Debt, morality and the cycle

By Buttonwood

AT THE heart of the battle between Greece and its EU partners over its debt crisis are conceptions about morality over debt and economics; issues that have been debated for thousands of years. The idea of interest payments on debt was around at the time of Hammurabi, ruler of Babylon in around 1800 BC; his code set maximum rates of 33.3% for loans of grain and 20% for those of silver. There was a lot of focus on what was "fair"; those who lent cattle to their neighbour were entitled to some or all of the calves that might be born. The Sumerian word for interest, mas, means calves. Aristotle argued that an inert commodity like silver, which did not bear fruit, should not carry interest.

The concept of usury (an excessive interest rate) was developed by the Catholic Church, although the parable of the talents implies that money should be set to work. See Matthew 25:27

Well then, you should have put my money on deposit with the bankers, so that when I returned I would have received it back with interest

Later on, there was the concept of productive and unproductive loans: lend your neighbour the money to pay for hospital treatment, and no interest should be expected; lend him the money to start a business, and interest should be handed over.

By and large, the creditor was seen as the potentially immoral party in the transaction; there was sympathy for the debtor who could not repay debt owed to the "grasping" lender. But here is the rub. Creditors risked not getting their money back and so needed to charge high rates to compensate, but restrictions on rates did not allow this to happen.

Unsurprisingly, Homer and Sylla, in their epic history of interest rates, find virtually no data on credit and rates from the end of the Roman Empire to the 12th century. A step change in moral attitudes really came about with the rise of the merchant states of the Netherlands and Britain in the late 17th and early 18th centuries. The rulers of these states financed themselves with loans from the wealthy of the land (the Bank of England dates from this period). Parliaments in those states had a strong interest in having the monarch pay money back. As the states demonstrated their creditworthiness, their cost of borrowing fell. To these creditors, many of whom were motivated by an austere Protestantism that emphasised the work ethic, failure to repay debt showed a lack of moral fibre. The idea of the "debtors' prison" is brought down to us by Dickens (who had childhood experience of the phenomenon); but even with his innate sympathy for their plight, he made both Mr Dorrit and Mr Micawber rather ridiculous figures.

The moral tide turned after 1945, perhaps because debt has become so widespread; if debtors are sinners, then we are all guilty. For those who experienced the 1930s depression, debt was the road to ruin. For those born after 1945, debt was both easy to access and the only way to deal with life; it helped that inflation eroded the real burden of repayment.

Tied up with this history is the role of the state as both debtor and controller of the money supply. Medieval monarchs needed to borrow money to finance their wars; when the time came to repay, they could simply refuse to do so, or repay in deflated currency. As already stated, British and Dutch merchants had much better experiences with their own governments after 1700. But lending to other people's governments has always been a trickier matter. Even if the government is an ally, things can change rapidly, as French investors who bought Tsarist bonds before 1917 subsequently discovered.

How can you enforce a contract with a sovereign nation? The British resorted to sending in gunboats on a few occasions and Woodrow Wilson's actions in Haiti and the Dominican Republic can be seen in a similar light. The saga of first world war reparations gave the debate a new twist; Keynes, in his famous "Economic Consequences of the Peace", argued that the corollary of German repayment would have to be a German trade surplus at the expense of the other nations. The old mercantilist idea of "piling up surpluses" was mistaken; it was expansion of trade that made nations prosper, not a surplus or deficit.

But the moral argument did not go away and showed up in the idea of "odious debt"—the idea that citizens should not be responsible for the debts run up by kleptocratic rulers (like Mobutu in Zaire). Various proposals for debt forgiveness of African nations were put forward in the 1980s and 1990s.

Coming forward to the Greek/German debate, this clearly pits the concept of debtors as irresponsible spendthrifts against creditors as greedy misers. It also revives Keynes's ideas about the futility of building up trade surpluses in the form of claims on another nation's economy that are unlikely to be repaid. The moral debate about odious debt doesn't really apply; Greece has been a democracy since 1974. But there is clearly an economic argument for saying that everyone would be more prosperous if the slate was wiped clean and everyone started again. The counter-argument is one of moral hazard; that Greece would not reform under such circumstances and that other nations would copy its example.

Your blogger has argued elsewhere that, just as the moral arguments go through a cycle, so do the relations of creditors and debtors. Debtors borrow too much, creditors are too confident about the former's ability to repay and a crisis hits; in the course of this crisis, the debtors fail to repay in real terms. These cycles have occurred at regular intervals on a worldwide basis, with the outcome varying between outright default and inflation. The monetary system alters as a result and the creditor tries to find another way of tying their debtors' hands; the gold standard, the Bretton Woods system of fixed exchange rates, the euro with the Maastricht rules and so on.

The extraordinary financial situation that currently exists, with negative rates on cash and bonds, QE and all the rest, is a sign of a crisis slowly unfolding. A new system will emerge at the end of it, I am sure, although whether this will be the result of deflation and outright default or inflation and the real erosion of capital is hard to tell. At the moment, it looks like the former—and Greece is only the starting point.