In this morning's Wall Street Journal, David C. McCourt, Economist in Residence at the University of Southern California and who is on the board of University College in Dublin, Éire, published an op-ed relating to the recent downgrade of Irish government bonds to "junk" grade. ("Let the Celtic Tiger Roar Again," WSJ, 07/14/11, A17.)
According to Dr. McCourt, all that is necessary (okay, not all, we don't want to make his proposal sound simplistic) is for Éire "to recapitalize its banks and cut their debt burden." The idea is to emulate what was done following the savings and loan crisis in the U.S. in the 1980s . . . brought on by the partial repeal of Glass-Steagall: "require the European Central Bank — the Irish banks' largest single creditor — to work with the Irish government, maybe even accepting a debt-for-equity swap. In other words, the EU needs to bet on Ireland's future by becoming a shareholder."
This is close enough to the real solution to be credible. There are, however, two things wrong with it, both of them directly opposed to fundamental principles of sound finance and the Just Third Way. Debt for equity is a viable strategy. It's used in bankruptcy all the time, where existing shareholders lose most if not all of their ownership, and creditors take over, exchanging their debt for equity. So what's wrong with the European Union taking equity in exchange for the near-worthless debt?
First, if we understand the situation, much if not all the debt is Irish government bonds. If restricted to its proper role, government produces no marketable goods or services. A debt-for-equity swap in a bankruptcy is consistent with the goal of keeping an otherwise viable business going so that it can produce marketable goods and services in the future, hopefully turning it back into a profitable enterprise. Since a government doesn't produce anything, it cannot be construed as a "profitable enterprise," and can only repay out of future taxes levied on productive citizens. A debt for equity swap under these circumstances is illegitimate since there is no viable business to keep going.
Second, government is not in business to make a profit. Government is an expense of the citizens. That's why they pay taxes — to meet the legitimate costs of government. As John Locke reminded us in his Second Treatise on Government (1689), "'Tis true, Governments cannot be supported without great Charge, and 'tis fit every one who enjoys his share of the Protection, should pay out of his Estate his proportion for the maintenance of it." (§ 140.) The problem is that debt financing by government by means of emitting bills of credit instead of borrowing from existing private sector savings induces inflation, a "hidden tax" by means of which, as Henry C. Adams pointed out in Public Debts: An Essay in the Science of Finance (1898), politicians are able to evade their responsibilities and undermine the political foundations of the State:
"As self-government was secured through a struggle for mastery over the public purse, so must it be maintained through the exercise by the people of complete control over public expenditure. Money is the vital principle of the body politic; the public treasury is the heart of the state; control over public supplies means control over public affairs. Any method of procedure, therefore, by which a public servant can veil the true meaning of his acts, or which allows the government to enter upon any great enterprise without bringing the fact fairly to the knowledge of the public, must work against the realization of the constitutional idea. This is exactly the state of affairs introduced by a free use of public credit. Under ordinary circumstances, popular attention can not be drawn to public acts, except they touch the pocket of the voters through an increase in taxes; and it follows that a government whose expenditures are met by resort to loans may, for a time, administer affairs independently of those who must finally settle the account." (22-23.)
Thus, as Locke continued § 140 in the Second Treatise, "But still it must be with his own Consent, i.e., the Consent of the Majority, given it either by themselves, or their Representatives chosen by them. For if any one shall claim a Power to lay and levy Taxes on the People, by his own Authority, and without such consent of the People, he thereby invades the Fundamental Law of Property, and subverts the end of Government. For what property have I in that which another may by right take, when he pleases to himself?" (Second Treatise, loc. cit.)
We necessarily conclude that emitting bills of credit allows a government to finance operations without resorting to taxation. This renders the government unaccountable to the people who eventually are stuck paying the bill. As a case in point, the United States government has not been out of debt since 1835 (Harold Moulton, The New Philosophy of Public Debt. Washington, DC: The Brookings Institution, 1943, 51). The politicians who, during the administration of Andrew Jackson, spent the money that is still not repaid, are completely unaccountable to the taxpayer of today. True, the national debt from the 1830s is, compared to the $14 trillion plus we're faced with today is a drop in the bucket — but we still have to pay for what people long-dead spent.
Third and finally, this is not a real plan to turn things around. What is needed is something to get the government out of debt, and the citizens — not the State — put into the position of equity owners. This will allow ordinary people to produce marketable goods and services for a profit, not the State to manipulate the economy for political ends. To this end, pundits like Dr. McCourt should be investigating Capital Homesteading, not proposing even greater growth of the public sector at the expense of the private sector.