How Britain and the U.S. Escaped Their Debt Load

How Britain and the U.S. Escaped Their Debt Load
March 17, 2011

(This item originally appeared in Forbes on March 17, 2011.)

Historically, when governments amass too much debt, they default on it. That’s just the way it is.

But there have been two exceptions to this rule: One was the United States after World War II; the other was Britain after the Napoleonic Wars (1797-1815).

How did they do it? What was their strategy?

Some estimates show that the British government’s debt after Waterloo was over 250% of GDP. However, that is a ridiculously high figure, and modern GDP statistics date back only to 1950 or so. Let’s just say that it was a whopping big debt.

We can begin by listing what Britain’s government did not do: It did not indulge in exorbitant government spending to “stimulate the economy.” It did not devalue the currency. And it did not raise taxes.

Rather, Britain’s approach was right in line with what I call the magic formula: low taxes, stable money.

To help pay for the war Britain introduced an income tax. It was the first modern income tax in the world, dating from 1799.

With the war’s end in 1816 Britain eliminated the income tax. Given the enormous debt, this was considered rather daring at the time.

The second thing Britain did was to return to the gold standard. The pound was delinked from gold at the onset of hostilities, and its value floated downward. This naturally led to an increase in interest rates, to the 5% to 6% range from the 3.5% common with a gold standard. The gold standard was reinstated in 1821, and bond yields fell back to the 3.5% range, where they stayed until 1914. This allowed the government to finance its large debt cheaply.

Over time the economic growth allowed by the low-tax environment and stable money increased the size of the economy dramatically. This was the Industrial Revolution, which was led by Britain. Why did it happen in Britain, and not Spain or Italy? The Magic Formula allowed capitalism to flourish.

What about the U.S.? Did the U.S. government raise taxes to pay off the enormous debt (125% of GDP) incurred during World War II?

How Britain and the U.S. Escaped Their Debt Load

No, it did not. Republicans managed a small tax cut immediately after the war’s end. Then in 1952 Republicans won both Congress and the presidency on a plan to reduce tax rates by 30%. However, after the election, Eisenhower decided not to push through with the tax cut plan.

Further tax cuts had to wait until President Kennedy, whose tax cut plan–almost identical to the Republicans’ 1952 proposal for a 30% reduction in rates–was enacted in 1964, after Kennedy’s death.

As was the case for the British pound during the Napoleonic Wars, the U.S. dollar was also quietly delinked from gold during World War II. Although officially the dollar was pegged at $35 per ounce, in practice it floated somewhat, falling as far as $45 per ounce at one point. This was resolved with the Fed Accord of 1951, which returned the dollar to a much more firm link to gold at its official $35 per ounce rate.

U.S. government spending contracted dramatically after the war. Although large deficits were not a feature of the 1950s and 1960s, neither were large surpluses. The total nominal amount of debt grew slightly in those decades.

As was the case with Britain, the U.S. government’s large debt-to-GDP ratio came down due to expansion in the denominator. Lower taxes and stable money provided a foundation for impressive postwar growth.

With these two examples in mind, I propose a basic plan for governments with too much debt:

First, you have to get government spending down to a point at which deficits are small (under 3% of GDP), and preferably non-existent.

Second, you should introduce a tax system that allows capitalism to thrive. This probably means lower tax rates, although tax revenue as a percentage of GDP might remain stable. Something like a “flat tax” system, recently implemented by over thirty governments to great success, would be a good model. Other options are possible. The introduction of these flat tax systems did not lead to any meaningful decline in revenue-to-GDP. Do not try to increase the revenue-to-GDP ratio with the introduction of new taxes.

Third, you should aim for a stable currency. No devaluations. This will allow you to finance the large existing debt at low rates.

Eventually the growth of GDP will allow the debt-to-GDP ratio to fall to reasonable levels.

This plan of action probably seems rather sensible and self-evident. However, I note that it is completely opposite to today’s conventional wisdom and the strategies of most highly indebted governments.

It is perhaps no surprise that governments today find it difficult to reduce their large deficits. This is mostly bureaucratic turf-defending, but some have been arguing that reducing large deficits will lead to an economic decline that will make the debt burden worse. Sophistry aside, it doesn’t seem likely to me that the solution to excessive spending is more excessive spending.

Most indebted governments want to raise taxes even more. Greece’s official tax system was ludicrously oppressive to begin with, and thus largely ignored. Making an absurd, suffocating system even more absurd just makes the present problem worse. Greece is a prime candidate for a flat-tax system, something like the 13% system adopted by Russia in 2000, combined with a reduction in payroll and VAT taxes.

A chorus of commentators has argued that Greece should withdraw from the eurozone, devalue its currency and even print money to pay debts. This is really another form of default, and in any case would make refinancing of the existing debt burden impossible. Nobody buys the debt of a devaluer.

What would happen to governments that use this strategy? It’s obvious: They will default. Just like every other government in the last 300 years that did not adopt the British/U.S. program of balanced budgets, low taxes and stable money.

What about after the default? The same principles apply. The budget would be balanced by necessity, simply because the defaulted government will not be able to issue new debt. Low taxes and stable money would allow the economy to flourish. That’s exactly what you want after the trauma of government default.

When you create an environment in which capitalism can thrive–low taxes and stable money–then capitalism thrives. Just look at the situation in Greece, Spain or Japan and ask “can capitalism thrive in this environment?” Usually the answer is immediately obvious. It is either “yes, seems OK to me,” or “you must be joking.”

It really is that simple.