[OPE] Michael Hudson: debt dependency and the "capacity to pay" principle

(Excerpt from "Recovering from Neoliberal Disaster: Why Iceland and Latvia
Won’t (and Can’t) Pay the EU for the Kleptocrats’ Ripoffs", by Prof. Michael
Hudson, Global Research, August 17, 2009
http://www.globalresearch.ca/index.php?context=va&aid=14800 )

Why Iceland's move is so important for international financial restructuring

For the past decade Iceland has been a kind of controlled experiment, an
extreme test case of neoliberal free-market ideology. What has been tested
has been whether there is a limit to how far a population can be pushed into
debt-dependency. Is there a limit, a point at which government will draw a
line against by taking on public responsibility for private debts beyond any
reasonable capacity to pay without drastically slashing public spending on
education, health care and other basic services?

At issue is the relationship between the financial sector and the “real”
economy. From the perspective of the “real” economy, the proper role of
credit – that is, debt – is to fund tangible capital investment and economic
growth. The objective is to create a tax system and financial regulatory
system to maximize the latter.

After all, it is out of the economic surplus that interest is to be paid, if
it is not to be extractive and outright predatory. But creditors have not
shown much interest in economy-wide wellbeing. Bank managers and subprime
mortgage brokers, corporate raiders and their bondholders, and especially
the new breed of kleptocratic privatizers applauded so loudly by neoliberal
economic ideologues simply (and crassly, I have found) ask how much of a
surplus can be squeezed out and capitalized into debt service. From their
perspective, an economy’s wealth is measured by the magnitude of debt
obligations – mortgages, bonds and packaged bank loans – that capitalize
income and even hoped-for capital gains at the going rate of interest.

Iceland has decided that it was wrong to turn over its banking to a few
domestic oligarchs without any real oversight or regulation, on the by-now
discredited assumption that their self-dealing somehow will benefit the
economy. From the vantage point of economic theory, was it not madness to
imagine that Adam Smith’s quip about not relying on the benevolence of the
butcher, brewer or baker for their products but on their self-interest is
applicable to bankers. Their “product” is not a tangible consumption good,
but debt – indeed, interest-bearing debt. And debts are a claim on output,
revenue and wealth, not wealth itself.

This is what pro-financial neoliberals fail to understand. For them, debt
creation is “wealth creation” (Alan Greenspan’s favorite euphemism), because
it is credit – that is, debt – that bids up prices for property, stocks and
bonds and thus increases financial balance sheets. The mathematically
convoluted “equilibrium theory” that underlies neoliberal orthodoxy treats
asset prices (wealth in the financial sense of the term) as reflecting
prospective income. But in today’s Bubble Economy, asset prices reflect
whatever bankers will lend – and rather than being based on rational
calculation their loans are based merely on what investment bankers are able
to package and sell to gullible financial institutions trying to pay
pensions out of the process of running economies into debt, or otherwise
disposing of credit that banks freely create.

There amount of debt that can be paid is limited by the size of the economic
surplus – corporate profits and personal income for the private sector, and
the net fiscal revenue paid to the tax collector for the public sector. But
for the past generation neither financial theory nor global practice has
recognized any capacity-to-pay constraint. So debt service has been
permitted to eat into capital formation and reduce living standards.

As an alternative is to such financial lawlessness, the Althing [i.e.
Iceland's national parliament - JB] asserts the principle of sovereign debt
at the outset in responding to British and Dutch demands for Iceland’s
government to guarantee payment [i.e. some €2.6 billion to British
depositors and €1.3 billion to Dutch depositors] of the Icesave bailout:

The preconditions for the extension of government guarantee according to
this Act are:

1. That ...account shall be taken of the difficult and unprecedented
circumstances with which Iceland is faced with and the necessity of deciding
on measures which enable it to reconstruct its financial and economic
system. "

This implies among other things that the contracting parties will agree to a
reasoned and objective request by Iceland for a review of the agreements in
accordance with their provisions.

2. That Iceland’s position as a sovereign state precludes legal process
against its assets which are necessary for it to discharge in an acceptable
manner its functions as a sovereign state.
Instead of imposing the kind of austerity programs that devastated Third
World countries from the 1970s to the 1990s and led them to avoid the IMF
like a plague, the Althing is changing the rules of the financial system. It
is subordinating Iceland’s reimbursement of Britain and Holland to the
ability of Iceland’s economy to pay:

In evaluating the preconditions for a review of the agreements, account
shall also be taken to the position of the national economy and government
finances at any given time and the prospects in this respect, with special
attention being given to foreign exchange issues, exchange rate developments
and the balance on current account, economic growth and changes in gross
domestic product as well as developments with respect to the size of the
population and job market participation.

This weekend’s pushback is a quantum leap that promises (or to creditors,
threatens) to change the world’s financial environment. For the first time
since the 1920s the capacity-to-pay principle is being made the explicit
legal basis for international debt service. The amount to be paid is to be
limited to a specific proportion of the growth in Iceland’s GDP (on the
assumption that this can indeed be converted into export earnings). After
Iceland recovers, the payment that the Treasury guarantees for Britain for
the period 2017-2023 will be limited to no more than 4% of the growth of GDP
since 2008, plus another 2% for the Dutch. If there is no growth in GDP,
there will be no debt service. This means that if creditors take punitive
actions whose effect is to strangle Iceland’s economy, they won’t get paid.

The moral is that Newton’s Third Law of motion – that every action has an
equal and opposite reaction – is applicable to politics and economics as
well as to physics. As the most thoroughly neoliberalized disaster area,
Iceland is understandably the first economy to push back. The past two years
have seen its status plunge from having the West’s highest living standards
(debt-financed, as matters turn out) to the most deeply debt-leveraged. In
such circumstances it is natural for a population and its elected officials
to experience a culture shock – in this case, an awareness of the
destructive ideology of neoliberal “free market” euphemisms that led to
privatization of the nation’s banks and the ensuing debt binge.

Iceland promises to be merely the first sovereign nation to lead the
pendulum swing away from an ostensibly “real economy” ideology of free
markets to an awareness that in practice, this rhetoric turns out to be a
junk economics favorable to banks and global creditors. Interest-bearing
debt is the “product” that banks sell, after all. What seemed at first blush
to be “wealth creation” was more accurately debt-creation, in which banks
took no responsibility for the ability to pay. The resulting crash led the
financial sector to suddenly believe that it did love centralized government
control after all – to the extent of demanding public-sector bailouts that
would reduce indebted economies to a generation of fiscal debt peonage and
the resulting economic shrinkage.

As far as I am aware, this agreement is the first since the Young Plan for
Germany’s reparations debt to subordinate international debt obligations to
the capacity-to-pay principle. The Althing’s proposal spells this out in
clear legal terms as an alternative to the neoliberal idea that economies
must pay willy-nilly (as Keynes would say), sacrificing their future and
driving their population to emigrate in what turns out to be a vain attempt
to pay debts that, in the end, can’t be paid but merely leave debtor
economies hopelessly dependent on their creditors. In the end, democratic
nations are not willing to relinquish political planning authority to an
emerging financial oligarchy.

No doubt the post-Soviet countries are watching, along with Latin American,
African and other sovereign debtors whose growth has been stunted by the
predatory austerity programs that IMF, World Bank and EU neoliberals imposed
in recent decades. The post-Bretton Woods era is over. We should all
celebrate.

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Received on Tue Aug 18 16:28:40 2009