Baffling Belief in Government Promises

It is election year in the USA and elsewhere and, again, we will vote for the leaders of the free world.  Politicians will make promises, and depending on our age, we will believe them.  Then the politicians will break those promises, sometimes because there has been a dramatic change in circumstances.  But inevitably, promises are more often than not broken. 

And the USA and Japanese governments, and elsewhere, will issue their government bonds.  To pay for the fiscal deficits or to repay (rollover) previous bond issues.  Or in the case of the UK, gilts.  These bonds are a “promise” to repay the principal and interest (coupons) at some time in the future to the investors that buy the bonds.  They are unsecured. 

Given that governments have an overt track record in “not” keeping their promises, why do we keep believing them?  Its baffling.

Japan has recently experienced its first balance of trade deficit for 31 years, or since 1981.  That is, the value of its imports was greater  than its exports.  Its current account remains in surplus, because international investments made over time continue to pay returns.  This latter means its income from exports and offshore investments in aggregate are still greater in value than its imports.  However the balance of trade is a big indicator of its future capacity.    

In mid 2011, its debt to GDP was 512% and most of that is the government’s with 226% of GDP.  By way of contrast, USA is 80%, Ireland 85% and UK 81%.  However it owes approximately 95% of that to its own population so it does not have to stare down the international investing community as Greece and Italy do.  The Japanese believe their government will repay the debts. 

What has stirred up the hornets nest however is the expectation that Japan over the near term will develop current account deficits (“CADs”) as well as trade deficits.  And then they will need to use the investment capacity of international investors to fund those deficits.  There are many reasons for this and it is covered well by Reuters and The Japan Times.

CADs are not necessarily a bad thing if you have the future capacity to repay the debt used to fund the deficits.  This could come from raising taxes, economic growth, or printing new money.  However, Japan is not in this position.  Hence the raging debate that it may soon not be able to pay as promised.

Yet it is not alone.  Over decades in international banking, many countries have defaulted on their debt.  Wikipedia has a comprehensive list of the defaults going back centuries, but would it shock you to know that of all the countries in the world only 8 have not defaulted in the last century.  They are:  Sweden, Portugal, The Netherlands, France, England, Malaysia, Denmark and Australia.

Countries that have defaulted, in some cases multiple times include Africa (22 nations), Americas (27), Asia (14) and Europe (22).  So when considering the EU crisis, or the Japan potential crisis, and government defaults, remember that it is easier to list those that have not defaulted than those who have.

Pesek of Bloomberg wrote last week of a debate occurring between Krugman and Fingleton about Japan.  What is extraordinary about this article is that he ends it with this statement “It doesn’t take a Nobel Prize to know that paying off debt gets harder when you’re running out of people”.  Referring to Krugman, of course, whom he supports in the debate.

There it is.  There is the red flag.  We know today that Japan already has little hope of paying on its promises.  Yet merrily we go on our way believing the promises of governments all over the world.  

Given the extraordinary number of defaults over the centuries, the probability is that governments are not going to pay it back by honouring their promises.  Is it a case of get out or get over it?