Global markets’ selloff last Friday reflects a reality facing central bankers from Washington to Athens — world debt levels are simply too great to deal with through conventional means

Since 2007, total public and private debt in major economies has increased, to more than 420% of GDP from 381%. If unfunded entitlement obligations, such as pensions, health care and aged care commitments, are included, the level of indebtedness increases dramatically. Even in emerging countries, where at the commencement of the crisis the levels of borrowing were less extreme, debt levels have increased.

“ The global economy could become trapped in QE — forever. ”

Reduction of these liabilities is extremely difficult, perhaps impossible in a world of no- or low growth and low inflation. Despite some analysts’ views that this is a “beautiful deleveraging,” the reality is that the process will have a major economic impact and take many years. As Illinois Tool Works ITW, -0.91% CEO David Speer noted: “… It took us a decade to get in the ditch we are in…There isn’t going to be instant gratification to get us out of it. We’re going to have to get used to a lower-growth economy, and that is going to be a big adjustment for all of us.”

Traditional tools to deal with high debt levels — austerity, growth, inflation or default/ restructuring — are unavailable or unpalatable. Policymakers will rely on existing fiscal and especially monetary policies to avoid economic collapse.

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The sequence of events may repeat. A weak economy forces policymakers to implement a program of expansionary fiscal measures and QE. If the economy responds, then higher levels of economic activity and some of side effects of QE will encourage a withdrawal of stimulus. This will result in higher interest rates and a slowing economy, which will trigger expansionary initiatives, leading to another round of the same cycle.

If the economy does not respond to expansionary policies, then there will be pressure for additional stimulus, as policymakers will be forced to react to maintain their aura of control of the economic engine.

Indeed, the global economy could become trapped in QE — forever.

Financial repression

With policy options limited, governments will resort to increasing financial repression. Introduced in 1973 by economists Edward S. Shaw and Ronald I. McKinnon, financial repression refers to measures implemented by governments to channel savings and funds to finance the public sector, lower its borrowing costs, and liquidate debt.

Measures include increases in existing taxes and new taxes, in combination with reduction in the level of state benefits or public services.

Higher tax rates will be accompanied by subtler measures. Co-payment schemes for government services, means-testing, user pay surcharges and special levies are already evident. New levels of wealth taxes and estate taxes will be considered. Entitlement liabilities, such as retirement benefits, will be managed by increasing the allowable minimum retirement age, reducing benefit levels, linking to actual contribution by individuals over their working life, and eliminating inflation indexation. Many of these policies will be packaged as socially and ethically progressive initiatives, belying the financial imperatives.

Policymakers will maintain low nominal and negative real rates of interest, engineering large changes in interest income and expense, with major implications for wealth distribution.

In a 2013 study, McKinsey Global Institute found that between 2007 and 2012, interest rate and QE policies resulted in a net transfer to governments in the United States, the United Kingdom, and the eurozone of $1.6 trillion, through reduced debt service costs and increased central banking profits. These losses were borne by households, pension funds, insurers and foreign investors. Households in these countries together lost $630 billion in net interest income, with the major losses being borne by older households with significant interest-bearing assets. Meanwhile, non-financial corporations in these countries benefited by $710 billion through lower debt service costs.

Deliberate devaluation of currencies is another tool. At various times in recent years, the U.S., Europe, Japan, China and Australia have sought to devalue their currencies, increasing the cost of imported products for consumers and reducing their purchasing power in foreign currency terms. The benefits of devaluation accrue to exporters, in the form of improved competitiveness and higher earnings. The costs are frequently paid for by the general population.

“ Japan provides a case study in the problems now confronting the world. ”

Another consequence is that governments will exert control over the use of savings, directing it into government securities. Currently, banks are large holders of government bonds, in part because of the lack of loan demand vitiating the need for regulation. If required, governments can legislate minimum mandatory holdings of government securities for banks, pension funds, and insurance companies. New liquidity regulations already require increased holdings of government bonds by banks and insurance firms.

Capital controls, such as those in Iceland and Cyprus, may be used to control outflows of funds. As in Cyprus, a bank depositor’s funds can be written down to absorb losses. The rapid resolution rules used for Cypriot banks are part of new global banking regulations. In a number of countries, such as Argentina, the government has seized pension fund assets to finance government activities.

Following Japan’s bad example

Japan provides a case study in the problems now confronting the world.

After the collapse of its debt-fueled bubble in 1989/1990, Japan has been mired in minimal growth and disinflation or deflation, despite repeated attempts to reflate the economy.

Public finances have deteriorated as chronic budget deficits have resulted in government debt increasing to 240% of GDP (135% net). Tax revenues are less than 50% of budget outlays, with 24% of budget spending needed to service debt. Japan’s total debt, at 450% of GDP, is higher today than at the onset of the crisis. Interest rates have been at or near zero for more than a decade. The Bank of Japan has used repeated bouts of QE to try to boost economic activity.

In early 2013, Japan launched new initiatives, combining fiscal expansion with a further, massive QE program. The scale of the program exceeds anything attempted before. The BoJ is committed to purchasing $140 billion per month of Japanese government bonds by 2014, roughly double the Federal Reserve’s equivalent current purchases of $85 billion and equivalent to roughly four times the U.S. as a percentage of GDP.

Japan’s plan, similar to programs being implemented elsewhere, is destructive. Debt monetization and the resultant loss of purchasing power effectively represent a tax on holders of money and sovereign debt. It redistributes real resources from savers to borrowers and the issuer of the currency, resulting in diminution of wealth over time. It highlights the reliance on financial repression, explicitly seeking to reduce the value of savings.

Satyajit Das is a former banker and author of “Extreme Money” and “Traders, Guns & Money.”