Throughout history, which methods of reducing government debt have proven to be the most successful? The answers may not be what you expect.
Fiscal policy is one of those areas where everyone has an opinion but few people can agree on any given idea. While reducing debt and stimulating the economy are the general goals of most governments in developed economies, achieving those goals often involves tactics that appear to be mutually exclusive and sometimes downright contradictory.
Take, for example, the issuance of government debt. Governments often issue bonds to get money. This enables them to avoid raising taxes and provides money to stimulate the economy through public spending, theoretically generating additional tax income from prosperous businesses and taxpayers.
It seems like a logical approach, but keep in mind that the government must pay interest to its creditors and at some point, the borrowed money must be repaid. Historically, issuing debt has provided an economic boost to various countries, but in and of itself has not been particularly effective in directly reducing long-term government debt.
When the economy is in pain, such as suffering from high levels of unemployment, governments can also seek to stimulate the economy by buying the very bond they have issued themselves. For example, the Fed implemented quantitative easing a couple of times since November 2008 to buy large amounts of government securities and other financial securities to spur economic growth and aid recovery from the financial crisis in 2007-2008. In the short-term, there are many experts who favor this tactic. Over the longer term, buying one's own debt has not proved to be any more effective than borrowing one's way to prosperity by issuing bonds.
Ways That Governments Reduce Federal Debt
Interest Rate Manipulation
Maintaining low-interest rates is another way governments seek to stimulate the economy, generate tax revenue and, ultimately, reduce the national debt. Low-interest rates make it easy for individuals and businesses to borrow money. In turn, the borrowers spend that money on goods and services, which creates jobs and tax revenues. Low-interest rates have been employed by the United States, the European Union, the United Kingdom and other nations with some degree of success. That noted, interest rates kept at or near zero for extended periods of time have not proved to be a panacea for debt-ridden governments.
Canada faced a nearly double-digit budget deficit in the 1990s. By instituting deep budget cuts (20% or more within four years), the nation reduced its budget deficit to zero within three years and cut its public debt by one-third within five years. The country did this without raising taxes.
In theory, others countries could emulate this example. In reality, the beneficiaries of tax-payer fueled spending often balk at proposed cuts. Politicians are voted out of office when their constituents are angry, so they often lack the political will to make necessary cuts. Decades of political wrangling over the Social Security program in the United States is a prime example of this, with politicians avoiding action that would anger voters. In extreme cases, such as Greece in 2011, protesters take to the streets when then the government spigot is turned off.
Tax increases are a common tactic. Despite the frequency of the practice, most nations face large and growing debts. It is likely that this is largely due to the failure to cut spending. When cash flows increase and spending continues to rise, the increased revenues make little difference to the overall debt level.
Cut Spending and Raise Taxes
Sweden was close to financial ruin by 1994. By the late 1990s, the country had a balanced budget through a combination of spending cuts and tax increases. U.S. debt was paid down in 1947, 1948 and 1951 by Harry Truman. President Dwight D. Eisenhower managed to reduce government debt in 1956 and 1957. Spending cuts and tax increases play a role in both efforts. (For related insight, read about the role of tax cuts in stimulating the economy.)
Pro Business/Pro Trade
A pro-business, pro-trade approach is another way nations can reduce their debt burdens. Saudi Arabia reduced its debt burden from 80% of gross domestic product in 2003 to just 10.2% in 2010 by selling oil.
Getting rich nations to forgive your debts or hand you cash is a strategy that has been employed more than a few times. Many nations in Africa have been the beneficiaries of debt forgiveness. Unfortunately, even this strategy has its faults. For example, in the late 1980s, Ghana's debt burden was significantly reduced by debt forgiveness. In 2011, the country is once again deeply in debt. Greece, which had been given billions of dollars in bailout funds in 2010-2011, was not much better after the initial rounds of cash infusions. U.S. bailouts date all the way back to 1792. (Learn how the biggest ones affected the economy by studying the top six U.S. government financial bailouts.)
Defaulting on the debt, which can including going bankrupt and or restructuring payments to creditors is a common and often successful strategy for debt reduction. North Korea, Russia and Argentina have all employed this strategy.
Controversy with Every Method
To quote Mark Twain, "There are three kinds of lies: lies, damned lies and statistics." Nowhere is this truer that when it comes to government debt and fiscal policy.
Debt reduction and government policy are incredibly polarizing political topics. Critics of every position take issues with nearly all budget and debt reduction claims, arguing about flawed data, improper methodologies, smoke and mirrors accounting and countless other issues. For example, while some authors claim that U.S. debt has never gone down since 1961, others claim it has fallen multiple times since then. Similar conflicting arguments and data to support them can be found for nearly every aspect of any discussion about federal debt reduction.
While there are a variety of methods countries have employed at various times and with various degrees of success, there is no magic formula that works equally well for every nation in every instance. Just as spending cuts and tax hikes have demonstrated success, default has worked for more than few nations (at least if the yardstick of success is debt reduction rather than good relations with the global banking community). Overall, perhaps the best strategy is one by Polonius from Shakespeare's Hamlet and espoused by Benjamin Franklin when he said: "Neither a borrower nor a lender be." (For related insight, explore a breakdown of the U.S. budget deficit.)