outcome will be an improving public debt/GDP ratio. Conversely, neo-Keynesian economists assess fiscal multiplier effects as substantial and likely to lead to protracted economic stagnation or recession. They are substantial because of credit-constrained households, the decline of productive investment in infrastructure and social solidarity, and loss of credibility as growth proves elusive and the public debt/GDP ratio deteriorates or proves inflexible. In practice, the operation of fiscal multipliers is context-specific. It varies with economic structure and the nature of the growth trajectory, notably the weight of household debt, with exchange rates, and with the effects of non-conventional monetary policy activism.

These internal debates about context-sensitivity within formal debt sustainability are very important and leave a large margin of doubt about results. However, the condition and development of the European and international economies is no less significant for a context-sensitive analysis of debt sustainability. A fast-growing international economy of eager consumers, confident investors, and rising opportunities for exports helps to reduce the costs of short, sharp remedial fiscal consolidation and structural reforms to correct external imbalances and to recover from domestic financial market shocks. GDP growth through exports, investment, and job creation helps fiscal consolidation and reduction of the public debt/GDP ratio by boosting tax revenues and reducing demands on public (p.198) expenditure. It also facilitates a more politically inclusive agenda that compensates the losers from rapid structural reforms and fiscal consolidation through measures to enhance employability, alleviate poverty, and reduce economic inequalities. In this kind of context, issues of automatic stabilizers, welfare-state retrenchment, and fiscal multipliers are secondary.

After 2002 Brazil succeeded in combining a huge $30 billion IMF rescue with an agenda of economic and social reforms. It averted an Argentinean-style default. Earlier, in the 1990s, after their domestic financial crises, Finland and Sweden constructed the so-called Nordic model out of their benign debt reduction strategy. This model was based on a ‘flexi-curity’ policy narrative, which linked more flexible labour markets and new firm domestic fiscal rules with stimulus to science-based innovation and growth and with generous social and employment policies to compensate for costs of adjustment. The rapid association of the Nordic model with success—and its projection into the EU Lisbon strategy—was made possible by a supportive international environment of rapid and sustained growth. In contrast, the post-2007 global financial and economic crisis offered a much less benign context for radical fiscal adjustment and structural reforms in Cyprus, Greece, Ireland, Italy, Portugal, and Spain. In a low-growth European environment investors remained sceptical about the continuing political will and state capacity to reduce public debt through harsh and prolonged fiscal consolidation and structural reforms. They were, accordingly, more prone to translate individual pieces of negative news as signals for market alarm and panic. The strategy for dealing with debt sustainability in one context proved less relevant in another where there was a high risk that Europe-wide recession would make debt reduction by individual states elusive, lead to declining confidence, and risk a debt-deflation spiral.

The lack of context-sensitive analysis of debt sustainability was also apparent in an intellectual amnesia that resulted from the lack of an historical and political understanding of public debt dynamics and their social, cultural, and ethical contexts. Historical data on the relationship of default to debt levels show how notions of fiscal ‘normality’ have changed over time. What was deemed normal and possible for a European state in 1815–1850s or in 1945–1960s did not hold in Europe from the 1870s to 1914 or from the 1970s. The post-1970s period saw the emergence of the notion of public debt/GDP ratios over 60 per cent as ‘excessive’. Later, at the turn of the twenty-first century public debt/GDP ratios over 90 per cent were viewed as growth-inhibiting (Reinhart and Rogoff 2010). Sovereign bond yields over 7 per cent were understood as signals of unsustainable public finances.

Crucially, the two periods 1815–1850s and 1945–1960s were located in the protracted, dark fiscal shadows of hugely destructive Europe-wide wars. Also, governing elites in the earlier period lived in fear of liberal and national revolutions. The post-1945 period was associated with the Cold War in Europe till 1989–1991, which pushed up military expenditures, and with increased welfare spending, notably on education, health, and pensions. The return to more restrictive notions of fiscal normality by the 1980s suggests historical parallels with the 1870s–1914 period. The two periods witnessed the renaissance of rentier power; rising inequalities of wealth and income; and new and growing social and political movements that began to challenge governing elites.

Based on historically limited data for the period since the 1960s, formal debt sustainability analysis has been helpful in capturing the effects of the demographics of rapid (p.199) population ageing and welfare-state growth. Post-2007 it has revealed the adverse public debt dynamics spawned by banking liquidity and solvency crises. The value of this analysis derives from data that have been formally compiled on a cross-national, harmonized basis. However, it suffers from its very limited historical time frame. Longer-term historical data have the converse problem. The data is not available on a standardized and harmonized basis. Cross-national variation in the availability and the quality of data limits the value of any attempts at cross-national comparison. Nevertheless, historical data provide an opportunity to capture patterns in public debt dynamics that shorter-term data ignore. It is possible to see changes in notions of fiscal ‘normality’ over time. Public debt/GDP ratios below the Maastricht 60 per cent emerge as an historical rarity. What emerges is the overriding significance of war and of banking crises for public debt dynamics. Definitions of geo-strategic and external and internal threat trump restrictive notions of fiscal ‘normality’. Moreover, what matters is tax capacity to service debt rather than the size of public debt.

US Public Debt

The most salient historical feature of US public debt dynamics is the big impact of wars and their legacies: the War of Independence, the Civil War, and the First and the Second World Wars (see Table 7.1). In the aftermath of Independence, the (p.200) first Secretary of the Treasury, Alexander Hamilton (1789–1795), was the architect of newly issued Treasury bonds. The United States inherited a huge debt problem from the Revolutionary War, not least the aftermath of the default in March 1780. Many states—mostly in the north—had borrowed heavily by issuing paper notes. Hamilton was faced with the threat of multiple defaults and loss of creditor confidence. However, he encountered strong opposition from southern states to collective debt redemption, as well as populist fears that the winners would be speculators, who had purchased these notes at steep discounts in the hope of redemption at par. Hamilton succeeded in passing a one-off federal assumption of states’ debts, with no haircuts for the speculators (Chernow 2005). In order to secure creditor confidence, he introduced new sources of revenue from customs and excise to service the interest costs on the new Treasury bonds. Under Hamilton’s leadership, the infant United States showed a capacity to act in supreme emergency that the euro area seemed to lack as its sovereign debt crises spread and mounted after 2007. He served as the architect of a new liquid market in US Treasury bonds.

Table 7.1 Historical Data on the US Federal Debt, 1790 to 2000, as Percentage of GDP

1790

29.6

1939

43.0

1800

15.1

1942

62.0

1820

8.3

1945

112.7

1840

0.3

1946

102.6

1860

1.9

1950

73.7

1861

16.8

1955

55.5

1866

31.4

1960

44.8

1870

27.9

1965

36.5

1880

18.4

1970

28.2

1890

7.8

1975

26.6

1900

6.6

1980

26.2

1910

3.7

1985

37.1

1916

2.7

1990

42.8

1919

33.4

1995

49.2

1925

21.6

2000

34.5

1929

14.9

1931

22.3

1934

44.0

Public debt problems plagued the new republic. During the 1840s the United States experienced state debt crises. Florida Territory and Mississippi totally repudiated their debts; Arkansas, Louisiana, and Michigan partially defaulted. Barings became involved in managing a number of these crises, principally temporary defaulters like Illinois and Pennsylvania (Flandreau and Flores 2010: 20). However, with respect to these crises, the US federal government and Congress proved unwilling to follow the Hamilton model. The principle of no bail-out was established in relation to US state defaults. Barings’ successful involvement proved commercially successful in generating longer-term underwriting business with key US states.

The Civil War of 1861–1865 proved another pivotal event. US public debt, accumulated by the Union, was forty-one times larger, increasing by some 30 per cent of GDP. It was also heavily short-term and chaotically structured (Noll 2012: 2). In 1865–1866 the Republican Party faced the threat that a south-dominated Democratic Party would seek to repudiate this Union debt and to ensure that the United States assumed the huge Confederate debt. It countered this threat by introducing the Fourteenth Amendment to the Constitution, which stated in section 4: ‘The validity of the public debt of the United States…shall not be questioned.’ The sanctity of the public debt was used as a key campaigning issue in the Republican Congressional victory in 1866 and the Presidential victory in 1868. By the 1870s successive budget surpluses had enabled debt repayment. The political issue of repudiation had lost its momentum (Foner 2002; Noll 2012).

The US public debt remained a manageable financial problem in part because of the lessons learnt from these painful experiences and in part because of sustained and rapid economic expansion after the Civil War. However, in the late nineteenth century the United States remained vulnerable to financial panics. This vulnerability derived from the combination of a fragile, chaotic banking system with the lack of a central bank with a lender-of-last-resort function. Following major bank failures in 1893, the pre-eminent US banker, J.P. Morgan, organized a syndicate to bail out the US federal government in 1895 with $65 million of gold. The federal government faced the imminent risk of a run on the Treasury and humiliating default (Chernow 1990). This vivid demonstration of the power of Wall Street enraged the Democratic Party and generated a populist reaction.

(p.201) War was the prime driver of public debt dynamics in the twentieth century, followed by domestic financial crises. During the First World War, US public debt climbed by some 30 per cent of GDP. In the Second World War it surged even more dramatically by nearly 80 per cent, reaching its all-time historic high of 112.7 per cent of GDP in 1945. In contrast, the Great Depression of the 1930s, its associated banking crises, and the New Deal of the Roosevelt Administration witnessed a much more modest public debt growth. In terms of impact on public debt, the Great Depression was eclipsed by the post-2007 financial and economic crisis. The US public debt/GDP ratio climbed from 36 per cent in 2007 towards 70 per cent of GDP in 2011. Before then, US public debt had exceeded 60 per cent of GDP only in the Second World War and in its immediate aftermath. After 1945 a combination of inflation and real GDP growth had helped to reduce the ratio rapidly (Aizenman and Marion 2009).

French Public Debt

French public debt data are of immense historical interest because of France's leading role in European sovereign debt markets, pre-1914. They illustrate a fascinating paradox. On the one hand, on the basis of a range of indicators, French sovereign creditworthiness looked highly suspect. France carried the burden of notably high public debt/total revenue ratios. It endured two heavy defeats in 1815 and in 1870 and subsequent foreign occupations; two heavy war indemnities; regime changes in 1815, 1830, 1848, 1852, and 1871; unstable governments, especially under the Third Republic after 1871; and persisting fears of social breakdown, which erupted in 1815–1816, 1848, and 1870–1871 with the Paris Commune.

On the other hand, France managed to avoid sovereign debt default, paid her war indemnities rapidly and in full (unlike post-1918 Germany), and sustained a remarkable stability in her debt interest rates. In the shadow of defeat at Waterloo in 1815, and Allied occupying forces, the Restoration Monarchy undertook major reforms to French public finances, amounting to a structural break after the defaults of the ancien régime and the Revolution (Oosterlinck, Ureche-Rangau, and Vaslin 2013). The French state remained creditworthy in the face of domestic political instability, adverse fiscal data, and negative geo-strategic developments after 1815 and again after 1866 when Prussia gained European ascendancy. The efficient secret of this French paradox stemmed from the cohabitation of contending political traditions—Legitimist, Bonapartist, and Republican—and continuity in the political strength of rentier power.

Rentier power was the thread that held together monarchical, imperial, and republican regimes: from Restoration France and the so-called July Monarchy of Louis-Philippe to Belle Époque, pre-1914 France. It helps explain how the paradox of suspect sovereign creditworthiness and stable debt interest rates was manageable. The institutional base of this power was to be found in the hautes banques and in the Banque de France. Its ideological justification drew on historical memories of the destruction of French creditworthiness and external prestige caused by the Law affair in the early eighteenth century and by the Revolutionary assignats. Rentier power was expressed in an enduring current of conservative liberal thought. It gave primacy to balanced budgets and monetary (p.202) stability, borrowing the economic principles of Robert Peel and William Gladstone. Conservative liberal thought rested on an aversion to fiscal extravagance and to creative financial practices, above all of the type that grew up in the Second Empire during the 1850s (Plessis 2002).

The Second Empire of Napoleon III (1852–1870) epitomized how this paradox operated. French public debt doubled between 1853 and 1865, excluding Paris, the departments, and the communes (Price 2001). It proved sustainable because of its nature and because French GDP grew by some 30 per cent between 1850 and 1869 (Maddison 2004: 424). The Emperor was attracted by Saint-Simon’s principle of using the state to mobilize finance for ‘productive’ investments in railways, roads, and other public works, typically outside the regular budget. The symbols and instruments of this ambition were the creative financing of Baron Hausmann to rebuild Paris and the new Crédit mobilier investment bank.

However, by 1860–1861 the traditional hautes banques, led by Fould and by Rothschild, were publicly backing liberal political campaigns, which exploited growing public fears that this promiscuous attitude to financing public debt would lead to higher taxes and interest rates. The appointment of Achille Fould as finance minister in 1861 symbolized the turning point towards the ‘Liberal Empire’. Fould succeeded in getting Napoleon III to formally surrender his power to decree credits for public works programmes outside the regular budget (Maddison 2004: 230). The falling prestige of the Emperor was paralleled by the declining power of the Crédit mobilier in favour of the hautes banques and their agenda of balanced budgets and monetary stability.

Table 7.2 French Public Debt/Total Revenues and Debt Interest Rates, 1815–1914, in Millions of Old Francs

Public Debt

Total Revenue

Public Debt

Interest Rate

1815

1272

876

145%

7.88

1820

3456

939

368%

6.65

1825

3941

978

403%

4.37

1830

4627

1020

418%

4.23

1835

4175

1068

391%

3.75

1840

4458

1234

361%

3.79

1845

5205

1393

374%

3.52

1850

4886

1432

341%

5.32

1855

6083

2309

218%

4.42

1857

8032

1799

446%

4.38

1860

9334

1962

476%

4.33

1863

12020

2265

531%

4.38

1865

13026

2169

600%

4.41

1870

11516

3125

368%

4.76

1875

19918

2870

694%

4.66

1880

20391

3531

577%

3.56

1885

23754

3320

715%

3.78

1890

25153

3376

745%

3.26

1895

25967

3416

760%

2.95

1900

25839

3815

677%

2.97

1905

25934

3766

689%

3.02

1910

25461

4274

596%

3.06

1914

25261

4549

555%

3.77

(Source: Bonney 2010; Fontvieille 1976, Table XXXVIII. The public debt to total revenue ratio is calculated by the author from this data)

Table 7.3 French Public Debt as Percentage of Total Revenue, 1815–1914

1815

145

1820

368

1825

403

1830

418

1835

391

1840

361

1845

374

1850

341

1855

218

1860

476

1865

600

1870

368

1875

694

1880

577

1885

715

1890

745

1895

760

1900

677

1905

689

1910

596

1914

555

(Source: Bonney 2010)

Tables 7.2 and 7.3 suggest some patterns in the evolution of French public debt. First, the public debt/total revenue ratio between 1820 and 1914 remained remarkably high, compared to the early twenty-first century. It did not fall below the low of 218 per cent in 1855 and hit a high of 760 per cent in 1895. Yet the debt interest rate in 1895 was well under half that in 1820. Intriguingly, the debt interest rate was lower under the Third Republic (1871–1940), despite the legacy of the Franco–Prussian War in 1870, than under either the July Monarchy (1830–1848) or the Second Empire. French GDP had recovered as early as 1874 and grew by over 30 per cent in size between 1894 and 1914.

Secondly, the public debt/total revenue ratio was at its lowest during the July Monarchy, the classic age of rentier power. Stendhal wrote of this regime: ‘the banks are masters of the state…the bank is the aristocracy of the bourgeoisie’ (Price 2001: 42). In 1830 James de Rothschild rallied to the support of the new King Louis-Philippe, offering a loan of 60 million francs. The July Monarchy was least interested in the overseas projection of French power and most focused on balanced budgets (Théret 1995). In a further gesture of his support for the peace policy of Louis-Philippe, and his opposition to the war-like policies of Adolphe Thiers, Rothschild provided him with a personal loan of two million francs in 1840. Conversely, the public debt/total revenue ratio was much higher during the Second Empire. In particular, the public debt data reflect the Crimean War, Napoleon III’s intervention in Italian unification, and his military adventurism in Mexico.

Thirdly, the Franco–Prussian War and the subsequent hefty French war indemnity left a long-term debt legacy for the Third Republic. It added some 20 per cent to the public debt/GDP ratio. However, France endured the effects better than Germany after (p.203) 1918. French debt interest rates were more elevated in 1815–1820 and in 1850 than after 1871. Moreover, post-1890 the so-called Belle Époque saw a decline in the public debt/total revenue ratio and in debt interest rates up to 1914, despite being a more militaristic phase of the Third Republic. This decline reflected the recognition within French governing elites that rivalling Germany required a combination of state stimulus to economic growth, creative ‘off-balance-sheet’ budgeting, and fiscal surpluses. It was a strategy similar to that employed by Napoleon III. The success of this strategy was followed by an inflationary surge between 1901 and 1913, which also helped to reduce the public debt/GDP ratio. Also, during the Belle Époque, the Banque de France competed with the German Reichsbank to accumulate the biggest gold reserves in Europe, over $800 million in 1914, to prepare—in its own words—for ‘every eventuality’ (Ahamed 2010: 70).

Fourthly, the public debt data show a complex association with periods of GDP growth. Between 1896 and 1914, rapid GDP growth generated increased tax revenues, (p.204) helping to reduce the burden of debt servicing. It coincided with a fall in the public debt/total revenue ratio. However, this association was less evident between 1850 and 1869. Napoleon III preferred to resort to creative forms of debt financing rather than to higher taxes in pursuit of his foreign policy ambitions and costly public works and urban renewal projects. Similarly, the correlations between macroeconomic stagnation or contraction and public debt dynamics are weak. Public debt/total revenue ratios remained relatively stable between 1815 and 1848 and between 1873 and 1896. Debt servicing as a percentage of public expenditure actually declined in the first period (see Table 7.4). It stayed relatively stable in the second. In 1879 under the Third Republic the Plan Freyssinet sought to stimulate economic growth by means of a public infrastructure investment programme. However, it was kept off-balance-sheet, thereby reducing the public debt/GDP ratio (Keyder 1985: 313). Off-balance sheet activity complicates both the data and makes conclusions about correlations difficult.

Table 7.4 French Debt Interest Payments as Percentage of Public Expenditure, 1815–1869

1815

49%

1918

59%

1949

4%

1820

25%

1920

50%

1950

5%

1825

23%

1925

41%

1955

6%

1830

24%

1930

22%

1960

5%

1835

23%

1935

23%

1965

13%

1840

20%

1939

18%

1969

12%

1845

19%

1850

25%

1855

25%

1860

23%

1865

22%

1870

27%

1875

33%

1880

34%

1885

35%

1890

34%

1895

30%

1900

27%

1905

25%

1910

22%

1914

21%

(Source: Fontvieille 1976, Table LVI. The percentage is calculated by the author from this data, rounded off)

Table 7.4 offers additional insights. Debt servicing as a percentage of public expenditure was at its highest at the end of wars: 49 per cent in 1815 and 59 per cent in 1918. It was at its lowest under the July Monarchy (19 per cent in 1845), at the end of the Belle Époque (21 per cent in 1914), and on the eve of the Second World War (18 per cent in 1939). Similarly, the biggest increases were associated with wars, notably between 1865 and 1875 and between 1914 and 1918. However, the biggest reductions in debt servicing (p.205) as a percentage of public expenditure were achieved in Restoration France, especially in 1815–1820, before the July Monarchy. They were also realized in 1926–1929 during the Third Republic after the consolidation of public finances and stabilization of the franc under Raymond Poincaré. Overall, for most of the period 1815–1939, French debt servicing amounted to 25 per cent or more of public expenditure. It was financed without default.

The post-1918 and the post-1944 periods saw a radical change in the importance of debt servicing in public expenditure. The main factor was inflation, which reduced the value of public debts and undermined the economic power of rentiers. By 1949 debt servicing accounted for less than 5 per cent of public expenditure, an outcome radically different from that after 1918. The ratio was still only 5 per cent in 1960, climbing to 12 per cent in 1969. Inflation proved a powerful tool in public debt dynamics. In particular, the period 1947–1970 saw a fall in the public debt/GDP ratio. It reflected the combination of exceptionally rapid economic growth with high inflation. However, this period can be seen as masking nascent fiscal imbalances (Dufrénot and Triki 2012).

From the early 1970s, the adverse effects of declining economic growth rates and falling inflation on the public debt/GDP ratio were not adequately offset by fiscal surpluses. In particular, from the mid-1980s, a policy of competitive disinflation was launched to match German performance as the anchor of the Exchange-Rate Mechanism (ERM). (p.206) It underpinned the French policy of playing the lead role in constructing economic and monetary union (EMU) and in sharing in German monetary power. The result of this policy priority was higher real interest rates, a return to pre-1914 levels of debt servicing costs as a percentage of public expenditure, and a rising public debt/GDP ratio (Dufrénot and Triki 2012). The post-2007 crisis added to public debt problems. Doubt about France’s sovereign creditworthiness increased for several reasons. The public debt/GDP ratio reached 86 per cent in 2011. Public expenditure rose to a record 56.6 per cent of GDP by 2010. Governments had not produced a single budget surplus since 1974. GDP growth forecasts proved repeatedly overoptimistic. Furthermore, internal problems within the state, particularly the large number dependent on its employment and its pension and other benefits, suggested risks of substantial political inertia. By 2012 France had lost its coveted triple-A credit rating.

Austro-Hungarian Debt

The public debt data of the Austro-Hungarian Dual Monarchy cover the period from its inception with the Compromise of 1867 and its collapse after the First World War. They illustrate the impact of war and its catalytic effect on industrial development (see Table 7.5). The public debt data also show how, within their monetary union, and the apportionment of common historical debt, the two constituent elements of the Hapsburg Empire pursued their independent fiscal policies, each managing its own special debt.

Table 7.5 Debt Burden and Debt Structure in the Austro-Hungarian Dual Monarchy, 1880–1895

Austria

Hungary

Debt Burden

Share of Gold Debt

Debt Burden

Share of Gold Debt

1880

63

11

78

25

1885

70

13

87

33

1890

75

17

99

32

1895

75

19

108

32

(Source: Flandreau 2001: 44)

The political background to the Compromise of 1867 was the humiliating defeat of Hapsburg aspirations in central Europe in 1866 and the subsequent war indemnity to Prussia. This profound shock led the governing elites in Austria, and especially Hungary, to develop a common interest in public borrowing to invest aggressively in modernizing their economic infrastructures. Hungary had the additional problem of building a fiscal reputation from scratch (Flandreau 2001). This problem was aggravated by the sovereign debt restructuring in 1868. The debt restructuring owed a great deal to Austrian frustration with the apportionment of the common debt between Austria and Hungary in the 1867 Compromise. It imposed losses on foreign creditors and set back Hungarian (p.207) efforts to build reputation in the financial markets. Building this reputation entailed high fiscal costs.

The two key players in helping establish and maintain the reputation of the two sovereign borrowers were the Austrian National Bank and the Vienna branch of the House of Rothschild. The Austrian National Bank gained increased powers in order to help restore the reputation of the florin and financial market discipline. In exchange the House of Rothschild was able to organize lending syndicates (Gille 1967). The outcome was some convergence in sovereign debt financing practices. Austria and Hungary competed to become the benchmark for each other.

Despite gaining reputation through the monetary policies of the Austrian National Bank, Hungary faced greater problems in its public debt financing. Its public debt was over 60 per cent of GDP from 1879 to 1904 and again in 1910–1911. Austrian public debt exceeded 60 per cent between 1875 and 1913. It stood at over 100 per cent for all but three years between 1890 and 1905 (Flandreau 2001). However, these figures hide the fact that Hungary’s debt burden was larger than that of Austria. In a marker of the ‘original sin’ of a new sovereign borrower, it relied on gold-denominated debt, as opposed to debt denominated in florins. Hungary’s gold-denominated debt grew rapidly between 1880 and 1995. It imposed a tightening financial market discipline on its sovereign borrowing. Though the Hapsburg Empire regained sovereign creditworthiness after the 1868 debt restructuring, the challenge proved more difficult for Hungary.

Once common public debt burdens were increased by the First World War, the Hapsburg Empire fell victim to destructive fiscal—as well as political—centrifugal pressures. Its collapse, the legacy of high debts and social and political crisis, and the demise of the gold discipline produced a crisis of the ‘tax’ state in both Austria and in Hungary. The newly independent state of Hungary resorted to ‘inflation tax’ on debt at the expense of creditors, on a scale not witnessed elsewhere in post-1918 Europe.

Belgian and Dutch Public Debt

The scale of impact of war on European public finances is borne out by Belgian and Dutch public debt data (see Tables 7.6 and 7.7). In 1815 the United Provinces inherited an onerous public debt/GDP ratio of over 150 per cent. It was mainly the product of the War of the Spanish Succession, four Anglo–Dutch wars, the French Revolutionary wars, incorporation into the French Empire in 1810, and British takeover of Dutch interests in Asia and South Africa during the Napoleonic Wars. The ratio remained over 200 per cent from 1821 to 1853 (except 1847) and did not fall below 100 per cent till 1871. In contrast, the Netherlands remained neutral in the First World War, after which in 1918 it had a public debt/GDP ratio of only 70 per cent. Only in the four years before 1914 had it had such a low ratio in the period since 1815. However, German occupation and Allied liberation in the Second World War returned the Dutch public debt/GDP ratio to 223 per cent in 1946. It remained over 100 per cent till 1953. The ratio was above 60 per cent till 1964 and again between 1983 and 2000 (see Table 7.7).

Table 7.6 Belgian Public Debt/GDP Ratio, 1835–2009

1835

9.81

1946

118.26

1840

17.18

1950

73.69

1845

33.02

1955

69.07

1850

33.72

1960

70.24

1855

22.03

1965

58.07

1860

20.03

1970

47.44

1865

18.08

1975

39.88

1870

15.11

1980

54.94

1875

19.33

1985

99.91

1880

26.19

1990

109.64

1885

35.97

1995

113.76

1890

36.28

2000

99.54

1895

42.12

2005

88.88

1900

42.80

2009

94.76

1905

47.15

1910

49.64

1913

49.47

1920

102.94

1925

116.26

1930

59.85

1935

84.09

1939

71.72

(Source: Banque Nationale de Belgique, Centre d’études économiques de la KUL, 2010)

Table 7.7 Dutch General Government Debt/GDP Ratio 1815–2005

1815

155.9

1920

59.6

1820

190.7

1925

82.0

1825

219.4

1930

75.6

1830

236.8

1935

117.1

1835

275.6

1939

106.5

1840

243.4

1946

223.0

1845

248.8

1950

141.0

1850

226.1

1955

87.9

1855

180.1

1960

78.7

1860

155.5

1965

57.3

1865

123.7

1970

49.6

1870

107.8

1975

39.6

1875

87.3

1980

45.4

1880

89.6

1985

69.4

1885

91.9

1990

75.8

1890

94.4

1995

76.1

1895

98.9

2000

53.8

1900

85.2

2005

52.7

1905

77.9

2007

47.2

1910

70.1

1914

61.2

(Source: The Dutch Fiscal Framework: History, Current Practice and the Role of the CPB. CPB Document 150, 2007)

This Dutch capacity to tolerate an elevated public debt/GDP ratio without default reflected its early development of a rentier society. In 1820 Dutch per capita GDP was (p.208) higher than British and remained so till the 1850s. Despite higher Belgian GDP growth, Dutch GDP per capita was only slightly below that of Belgium in 1914 (Maddison 2004: 437). Moreover, the Netherlands inherited a banking system with sophisticated debt financing and management techniques. The long struggle for independence against Hapsburg Spain, and with the English and the French, had made Dutch governing and banking elites familiar with the requirements of war financing. Well before 1815, Dutch society had exhibited a high tax capacity. Also, from the 1830s the Dutch proved remarkably successful in raising fiscal tribute from the Indonesian cultivation system, on a much bigger relative scale than the British in India (Maddison 2004: 88–9). In 1844 the Dutch government endowed Indonesia with a fictitious debt of 236 million guilders to cover the costs of liquidating the Dutch East India Company’s debts and those incurred during the revolt of 1825–1830. The legacy of these characteristics, along with predominantly liberal governments from 1848, helped make credible Dutch promises of honouring debts.

Nevertheless, pre-1914 data suggest that the Netherlands was much less fiscally virtuous than Belgium. The Netherlands’ public debt/GDP ratio did not fall below the Maastricht 60 per cent criterion once between 1815 and 1914. Economic structure and GDP growth played a major role in explaining the differences between Belgian and Dutch public debt dynamics. In addition to big inherited debts, the post-1815 Netherlands had a much weaker, more traditional manufacturing sector than Belgium. It suffered from (p.209) foreign competition, resulting in economic stagnation. Between 1830 and 1910 the gap in GDP size between Belgium and the Netherlands grew, notably in 1850–1870, from a position close to parity in 1830 (Maddison 2004: 424–5).

Belgium’s highest public debt/GDP ratio over this period was 50.98 per cent in 1909. Belgian fiscal virtue stemmed in part from the terms of the division of national debt on Belgian independence from the United Netherlands. After much acrimony, and a territorially less advantageous outcome, the split of the national debt was eventually much more favourable to Belgium than the original draft protocol of the London Conference in 1831. Belgians complained that the post-1815 union had penalized them through the punitive taxes that they had to pay to service the high Dutch public debt.

The Belgian public debt/GDP ratio fell from 33.72 per cent in 1850 to the low point of a mere 13.19 per cent in 1872 (see Table 7.6). GDP growth, along with conservative liberal economic policies, were the main factors explaining the trajectory of public debt over this period. Belgium led continental Europe in developing a modern economic structure, based on coal, iron, and engineering. It benefitted to a much greater extent than the Netherlands from export-led growth in the wake of moves towards free trade in Europe in the 1850s and 1860s. Over the period 1820–1913 its annual average GDP growth rate exceeded that of Britain and France (Maddison 2004: 262). Even with rising (p.210) welfare-state expenditures before 1914, the public debt/GDP ratio remained well below Dutch levels.

After 1918 war and social dislocation changed the relative positions of Belgium and the Netherlands. In 1925, for the first time since the early 1830s, Dutch GDP size overtook that of Belgium (Maddison 2004: 428–9). In contrast to its neutral neighbour, Belgium had a public debt/GDP ratio over 100 per cent from 1920 to 1926. However, from 1929, and the onset of the Great Depression, Belgium returned to its status as fiscally more virtuous than the Netherlands. After exiting the Second World War with higher indebtedness than Belgium, the Dutch public debt/GDP ratio did not converge with that of Belgium till the 1960s. The main shift to a more fiscally virtuous Netherlands began from the mid-1970s. Divergence grew as Belgium’s public debt/GDP ratio climbed from 39.17 per cent in 1974, surpassing 100 per cent between 1986 and 1999. This shift reflected the rapid decline in Belgium’s traditional heavy industries and rising tensions between her two main linguistic communities.

Seen in this longer historical perspective, Belgium’s record as a creditworthy state stands up to comparison with the Netherlands. Its claim to do so is strengthened after the 1970s by its higher domestic savings rate and strong domestic absorption of its sovereign bonds. Above all, the historical data shows an impressive Belgian record in public debt reduction in 1926–1931, 1946–1951, 1968–1975, and 1993–2006.

Prussian and German Public Debt

Prussian and Imperial German public debt data, since 1815 and 1871 respectively, offer insight into the significance of the relationship between the size of debt and tax capacity to service debt. They tell two different stories. Imperial Germany is a story of the difficult domestic politics of sovereign creditworthiness that followed from the mismatch between, on the one hand, assigned taxes and, on the other, a complex combination of expansionary political and geo-strategic ambitions with fears of geographic encirclement by France and Russia within the military under Emperor William II (see Table 7.8). The federal constitution assigned direct tax revenues to the member states rather than the Imperial government. Hence the Imperial government was unable to extract the revenue gains from the historically high GDP growth associated with growing German mastery of the new science-based second industrial revolution. Between 1890 and 1914 German GDP size more than doubled, in contrast to that of France which increased by some 40 per cent (Maddison 2004: 428). German annual average GDP growth in the period 1870–1913 was 2.83 per cent, compared to 1.90 in Britain and 1.63 in France (Maddison 2004: 262). However, Imperial defence expenditure faced fiscal limits that had no direct equivalents in Britain and France (Ferguson 1994).

Table 7.8 Prussia and German Reich Public Debt/GDP Ratios and Per Capita Public Debt in Marken, 1794–1913

Prussia Debt Ratio

Reich Debt Ratio

Prussia Per Cap.

Reich Per Cap.

1794

16.8

1807

32.7

1815

42.49

83.7

1820

27.95

58.5

1848

10.84

29.4

1866

14.69

44.4

1872

14.18

0.44

50.3

0.95

1882

26.72

4.85

97.0

10.67

1892

48.22

13.96

204.0

35.93

1902

37.99

16.58

189.0

50.79

1913

31.21

16.62

226.0

74.91

Table 7.9 Public Debt of German Empire 1877–1945, in Millions of Marks

Empire

States (Länder)

1877

16

1881

308

5244

1886

484

1891

1318

9230

1896

2125

1901

2503

10797

1906

3818

12495

1911

4910

15571

1914

5202

16841

1915

16715

17608

1916

39496

17981

1917

68877

18242

1918

104945

20582

1920

199728

10455

1921

263543

1922

352204

1923

6675048

1924

1958

1926

7141

1930

9630

2590

1931

11342

2752

1933

11690

2951

1936

14372

2850

1938

19098

2555

1939

30676

2112

1940

47889

2124

1941

85935

2162

1942

137629

1945

1943

195554

1746

1944

273354

1697

1945

379800

Note: Leaving aside both world wars and the period 1919–1927, Leineweber (1988) identified the periods of fastest growth in debt as pre-1914 (especially 1881–1891), 1929–1930, 1939–1940, 1963–1967, 1974–1976, and 1980–1981.

Table 7.10 Public Debt of the German Empire, Per Capita of Population in Marks

1877

0.37

1880

4.8

1885

8.8

1890

22.7

1895

40

1900

41

1905

53.1

1910

75

1914

77.6

(Source: Schremmer 1994: 110)

The Second Empire had the good fortune of being born free of debt in 1871. Till 1876–1877, it covered its military expenditure largely out of the French war indemnity (Schremmer 1994: 181). However, the subsequent rapid growth of Imperial public debt, especially in the 1880s, revealed the fiscal vulnerability of the Imperial government (see Table 7.9). It lacked a sizeable imperial tax base that could match the British and French governments. The political tensions consequent on this weak fiscal position (p.211) were apparent before 1914. They were sharply exposed by the First World War, when the Imperial government had to rely on debt financing and on the Reichsbank printing money by buying its debt.

Imperial German public debt problems reflected a deep-seated paradox and tension at the heart of the new regime. On the one hand, it was characterized by the entrenched executive power of the military, its immense social prestige after the wars of the 1860s, and the militarization of society. By 1913 key military figures were pressing the case for a preventative war. On the other, the Imperial government faced powerful constitutional and political constraints in gaining agreement for the five-year military budget. One constraint was the lack of significant independent tax capacity. Another was the political desire to appease the German Länder after unification in 1871 by costly fiscal equalization measures. A third factor was the deep suspicion of military fiscal profligacy by Chancellor Theobald von Bethmann Hollweg (1856–1921) from 1909. A determined effort was made to rebalance the Imperial budget and cut public debt (Clark 2013: 215–16).

In contrast to Imperial Germany after the Franco–Prussian War of 1870, Prussia had inherited a heavy public debt problem after the Napoleonic Wars (see Table 7.8). Prussian public debt underwent another big increase in the 1880s. This increase was also seen in other German Länder. It reflected their large-scale investment in public enterprises, including state guarantees, to support industrialization (Schremmer 1994: 114). The dynamics of public debt mirrored a very different conception of the role of the state in industrialization from that then dominant in Britain. Prussia and other Länder sought to mobilize credit to develop infrastructure, extract resources, and develop key industries. The capacity of the Länder to service this debt was enhanced, from the 1880s, by the generous fiscal equalization system, at the expense of the Imperial government. By 1913 half of German public debt was attributable to the Länder, another third to the municipalities (Schremmer 1994: 116).

(p.212) The First World War and its aftermath led to successive heavy losses raining down on the German rentier class. Wartime ‘hidden’ inflation was followed by post-war uncertainties about the scale of reparations and new pressures to increase social expenditures. Moreover, weak Weimar governments lacked sources of tax revenue. In political terms the debate about reparations was centre-stage. As initially conceived, Allied demands for (p.213) German reparations were higher than France’s reparations burden after 1871. However, they were not higher than the total burden of outstanding wartime debts on GDP borne by Britain and France in 1920 (Ritschl 2012b: 3). The problem lay at least as much, if not more, in German reluctance to pay rather than capacity to pay. The politics were further poisoned by persistent domestic rumours of new higher reparation demands and by French and Belgian occupation of the Ruhr in 1923. The subsequent catastrophic hyperinflation of 1923 forced a renegotiation of the reparation problem to help stabilize Germany (see Tables 7.9 and 7.10).

During the period of the Dawes Plan (1924–1929), the German government benefitted from a clause that protected German foreign-exchange reserves from reparation transfers. It also benefitted from new incentives to borrow on a massive scale from abroad, principally from the United States, enabling Germany to pay reparations on credit. Moreover, German fiscal policy adopted a neutral stance and failed to generate the surpluses needed to effect reparation transfers. German governments did not heed the criticisms of the Allied Agent-General for Reparations, who was located in the Reichsbank to monitor compliance with the Dawes Plan. However, from 1929 a stop in capital inflows caused a sharp reversion to policies of fiscal consolidation and harsh deflation. These policies were strongly advocated by the Reichsbank. By 1932 short-term foreign debts were being restructured and foreign-exchange controls introduced. In May 1933 Germany announced a unilateral debt default (Ritschl 2012).

An historical examination of public debt data provides little evidence that, before the 1950s, Germany could lay claim to be the European model of sound finances and creditworthiness. Both Imperial and Weimar Germany illustrated the dangers of mismatch between state liability and control. The absence of tax competencies to match commitments, above all externally, led to weak state capacity. After 1918, the Weimar Republic served as the archetypical model of how the attempt to avert the demands of external creditors in a context of weak state capacity could lead to ‘hyperinflation’. The outcome was a payments regime under the Dawes Plan, by which reparations were compensated by an inflow of principally US capital. In consequence, in 1929 Germany’s relations to its external creditors proved acutely vulnerable to a stop in capital inflows (Ritschl 2012b).

Table 7.11 German Public Debt 1950–2009, as Percentage of GDP and as Debt Per Capita

As Percentage of GDP:

1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

19.3

23.2

18.7

19.0

17.8

23.6

30.3

39.5

41.2

55.1

58.7

2005

2009

66.4

70.3

As Debt per Capita (in €):

1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

190

405

520

754

1,053

2,103

3,881

6,366

8,514

12,478

14,734

2005

2009

18,066

20,701

(Source: Statistisches Bundesamt, Schulden der öffentlichen Haushalte, Finanzen und Steuern, Fachserie 14, Reihe 5, 2010: 1.1.1)

(p.214) The public debt of the Federal Republic after 1950 had a very different trajectory, based on a combination of a stronger tax base for the federal government, debt forgiveness, and export-led GDP growth buttressed by wage moderation. The public debt/GDP ratio was very low in the 1950s and 1960s (see Table 7.11). It rose with the oil crises of the 1970s and early 1980s, and above all with German unification in 1990 after which it topped 50 per cent for the first time. The Bundesbank was the institutional anchor of Germany’s post-war self-reinvention as a ‘stability culture’, averse to inflation. From the 1970s it constructed an historical narrative that bolstered its own institutional independence and status by fixing on the 1923 hyperinflation as the reference point for historical lesson-drawing. This new German cultural model became the basis for constructing European economic and monetary union around fiscal discipline. EMU was built on the credibility of the most creditworthy of European states. Germany’s seriousness of commitment to its public debt reputation was reflected in the insertion of the so-called ‘debt brake’ into its Basic Law in 2009, its export into the euro area fiscal compact treaty of 2012, and a huge correction of Germany’s structural fiscal balance of 2.5 per cent between 2010 and 2012. Germany lent a fiscally ascetic nature to the euro area.

British Public Debt

Historical data on British public debt since 1688 suggest three patterns. They illustrate the enormous impact of wars and empire building; the symbiotic relationship between military/imperial ventures and commercial and rentier interests; and, not least, the assignment of buoyant tax revenues, based on early industrial and trading supremacy, to debt servicing (see Table 7.12). The fiscal underpinnings of this early, benign public debt dynamics derived from a virtuous circle of agricultural revolution, industrialization, trade expansion, empire building, and success in wars, combined with the professionalization of fiscal administration and the use of financial repression. Between 1700 and 1820 (p.215) GDP grew nearly 350 per cent, from some 60 per cent of French GDP size to overtake France (Maddison 2004: 424–5).

Hargreaves (1966: 291) highlights the effects of the Seven Years’ War. Public debt increased from £77,817,182 in 1757 to £132,120,664 in 1763. It then climbed to £243,206,140 in 1786 with the American War of Independence. The Napoleonic Wars left a huge overhang of public debt. It grew from £244,720,976 in 1793 to £834,262,726 in 1815 (see Table 4.1). Expressed as a percentage of GDP, public debt went up from 50 per cent after the War of the Spanish Succession to 140 per cent after the Seven Years’ War. In 1816 it reached 240 per cent, the legacy of over a century of war and empire building. Between 1815 and 1855 debt service costs accounted for almost half British public expenditure (Barro 1987).

There is no evidence that this debt legacy, which stood at over 90 per cent of GDP till the early 1860s, impaired British leadership of the first industrial revolution. It was accompanied by an annual average compound GDP growth rate of 2.05 per cent from 1820 to 1870, surpassed only by Belgium (Maddison 2004: 262). Moreover, the huge growth in British public debt per capita was accompanied by falling debt interest rates (see Table 7.12). This combination was the efficient secret of the eighteenth-century British state. However, this secret depended less on the growth in primary fiscal surpluses than on financial repression. The tightening of usury laws in 1714 privileged government borrowing (Drelichman and Voth 2008). In effect, British governments engineered a stealth subsidy to investors. It ensured that yields on government bonds remained relatively low and attractive (cf. Reinhardt and Sbrancia 2011).

Table 7.12 English/British National Debt 1688–1817

Debt Per Capita £..s.

Debt as % National Wealth

Average Interest Rate

1688 Revolution

0.4

0.31

1697 Wars of William III

3.10

5.75

7.18

1714 Wars of Anne

9.7

13.17

6.28

1749 Spanish–Austrian War

13.5

15.99

3.98

1766 Seven Years’ War

19. 4

26.62

3.65

1785 American War

29.15

24.42

3.90

1802 Great French War

45.17

28.81

3.83

1817 Great French War

50.0

31.48

3.77

(Source: Fisk 1921: 81)

Table 7.13 UK National Debt since 1855

% of GDP

1855

107

1860

101

1865

83

1870

73

1875

60

1880

59

1885

58

1890

48

1895

43

1900

33

1905

37

1910

33

1914

26

1916

61

1917

90

1918

114

1920

133

1923

180

1925

167

1930

162

1931

173

1935

168

1939

141

1940

121

1945

232

1946

252

1949

201

1950

197

1955

141

1960

110

1963

101

1964

93

1965

87

1970

67

1975

46

1980

43

1985

46

1990

35

1995

50

1998

50

Note: National debt fell within the later Maastricht 60 per cent rule only from 1880–1915 and 1971 onwards. Between 1918 and 1963 it remained over 100% GDP (over 200% from 1945 to 1949).

Nineteenth-century British public debt data reflect three factors: Britain’s pioneering role in the industrial revolution; its command of vast colonial resources and investments; and the consolidation of the domestic power of the rentier class (see Table 7.13). The two fiscal reformers who were central to this consolidation were Robert Peel and, above all, William Gladstone. Their reforms in the budgets of 1842 and 1853 sought to entrench fiscal probity, to establish income tax as a long-term basis for securing the interests of creditors, and to lock in large primary fiscal surpluses. In their wake the Crimean (p.216) War was financed without the fiscal difficulties that confronted France and Russia. Gladstone’s principles of public finance were emulated by liberal fiscal reformers across Europe, from Fould in France to Cavour in Piedmont. By 1875 the public debt/GDP ratio had declined from its post-1815 peak to 60 per cent. It stayed below this level till 1916, reaching its historic low of 26 per cent in 1914 (see Table 7.13). However, David Lloyd George’s 1909 budget was the decisive signal of a challenge to rentier ascendancy from the ‘New Liberalism’ of social reforms. The ‘People’s Chancellor’ provoked constitutional as well as political crisis. The 1909 budget set a new differential between earned and unearned income tax, introduced a super-tax, increased death duties, and proposed new land taxes.

(p.217) The First World War was a turning point in British public debt trajectory. In its aftermath Britain was no longer a massive net creditor state. Foreign assets no longer yielded returns in excess of the interest on debt. The war itself was financed by a combination of debt and taxation. Public debt escalated from £649,770,091 in 1914 to £7,831,744,300 in 1920 (Hargreaves 1966). It remained over 100 per cent of GDP till 1963 and did not return to pre-1914 levels till 1990 (see Table 7.13). Beginning in 1920, British governments responded with large primary fiscal surpluses. The Bank of England raised interest rates. The combination of sharp fiscal contraction with high interest rates led to harsh negative effects on GDP growth. These effects were compounded by British failure to retain a leadership role in the second, science-based industrial revolution. From 1920 to 1939 the public debt/GDP ratio exceeded 140 per cent.

A key feature of the 1920s was the efforts of the political and City establishment, centred on HM Treasury and the Bank of England, to reassure rentier interests. This institutional nexus was dominated by belief in the need to pursue deflation and engineer cuts in real wages. It involved the commitment to early return to the gold standard, which occurred in 1926, and willingness to confront organized labour. This priority to re-establishing a pre-war notion of fiscal ‘normality’ carried a heavy price in social and political bitterness, without reducing the public debt/GDP ratio. However, the 1931 economic and political crisis, with British exit from gold, initiated the use of devaluation and more accommodative monetary policy to restore growth and employment. It also witnessed British default on debt to the United States that had been accumulated in the First World War. In this changed context, the British public debt/GDP ratio fell from 1931 to 1940.

The legacy of the Second World War was a public debt/GDP ratio that exceeded 200 per cent between 1945 and 1949, reaching 252 per cent in 1946. The ratio was brought down in part by rapid economic growth and inflation and in part by financial repression through a host of rules aiming to hold nominal interest rates on debt below inflation. Nevertheless, the public debt/GDP ratio stood above 90 per cent till 1965, for two main reasons. The shadow of empire and aspiration to retain a global power role, not least as a nuclear power, led to continuing high levels of military expenditure. In addition, there was till the 1970s widely-shared agreement on increased welfare-state spending. These two factors helped ensure that the public debt/GDP ratio remained above the 60 per cent level till the 1970s. Nevertheless, despite the relative weakening of British GDP performance from 1950, this period coincided with historically high GDP growth. The background continued to be failure to establish a leadership role in the second industrial revolution.

(p.218) British historical public debt figures suggest a parallel between the period 1875–1914 and the period after the ending of capital controls and liberalization of credit from the end of the 1970s. Both periods witnessed phenomenal growth in British bank assets. The first period was ended by war; the second, by banking crises. War helped to build British sovereign creditworthiness in the eighteenth century, on the back of empire building and the first industrial revolution. However, war exhausted sovereign creditworthiness in 1914–1918 and 1939–1945. British sovereign creditworthiness reflected the character of its underlying economic structure. Unlike in Germany, it did not rest on a leadership role in the second industrial revolution. It was underpinned by banking assets, financial market liquidity, and innovative debt financing techniques. The post-2007 crisis exposed British fiscal vulnerability to an oversize, risk-prone, and volatile financial sector and—via this sector––to credit risks from any meltdown of the euro area. Its triple-A credit rating rested on shaky foundations, including a double deficit: current account and fiscal. In these circumstances a highly prudent fiscal strategy remained the most rational course.

Debt, Union, and Empire: Ireland and Scotland

The process of unifying the British state was bound up with empire, war, and debt. At the end of the seventeenth century, an impoverished and politically disunited Scotland sought to rebuild a strong national identity by emulating the imperial capacity of England. Its Parliament built on the bold ideas and financial acumen of the businessman William Paterson (1658–1719), a founder of the Bank of England and advocate of Dutch financial practices. In 1695 Paterson helped persuade the Scottish Parliament to establish the Bank of Scotland and the Company of Scotland. They were to provide the groundwork for a worldwide Scottish empire. However, the Company’s expedition to Panama in 1698 turned into a human and financial disaster. From the outset the English governing elite had resented this scheme as a threat to its own East India Company. Hence the City of London refused to subscribe to the Company of Scotland. Subsequently, the English king rejected offering any assistance to the Panama expedition. The outcome was huge Scottish debts contracted by the Company of Scotland, which were estimated at £250,000, a deepening of Scottish resentment against what was seen as English bad faith, and a Scotland that was represented as bankrupt.

The context of the Act of Union in 1707 was the combination of this weakened Scottish negotiating position with the English participation in the War of the Spanish Succession against King Louis XIV. The English sense of urgency about sealing the union with Scotland stemmed from fear that the French king would exploit Scottish resentment against England and the mounting and politically divisive costs of a prolonged war. Fifteen of the twenty-five articles in the Act dealt with economic and commercial issues on terms that were designed to suggest English benevolence, including the granting of free trade. Article 15 provided for the ‘Equivalent’, the sum of compensation to be paid to Scotland in recognition of its future share of the British national debt. However, the Equivalent was less generous than it seemed. Scottish debts on entering the union were calculated to be £710,000, with £250,000 accounted for by the debts of the Company (p.219) of Scotland. The Equivalent amounted to £398,085. The result was a shortfall of over £300,000 (Scott 2006: chapter 8). Moreover, the Equivalent was financed by introducing the English excise duty of alcohol to Scotland as well as by English borrowing, thus adding to the national debt of which Scots had to bear their share. This debt settlement left a considerable burden to be borne by Scottish taxpayers and the often poor creditors of the Scottish government.

The legacy was a Scottish discourse about English bribery, taken up amongst others by Sir Walter Scott. It was founded on English use of the Equivalent to exploit the self-interest of the many Scottish parliamentarians who were aggrieved creditors of the Company of Scotland. Nevertheless, the narrative of empire, which had driven the foundation of the ill-fared Company of Scotland, could be redeployed as the basis for a new nation building around the British state. Scotland’s disproportionately high participation in eighteenth- and nineteenth-century British empire building helped defuse public debt as a basis for reconstructing Scottish national identity.

In the case of Ireland, the narrative of debt and empire was more complex and had different consequences. Ireland retained an independent Exchequer beyond the Act of Union with Great Britain in 1800 up to 1817, when it was assimilated into fiscal union. It also had its own currency till monetary union in 1826. However, eighteenth-century Ireland found itself in a difficult fiscal position. On the one hand, it had its own Parliament, which from 1707 was subservient to the English Parliament. On the other, Ireland was caught up in the English financial revolution of this period and the rapid growth of Irish public debt. The growth of this Irish public debt took place within what could be represented as a colonial context.

As Moore (2010) suggests, Irish public debt played a role in consolidating a new Anglo-Irish identity, whose chief spokesperson was Jonathan Swift. Swift identified the central problem as the incompatibility of English-driven growth in public debt with the limitations on the rights of the Irish Parliament to control tax revenues. There was a serious, politically and economically damaging mismatch between liability and control. In his view, Irish public debt had become excessive as early as the 1730s because of the effects of trade restrictions on Irish revenues, the large remittances to absentee English landlord, and the heavy costs of supporting a standing army that was put in place by England.

The context of this colonial status was the geo-strategic and economic importance of Ireland to England. It was the ‘back door to England’, a vulnerability that was highlighted by the wars against France in the 1790s and Irish support for French Revolutionary ideas in the May 1798 uprising. Irish trade was also intimately bound up with the English market and English commercial policy. Above all, Ireland was a good place to station a standing army, given its unacceptability at home. It served as a reserve for managing wider imperial contingencies and as a force for order in an area of strategic vulnerability (McGrath 2012). Irish taxation and public debt in the eighteenth century were caught up in supporting the growth in the British military-fiscal state. Notably, the dreadful Irish famine of the 1740s did not register in the Irish public debt data.

The three turning points in Irish public debt were 1716, the 1770s, and the 1790s. In 1716 a small group of Anglo-Irish landowners loaned the Irish Treasury funds for national security, to be paid in perpetuity from future tax revenues. Swift became chief advocate of the interests of this group in a series of pamphlets that sought to mobilize (p.220) domestic public opinion. According to Moore (2010), the growth of this Irish public debt became bound up with the emergence of an Anglo-Irish national identity. However, the character of that new identity was demonstrated in the trajectory of public debt development.

The two decisive turning points related to the high costs of the English empire and war. The American War of Independence resulted in Irish public debt climbing from £1 million to £1.9 million between 1777 and 1783. It peaked at over £2.2 million in 1788 (Clarendon 1791). By 1782–1783 the fiscal deficit amounted to some 16 per cent of public expenditure. This period coincided with collapsing Irish trade, which affected revenues, two bank failures in 1778, and increased military expenditure.

An even more decisive turning point was the declaration of war against France in 1793. Irish public debt grew from £5.56 million in 1793 to £38.65 million in 1804 (Boyle and Geary 2004: 111). The Irish Exchequer faced mounting public unwillingness to subscribe to the new debt, except at exorbitant borrowing costs. Hence, it sought to finance this debt by looking to two alternative sources. First, it turned to the Bank of Ireland, which by 1796 was already agreeing to a rescheduling of debt repayments. The corollary was huge growth of money in circulation, far in excess of that in Britain, and currency depreciation. Secondly, faced by growing reluctance of the Bank, the Exchequer resorted for the first time to foreign borrowing in the London market. By 1800 some half of Irish public debt was funded through this source (Boyle and Geary 2004: 113).

The Act of Union in 1800 was essentially a political expedient in time of war. It aimed to close England’s ‘back door’ and to counter the political demands of the May 1798 Irish uprising. However, the Act did little to address Ireland’s fiscal and economic problems. Its financial provisions required the Irish Exchequer to shoulder a disproportionate share of imperial expenditures, which were mainly military. In consequence, by 1817 the Irish Exchequer was effectively bankrupt and merged into the British Exchequer, with a consolidated debt.

The Irish case illustrates the clash between two very different representations of public debt. In the one case, exemplified by Swift, it is seen as integral to the formation of an Anglo-Irish national identity, albeit a socially narrow one (Moore 2010). In the other, the growth of public debt is represented in Irish nationalist terms as colonial exploitation. Its burdens on Ireland are framed in terms of over-taxation, asymmetrical damage from English-imposed trade restrictions, and neglect of the poor. Public debt becomes integral to the formation of an anti-English Irish national identity, which focused on the disconnection of the poorest part of the population from the monetized economy of public debt (McGrath 2012).

Italian Public Debt

The evolution of Italian public debt after unification in 1860–1861 tells a familiar story of war’s impact. In sharp contrast to Imperial Germany, the wars of unification left a heavy debt legacy. Camille de Cavour, prime minister of Piedmont from 1852, displayed formidable financial acumen in employing his liberal economic credentials, especially commitment to a balanced budget, to attract plentiful external credit on favourable (p.221) terms. He exploited his familiarity with English political economy and with Second Empire France to encourage competition amongst British and French banks. Emperor Napoleon III was sympathetic to Cavour’s ideas on using debt financing to develop rail infrastructure, seeing opportunities for French banks. Above all, he was keen to support the bid for Piedmont’s hegemony in the Italian peninsula at the cost of the Hapsburg Empire. In pursuing his twin ambitions, Cavour faced the constraints of the small size, relative economic backwardness, and lack of domestic capital of Piedmont. He depended on mobilizing the support of Napoleon III, and British neutrality, to fight Austria.

However, the consequence of Cavour’s combination of political audacity, diplomatic cunning, and financial dealings was that the national debt was almost ten times higher in 1860 than in 1847 (Mack Smith 1985: 101). Half of the accumulated debt inherited by Italy in 1861 was accounted for by Piedmont. Alarmingly, the annual deficit in 1861 amounted to almost the total revenue of all the former Italian states put together (Mack Smith 1985: 267). This inherited fiscal burden on unified Italy bore down heavily not just on Piedmont but also on the economically poorer states. It also frustrated the expansionist, imperial policies of successive Italian monarchs, beginning with Victor Emmanuel, and prime ministers, notably Francesco Crispi in 1887–1891 and 1893–1896. They sought to turn Italy into one of the ‘great power’ European players, alongside Austria, France, Germany, and Russia.

Table 7.14 Italian Public Debt Since 1861

In Millions of Euros at 2002 Values: All Figures Relate to December of the Year

1861

1.7

1947

914.8

1871

4.9

1950

1,582.0

1881

6.1

1955

2,978.3

1891

7.2

1960

4,032.1

1901

7.9

1965

6,140.0

1911

8.8

1970

13,086.6

1916

15.9

1975

41,899.4

1919

56.4

1980

114,066.0

1921

91.4

1985

347,592.6

1925

92.9

1990

667,847.7

1931

83.1

1995

1,151,488.8

1933

56.5

2000

1,300,340.7

1939

79.4

2005

1,512,779.1

1941

137.2

2007

1,598,971.2

1943

257.3

1945

566.7

(Source: Francese and Pace 2008). Francese and Pace are only able to compute reliable debt/GDP figures for very limited time periods.

The inherited public debt problem was aggravated from the outset by a weak tax system, the illusory ambitions of King Victor Emmanuel for military action, and the costs of financing potential insurrections against Austrian rule in Hungary and the Balkans (Mack Smith 1971). It was deepened by the financially catastrophic Third Italian War of Independence in 1866 against Austria. Ruinous colonial wars in Africa added to the public debt problem, above all in Eritrea in 1888 and the humiliating defeat at the battle of Adowa in 1896, both associated with Crispi (see Table 7.14). The First World War left a grim public debt legacy. It peaked at close to 160 per cent of GDP in 1920–1921.

However, the interwar period was characterized by a sharp fall in the public debt/GDP ratio. The explanation lies in the combination of external debt forgiveness with the tough fiscal medicine administered by the Fascist governments of Benito Mussolini between 1922 and 1926. The public debt/GDP ratio was cut from 74.8 per cent to 49.7 per cent in this period. The fiscal medicine included de facto default in the form of a forced conversion to extend the maturity of debt in 1926. This medicine was administered again in 1934. In particular, Italy benefited, to a greater extent than Britain and France, from the international relief of pre-war and wartime debts in 1925–1926 with the Washington and the London agreements. Debt to the US government was reduced by some 80 per cent. Credibility was further strengthened by the securing of a large House of Morgan loan in 1926 (Chernow 1990). Along with combating socialism in the north and organized crime and the mafia in the south, public debt reduction was seen as the basis for renewing the image of Italy as a strong state able to claim a seat at the high table of European diplomacy. Strikingly, in contrast to other major European states, Italian public debt remained below 100 per cent during the Great Depression of the 1930s (Francese and Pace 2008: 19). However, Mussolini’s final fiscal legacy was ruinous public debt from his foreign policy adventurism and opportunistic entry into the Second World War.

In the post-1945 period, up to the 1970s, the most salient factor in making Italian public debt sustainable was the combination of historically high economic growth, (p.222) very high inflation, and a high domestic savings rate. The public debt/GDP ratio was kept on a sustainable path by a ‘nominal growth dividend’ that exceeded the interest cost on public debt. This dividend—and the big reduction in the real value of public debt—was accounted for more by inflation than by real GDP growth (Piergallini and Postigliola 2011).

In addition, domestic savings flowed into Italian sovereign bonds because of the lack of alternatives. Italian public debt dynamics rested on a paradox of trust. The public distrusted the political class, because of its intense factionalism, clientelism, and pervasive corruption. At the same time, it was willing to buy Italian sovereign bonds. Italian fiscal profligacy was possible without debt default or restructuring because it rested on a supportive structure of virtuous households, a cautious and prudent banking sector, and weakly developed equity markets. There was an implicit contract in which the banks, notably Mediobanca, were prepared to underwrite the Italian sovereign bond market and act as bulwarks against external debt dependency. They did so in exchange for being left alone to manage a highly profitable structure of cross-shareholding in Italian business, the so-called salotto buono.

External debt relief in the 1920s and high post-1945 inflation provide exceptional factors that help explain the main substantial public debt reductions. Nevertheless, long-term historical data indicate that Italian governing elites have, on significant occasions, demonstrated state capacity to actively use fiscal policies to reduce public debt. Pronounced increases in primary fiscal surpluses were achieved by Cavour’s (p.223) Piedmont-based conservative liberal successors during the so-called ‘Historical Right’ period (1868–1876). Prime Minister Giovanni Lanza and Finance Minister Quintino Sella sought—in vain—to present Piedmont as the ‘Prussia’ of Italy. Increases in primary fiscal surpluses were repeated in the first Fascist period (1921–1927) under Finance Ministers Alberto De Stefani and Giuseppe Volpi.

Similarly, during the first ‘Golden Age’ period (1951–1957), Finance Ministers Ezio Vanoni, Roberto Tremollini, and Giulio Andreotti delivered significant primary fiscal surpluses. This capacity was again demonstrated during the ‘Maastricht’ period (1991–1999), especially after the crisis of Italian exit from the ERM in 1992 and the challenge of meeting the Maastricht convergence criteria for euro entry in 1996–1997. In 1992–1993 Italy was saved from imminent default. Primary fiscal surpluses were also achieved by Finance Minister Giulio Tremonti during the second centre-Right government (2001–2004) of Silvio Berlusconi; by Finance Minister Tommaso Padoa-Schioppa during the last centre-Left government (2005–2008) of Romano Prodi; and by Mario Monti during his 2011–2013 technocratic government, when Italy underwent an extreme correction in its structural fiscal balance of some 3.4 per cent of GDP. These historical examples suggest reserves of Italian state capacity in crisis that differentiates her from other southern European states.

Italy managed to avoid association with the south European ‘arc of default’. A key factor was the ‘other face’ of Italy: the quality of a very small Italian technocratic elite and the international and European prestige that its members enjoyed. They were invited to assume the reins of power at times of acute crisis. Examples include 1992–1993, when Italy was at risk of default; 1995–1996, at a time when Italy faced the threat of exclusion from stage three of EMU; and 2011, when Italian bond yields soared and the centre-Right government of Berlusconi was politically paralysed. At such times, Italians could look back to the twelfth-century model of the podestà, the impartial magistrate or governor who was above faction and who had been temporarily appointed by the city states to restore order. Technocratic governments were welcomed as a necessary external expedient, enforcing overdue, urgent, and comprehensive fiscal and structural reforms (Monti 2011). The notion of external discipline (vincolo esterno) played a key role in legitimating this strand in Italian thinking about public debt.

Italy’s triple crises of 1992–1993, which were represented by the end of the Cold War, exit from the ERM, and corruption trials, held the promise of a fiscal transition. The status and power of the Treasury was reinforced. However, the challenges of ERM exit and then joining the final stage of European monetary union in 1999 proved less than radical in strengthening long-term Italian debt sustainability. The Italian political system showed a tendency to revert to inward-looking, highly partisan, and factionalized behaviour, notably under Berlusconi in 2008–2011, and again after the 2013 elections. Ministers continued to behave as feudal lords, protecting their fiscal turf.

Table 7.14 shows that, overall, the period from the 1970s saw an enormous increase in Italian public debt, unprecedented by Italy’s own standards. Two factors were at work. The first was an enormous growth in infrastructural investments and welfare spending and their exploitation by party political factions for patronage purposes. There was a failure to use debt productively to build up long-term GDP growth potential and to strengthen sovereign creditworthiness. A fiscal politics of factionalism created conflicting signals that added to market insecurities about Italian public debt. The second factor (p.224) was the growing economic and political significance of small- and medium-sized enterprises, which had greater opportunities for tax evasion than larger companies. Their owners represented an important part of the electoral base of centre-Right parties, which were in consequence unwilling to engage in major tax reforms.

More seriously, the paradox of trust as an explanation for benign Italian public debt dynamics began to unravel. The European financial market integration that followed monetary union after 1999 induced the big Italian banks and investors to diversify their sovereign bond holdings outside Italy. By 2008 an increasing proportion of Italian sovereign bonds was held outside Italy, one-third by French banks. In consequence, monetary union served to weaken the historic connection of Italian sovereign bonds to the high domestic savings rate. Italy had become more vulnerable to international market pressures.

The post-2011 Italian sovereign debt crisis had paradoxical effects on the structure of financial power that had traditionally underpinned Italian creditworthiness. On the one hand, the risk that the paradox of trust would unravel was diminished by the subsequent financial market fragmentation. The Italian government sought to mobilize domestic financial power. On the other hand, the post-2011 crisis precipitated an unwinding of the salotto buono. As Italian bank shares lost as much as 90 per cent of their value, it became clear that the cross-shareholdings served as a vehicle for contagion across the economy. In 2013 the crisis at the venerable Monte dei Paschi bank of Siena cast a negative light on Italy’s eighty-six banking foundations. These foundations were deeply locked into local and regional clientelist political networks and came to share in their opprobrium. The Italian state’s creditworthiness seemed less well protected by the combination of virtuous households with a domestically-oriented banking system.

Seen over a long time period, Italy’s compliance with the Maastricht rule was the exception. Its public debt/GDP ratio was under 60 per cent for only 39 of a 147-year period: 1861–1863, 1926, and 1946–1981. In 1926 it was helped by international debt relief and in 1946–1981 by the combination of relatively high growth with inflation. The ratio was over 100 per cent for fifty-three years.

Spanish Public Debt

In sharp contrast to Italy, the history of Spanish public debt since 1800 is marked by the largest number of defaults in Europe (Comín 1996). In the nineteenth century public debt accounted for almost 100 per cent of Spanish stock-exchange trades and remained over 50 per cent till 1935. Holding this public debt was attractive because of the lack of financial alternatives. Spain remained a relatively backward economy. It was entrapped within the anti-usury doctrines of a powerful Roman Catholic Church and addicted to the aristocratic code of the non-productive hidalgo. An additional attraction to holding public debt was that, over the period 1800–1936 (except 1915–1920), real interest rates on public debt were rarely negative (Comín 2012; Prados de la Escosura 2003).

At the same time, defaults on public debt contributed to the uncertainties, turbulence, and lack of confidence that held back Spanish economic development. Avoiding sovereign default was a chief concern of the small professional, liberal middle class. (p.225) However, the clashes between liberalism and traditionalism, civil wars, repeated military interventions, and regime changes concealed a striking continuity of monarchical, aristocratic, army, and Church power. Their power frustrated liberal attempts to reform state, society, and economy in ways that would make high public debts sustainable without default. Monarchy, army, and Church stood for ‘Eternal Spain’. The corrupt practices that gathered around the political bosses (caciques) provided another source of continuity and inertia.

Table 7.15 Spanish Public Debt Since 1850

Central Government Public Debt/GDP Ratio

External Debt/Sovereign Debt

Debt Servicing/Spending

1850

91.7

40.2

11.7

1855

62.9

38.5

20.1

1860

59.3

33.6

15.8

1865

70.5

23.7

29.1

1870

122.1

33.9

52.6

1875

150.3

33.2

12.5

1876

169.0

30.5

29.8

1880

152.5

32.1

37.6

1885

71.3

30.1

31.0

1890

77.9

29.2

34.7

1895

86.1

26.8

30.0

1900

124.1

12.9

31.9

1902

128.0

9.5

30.7

1903

114.3

8.2

46.1

1905

110.4

8.3

41.1

1910

89.7

9.9

36.0

1914

76.5

9.9

28.4

1918

50.7

7.9

25.3

1920

44.4

2.5

20.1

1925

56.6

0.6

20.8

1930

58.9

0.4

23.3

1935

65.9

0.3

23.2

1940

71.8

0.2

16.9

1945

69.6

4.9

15.8

1950

46.2

2.5

14.4

1955

38.9

2.4

15.0

1960

29.4

7.7

9.1

1965

18.1

9.3

4.3

1970

19.2

13.2

2.6

1975

11.9

13.7

2.3

1980

10.2

21.9

3.1

1985

31.5

16.6

17.8

1990

40.1

3.8

24.3

Debt Servicing/Public Spending Ratio

1850

11.6

1870

52.6

1875

12.5

1879

33.3

1882

25.4

1883

30.4

1894

40.1

1898

43.0

1903

46.0

1914

28.4

1917

48.6

1920

20.1

1923

28.1

1932

21.4

1941

19.4

1975

2.3

1981

1.9

1997

47.8

1999

32.9

2007

7.3

(Source: Kind permission of Francisco Comín, University of Alcalá, Madrid)

To add to Spain’s problems, at least till 1903, public finances were highly vulnerable because of excessive reliance on externally-held central government debt. Over almost all the period 1850–1890 it amounted to over 30 per cent of public debt (see Table 7.15). Defaults led to repeated exclusion of Spanish public debt from trading on European stock exchanges. Symptomatic of its isolation, Spain never belonged to the gold standard. However, sharp reduction in external debt, and later neutrality in the First World War, helped Spain achieve a banking and industrial renaissance between 1903 and 1918. From 1902 to 1965 external debt represented less than 10 per cent of public debt.

Part of the Spanish problem was public debt legacy. Despite the defaults of King Ferdinand VII, the Napoleonic Wars and absolute monarchy bequeathed a huge public debt legacy to nineteenth-century liberal governments. Though liberal governments sought to draw a line under resort to default, the debt legacy combined with domestic constraints and external debt burdens to induce them to repeated debt restructurings. They were constrained by the entrenched power of aristocracy, army, and Church and their devotion to imperial ventures. Liberal governments also faced pervasive corruption and continuous internal political instability and threats of civil war. They had to contend with chronically weak tax capacity, inadequate fiscal controls of the Spanish Treasury, and the mushrooming practice of off-balance-sheet financing. The disruptions that were associated with regime change were further aggravated by a bewildering succession of finance ministers within each regime, none in office long enough to gain mastery of the Treasury. An undeveloped domestic financial system made it difficult, and potentially too costly, to avoid dependence on external financing of public debt.

Spikes in public debt were linked to the three Carlist Wars (1833–1840, 1846–1849, and 1872–1876). They were also caused by disastrous imperial adventures, backed by the monarchy, aristocracy, army, and Church. The Spanish–American War of 1898 led to the loss of Cuba, the Philippines, and Puerto Rico and had a highly negative effect on Spanish public finances. The so-called Rif War in Morocco (1920–1926) was another drain on Spanish finances.

Available figures since 1850 show that between 1867–1882 and 1896–1909 the public debt/GDP ratio was above 90 per cent. It peaked at 169 per cent in 1876—following the Third Carlist War—and at 128 per cent in 1902—in the wake of the 1898 war (see Table 7.15). The scale of the public debt problem was revealed in the debt servicing/public expenditure ratio and in the debt servicing/revenue ratio. The debt servicing/ expenditure ratio reached an alarming 52.6 per cent in 1870 and 46.1 per cent in 1903 (Prados de la Escosura 2003). It stood at over 30 per cent between 1880 and 1914. Debt servicing as a percentage of revenue was over 30 per cent in 1856, 1863–1873, 1877–1881, and 1883–1920.

Nevertheless, despite the heavy weight of debt legacy and political inertia, Spanish history is marked by episodes of huge public debt reductions: 1850–1863, 1880–1883, (p.226) 1902–1920, 1945–1975, and 1996–2007. In the nineteenth century the key instrument was debt restructuring. It was used by a succession of liberal, reforming finance ministers, who sought to appease suspicious, often hostile foreign creditors. They included the restructurings of Fernández Gamboa in 1841; Alejandro Mon in 1844; Bravo Murillo in 1851; Garciá de Barzanallana in 1867; Pedro Salaverría in 1876; Juan Camacho in 1881; and Fernández Villaverde in 1900. The bold, coercive debt restructuring by Murillo encountered serious opposition from external creditors, leading to Spanish exclusion from other European exchanges. In contrast, Camacho used a voluntary, negotiated restructuring to radically reduce public debt (Comín 2012).

(p.227) The key turning point came with the Spanish–American War, including the assumption of the Cuban and Philippine debts issued between 1899 and 1902. Villaverde responded with a radical debt restructuring. He broke new ground by forcing Spanish citizens holding Spanish external public debt to convert it into domestic debt and by imposing a 20 per cent tax on all domestic debt interest. Villaverde achieved fiscal surpluses between 1899 and 1908. Though he failed to get Spain to accept external discipline by adopting the gold standard, his tenure of the finance ministry had long-term effects in changing attitudes to public-debt management.

Strikingly, there was no public debt crisis in the post-1918 period, at least until 2011. Spain had not participated in the First World War. The high point of the interwar public debt/GDP ratio was 67.6 per cent in 1933. The debt servicing/public expenditure ratio did not climb above a high of 28.1 per cent in 1923 and fell to 21.4 per cent in 1932. Finance ministers made occasional use of debt restructuring, but essentially to take advantage of low market interest rates. Their statecraft relied instead on a mixture of inflation, financial repression, and monetary financing by the Bank of Spain.

(p.228) Following Villaverde’s debt restructuring, there had been a sharp decline in reliance on externally-funded public debt. Neither side in the Spanish Civil War (1936–1939) was in a position to resort to large-scale external debt financing. Means other than formal external borrowing were used. The Republican government shipped its huge gold reserves to the Soviet Union in exchange for support. The nationalist authorities handed over control of Spanish mineral wealth to German interests in exchange for German help. The relatively low public debt/GDP and debt servicing/public expenditure ratios after the Spanish Civil War were the result of reliance on monetary financing by the Bank of Spain.

There was also no public debt crisis in the post-1939 Franco period. Under his policy of autarky and harsh financial repression, the public debt/GDP ratio declined from 71.8 per cent in 1940 to a legacy of 8.2 per cent. The debt servicing/public expenditure ratio fell to a mere 2.3 per cent (Prados de la Escosura 2003). Franco used two key instruments to achieve this public debt reduction. He repudiated the debts of the republican governments, following the practice of Ferdinand VII in 1814 and 1823. In addition, José Larraz López undertook a debt restructuring in 1939. Thereafter, the main instruments for achieving the low debt servicing/public expenditure ratio and the low external debt/sovereign debt ratio under Franco were financial repression and inflation (Comín 2012).

The post-Franco transition to democracy and EU entry in 1986 witnessed an escalation in public debt/GDP and debt servicing/public expenditure ratios, lasting till 1996–1997. Equally, the convergence process for euro entry in 1999 and the first decade of the euro saw a striking sharp reduction in both ratios. However, the risks of sovereign debt crisis were not captured in Spanish fiscal statistics, which remained formally strong, boosted by high GDP growth and inflation. The sources of vulnerability proved to be the exceptionally high external debt/GDP ratio, which by 2010 had reached 170 per cent; the asset-price boom in construction and property; overleveraged households; the fragile asset quality of the savings banks (cajas); and the sub-national finances of the powerful autonomous communities created after Franco.

Historical Lessons: War, Welfare States, Financial Crisis, and State Capacity

Historical data about the contingencies and vulnerabilities that affect public debt dynamics suggest some general lessons about the limitations of formal debt sustainability analysis. First, war, and threat of war, has the capacity to radically reframe discourse about what is an acceptable level of public debt. Once publics are persuaded of an existential threat and a just cause, their willingness to pay taxes and to purchase ‘national’ debt is transformed. This willingness was exploited by Napoleon III to issue a national bond to help finance war on behalf of Italian unification and French territorial gains. Jay Cooke followed this example in devising new national bond issues to finance the Union armies in the US Civil War (Oberholtzer 1907). These measures of war financing help reduce dependence on banks and financial institutions and exploit appeals to national identity and exceptionalism.

(p.229) War also serves as a catalyst in restructuring domestic social interests. Widespread public bondholding makes post-war debt repudiation and resort to hyperinflation politically unattractive instruments. The United States avoided repudiation of the Union debt after 1865. In contrast, the reputation of the Weimar Republic was tarred by the effects of hyperinflation in 1923. The aftermath of war can undermine rentier power in other ways. The huge post-1917 debt repudiation by the new Soviet government in Russia produced widespread shock effects, notably in France.

War is important in terms of the huge costs of financing military operations and, above all, in terms of the tendency to underestimate their likely length. As during the US Civil War, expectations of short war can lead to rapid and often chaotically structured public debt expansion (Noll 2012: 3). Three developments in warfare have increased the threat of uncontrollable debt dynamics. First, the growing spatial scale of warfare was signalled by the Seven Years’ War in the eighteenth century and its role in the emergence of Britain as a world power. Secondly, from the end of the eighteenth century, war began to involve an increasing scope of societal mobilization. It became ‘total’ war. Above all, modern war technologies and emulation of war-fighting best practice had direct effects both on military spending and on populations. Thirdly, the devastating aftermath of new mass warfare contributed to political agenda change. It strengthened the rationale for large-scale public welfare-state expenditure as a means of sustaining social consensus.

Another historical feature is that welfare-state development began to play a new role in shaping the dynamics of public debt, especially after 1945. It was associated with a reframing of discourse about acceptable public debt. In particular, the interwar period in Europe served as a chilling lesson about the dangers of neglecting to build and maintain social consensus. From the early twentieth century, the parameters of discourse about public finances and debt changed under the combined impacts of shared experience of ‘total’ war, franchise extension, and the rising expectations associated with mass education, literacy, media, and exposure to consumer culture. Within a few decades the dynamics of welfare-state development began to increasingly reflect population ageing, notably in health, social care, and pensions spending. This development also substituted for the demise of the ‘extended’ family as welfare provider.

A third historical lesson is that public debt dynamics have become increasingly vulnerable to the radically new scale of banking and financial institutions. This vulnerability grew as societies became more affluent, as pension provision for longer life expectancy became more critical, and as opportunities for international expansion grew, not least with the digital revolution. Enormous creative energy was employed in creating new esoteric debt instruments; private as well as public debt grew exponentially; and financial institutions became more highly leveraged, with investment bankers operating within more generous credit limits. Cross-nationally active financial institutions often dwarfed the European states that were supervising and regulating them. They were potentially not just ‘too big to fail’ but also ‘too big to save’. This vulnerability was exposed dramatically in the post-2007 crisis. States stepped in to rescue ‘systemically-significant’ financial institutions from failure and tried to come to grips with the scale of toxic and opaque debt. Public debt levels threatened to explode towards wartime levels. However, they did so in an economic and political context in which the prevailing notion of fiscal normality remained restrictive. ‘Rescuing bankers’ was a much less attractive just cause than waging war on enemies. Table 7.16 shows just how significant the effects of (p.230) financial-sector support were in euro area Member States in the period 2008–2012. There were major impacts on gross central government debt in Ireland, Greece, Germany, Portugal, and Cyprus. The effects on contingent liabilities through state guarantees were most pronounced in Ireland, Greece, Belgium, and Portugal.

Table 7.16 Net Impact of Financial-Sector Support on General Government Gross Debt and Contingent Liabilities in Euro Area Member States, 2008–2012, as Percentage of GDP

General Government Gross Debt 2008–2012

Contingent Liabilities 2008–2012

Belgium

6.7

15.7

Germany

11.6

2.2

Ireland

31.4

69.8

Greece

14.5

27.9

Spain

5.1

6.5

France

0.2

2.5

Italy

0.2

5.5

Cyprus

10.0

5.6

Luxembourg

6.7

5.0

Netherlands

6.9

3.2

Austria

3.4

3.8

Portugal

10.6

10.0

Slovenia

4.1

0.6

Euro Area

5.7

5.7

(Source: European Central Bank, Monthly Bulletin, June 2013: 86)

A fourth lesson that emerges, above all from American, British, and Dutch data, is the correlation of the post-1870s classic gold standard period with historically low public debt/GDP ratios. The IMF estimated that the world public debt/GDP ratio fell from 45 per cent in 1880 to 23 per cent in 1914, the lowest ever (Ali Abbas, Belhocine, ElGanainy, and Horton 2010). However, this correlation depended on specific domestic economic and political conditions, notably high GDP growth and the political ascendancy of rentier interests. Their ascendancy acted as a disincentive to resort to inflation as an instrument for public debt reduction. It provided the political constituency that supported the combination of the gold standard with disciplined domestic fiscal policy. In this context, British public debt reached its historically lowest level in 1914.

The historical data also highlight the effects of the Great Depression and the demise of the gold standard in 1931–1933, outside a small European ‘gold block’. This period saw a rise in the world public debt/GDP ratio to a new peak of 80 per cent in 1932. Strikingly, the ratio for the Group of 20 (G20) states was 20 per cent higher in 2007 than in 1928, on the eve of the Great Depression. It rose at a faster pace post-2007 than (p.231) post-1931 (Ali Abbas et al. 2010). However, the world public debt/GDP ratio had some way to go to reach its historic peak of almost 150 per cent in 1946.

Longer-term historical data help broaden analysis of debt sustainability and bring out the dynamic effects of war, banking and financial crises, and welfare-state development. In particular, war and banking and financial crises illustrate how extreme, extraneous events can radically shift debt trajectories. Geo-strategic and financial indicators emerge as more powerful indicators of risk to sovereign creditworthiness than conventional economic and fiscal variables. They include the sophistication of diplomacy, the effectiveness of deterrence, the state of banking and household balance sheets, and the quality of financial market supervision and regulation.

Conventional formal debt sustainability analysis has its own problems of dealing with context-specific and time-specific contingencies, as well as with implicit and ‘off-budget’ liabilities. Uncertainty surrounds the reliability of basic economic data, as well as the precise causal mechanisms at work. It affects what can be realistically expected from efforts to forecast medium-term economic development, to estimate fiscal multipliers, and to specify the nature of the relationship between public debt and GDP growth. Uncertainty pervades attempts to calculate the liabilities associated with population ageing, with the banking sector, and with cross-national financial assistance in the euro area (European Central Bank 2012a: 63–4). The contingent and implicit liabilities associated with foreign, defence, and security policies are even more difficult to capture.

Other core determinants of long-term debt sustainability remain extraneous to this type of formal economic analysis. Welfare-state development—and, in some states, the welfare function of the extended family—provides an insurance mechanism against the personal risks associated with rapid fiscal and structural adjustments to ensure debt sustainability. It also contributes to economic growth through social investment in education, training, labour mobility, health care, and childcare. Social investment and, more broadly, the quality of public finances are not factored into formal debt sustainability analysis. Yet they are essential to compensate and empower losers. Excessive social imbalances endanger debt adjustment strategies (Vandenbroucke, Diris, and Verbist 2013). Hence debt adjustment needs to give priority to social indicators like child poverty, education, and training. On these measures of social investment Romania, Bulgaria, Italy, Latvia, and Spain looked vulnerable.

Similarly, cultural and institutional indicators are excluded from formal debt sustainability analysis. Culturally specific historical path dependencies can be traced in public debt dynamics. They are expressed in various forms of institutional inertia in fiscal, economic, and social policies. In France, for instance, the scale of public-service employment has entrenched defence of entitlements and made debt retrenchment politically very difficult. In Britain, by contrast, the intimate nexus of City of London, Bank of England, and Treasury has helped privilege formal debt sustainability analysis and a discourse of fiscal austerity.

Formal debt sustainability analysis also overlooks two factors that have a profound influence on public debt trajectories: state capacity to tax, to deliver productive investment, to control expenditure, and to maintain financial stability; and political and ideological willingness to prioritize debt reduction. What constitutes sustainable debt emerges as context-specific. It varies with executive autonomy, the professionalization of public administration, the ideological nature of governing parties, the nature of party (p.232) system competition, and the strength of institutional incentives to veto change and to engage in rent-seeking activity. Sovereign debt does not simply become a problem when it crosses a ‘critical’ public debt threshold like 90 per cent of GDP. The ‘fiscal space’ that is enjoyed by a state before it reaches this point is contingent on state capacity. At the time of their defaults in 1998, Russia had a public debt/GDP ratio of 75.4 per cent, the Ukraine of only 39.1 per cent. In the period 1840–1880, the Dutch public debt/GDP ratio was higher than that of chronically defaulting Greece. The crucial factor was not the size of public debt. It was state capacity to service debt through efficient, rigorous tax collection and control of public expenditure, along with political willingness to pay. State capacity is lower in states where clientelism, patronage, and corruption are rife. It is also impaired in states where complex multiparty coalitions preside over a feudalistic government structure, in which ministers safeguard domains of entrenched entitlements.

State capacity and political and ideological willingness to prioritize debt reduction are highly context-specific. They vary across space and over time. This variation is apparent in the use of debt restructuring, structural reforms, inflation, and financial repression. Thus financial repression, which involves creating ‘captive audiences’ for public debt and manipulating interest rates, was an important tool of statecraft, practised in different ways by British governments in the eighteenth century, by Franco’s Spain, and by the United States and Italy after 1945. Financial repression regained attraction as the sovereign debt crisis mounted in Europe after 2008 (Reinhart 2012). In broad terms, opportunities to engage in financial repression narrowed once investors could escape through more globalized markets, once more open democratic politics took root, and once governments were held to account for adverse effects on private-sector investment and credit growth. Nevertheless, scope for financial repression remained (Reinhart and Sbrancia 2011). In some states banks are more vulnerable to pressure from their governments to acquire domestic sovereign debt. They can be induced to do so by changing regulatory requirements. States can also engineer situations where yields on sovereign bonds are kept just below the prevailing rate of inflation for many years, acting as a silent tax on creditors. These forms of financial repression played a key role in bringing down the huge post-1945 public debt levels, alongside growth. Between 1945 and 1970 Italy ‘raised’ more by wiping out government debt through negative interest rates than it managed to secure from conventional taxes (Reinhart and Sbrancia 2011).

Perhaps most importantly of all, the limited historical time horizon of formal debt sustainability analysis offers no insight into the changing politics of fiscal ‘normality’. It fails to show how this politics is embedded in the changing balance amongst social interests. This balance shapes dominant economic cultures and their characteristic ideologies of debt and conceptions of state virtue. Longer-term historical data illustrate how public debt levels well in excess of the conventional notion of fiscal normality from the 1980s to 2010s proved compatible with the avoidance of default and even with reduced debt interest rates. The historical data show that compliance with the Maastricht 60 per cent debt/GDP rule has been the exception, not the rule. Moreover, they do not suggest that compliance with this rule has been a precondition for economic growth. British public debt fell within this rule only from 1880 to 1915 and from 1971 to 2008.

The historical data also indicate that the association between public debt and GDP growth is too context-specific and contingent to be amenable to a simple rule. Sustainable debt is bound up with a range of economic variables like the nature of public (p.233) expenditure, type of economic structure, the absorptive capacity and sophistication of the banking system, the buoyancy of international economic growth, exchange rates, and real interest rates. More fundamentally, it depends on state capacity to extract tax efficiently and to invest productively in infrastructure and in building social solidarity. In the cases of Italy and Spain—as well as of Greece and the Ottoman Empire, considered in Chapter 5—these context-specific factors suggest an association between high public debt and weak economic growth. However, this association is much less clear in the debt histories of Belgium, Britain, France, the Netherlands, and the United States. The historical lesson is that, in certain conditions, high public debt—potentially well below 90 per cent of GDP in some cases—has costs for economic growth. However, slow GDP growth is always bad for public debt accumulation, and not all debt accumulation is bad for growth.

Despite its many limitations, formal debt sustainability serves an invaluable function in counselling fiscal prudence and arguing for substantial safety margins to cope with unexpected shocks and short-term opportunistic political behaviour. In this sense the lessons from formal economic reasoning and the historical analysis of public debt converge. Long-term historical data highlight the regularity and the significance of extreme events such as war and banking and financial crisis, as well as of longer-term trends in welfare-state development. Their significance in radically transforming public debt trajectories suggests fiscal prudence, potentially more than is allowed for in the EU Stability and Growth Pact ceiling on public debt. Prudence becomes all the more pressing once trend GDP growth declines and tax capacity diminishes, along with the absorptive capacity of the banking system for public debt.

Historical analysis adds the crucial dimension of context-specificity and idiosyncrasy. It draws out the long-term impacts of specific historically formative experiences, like the differences between the legacies of German and Italian unification. Economic structure provides another source of variation through effects on potential GDP growth. Historical analysis also shows the decisive importance of state capacity and political and ideological willingness to extract taxes and to deliver productive infrastructural and social investment that helps generate economic growth and build social solidarity and inclusivity. (p.234)