No subject

pursued in the United States and the United Kingdom will not resolve the
crisis because they do not lower the debt ratio.
In particular, having governments buy distressed assets from the banks, or
provide loan guarantees, is not an effective solution. It does not reduce
the volume of debt, or force recognition of losses. It merely re-denominates
private sector obligations to be met by households and firms as public ones
to be met by the taxpayer.

This type of debt swap would make sense if the problem was liquidity rather
than solvency. But in current circumstances, taxpayers are being asked to
shoulder some or all of the cost of defaults, rather than provide a
temporarily liquidity bridge.

In some ways, government is better placed to absorb losses than individual
banks and investors, because it can spread them across a larger base of
taxpayers. But in the current crisis, the volume of debts that potentially
need to be refinanced is so large it will stretch even the tax and
debt-raising resources of the state, and risks crowding out other spending.

Trying to cut debt by reducing consumption and investment, lowering wages,
boosting saving and paying down debt out of current income is unlikely to be
effective either. The resulting retrenchment would lead to sharp falls in
both real output and the price level, depressing nominal GDP. 
Government retrenchment simply intensified the depression during the early
1930s. Private sector retrenchment and wage cuts will do the same in the
2000s. 

BANKRUPTCY OR INFLATION
The solution must be some combination of policies to reduce the level of
debt or raise nominal GDP. The simplest way to reduce debt is through
bankruptcy, in which some or all of debts are deemed unrecoverable and are
simply extinguished, ceasing to exist.

Bankruptcy would ensure the cost of resolving the debt crisis falls where it
belongs. Investor portfolios and pension funds would take a severe but
one-time hit. Healthy businesses would survive, minus the encumbrance of
debt.

But widespread bankruptcies are probably socially and politically
unacceptable. The alternative is some mechanism for refinancing debt on
terms which are more favourable to borrowers (replacing short term debt at
higher rates with longer-dated paper at lower ones).

The final option is to raise nominal GDP so it becomes easier to finance
debt payments from augmented cashflow. But counter-cyclical policies to
sustain GDP will not be enough. Governments in both the United States and
the United Kingdom need to raise nominal GDP and debt-service capacity, not
simply sustain it.
There is not much government can do to accelerate the real rate of growth.
The remaining option is to tolerate, even encourage, a faster rate of
inflation to improve debt-service capacity. Even more than debt
nationalisation, inflation is the ultimate way to spread the costs of debt
workout across the widest possible section of the population.

The need to work down real debt and boost cash flow provides the motive,
while the massive liquidity injections into the financial system provide the
means. The stage is set for a long period of slow growth as debts are worked
down and a rise in inflation in the medium term.

John Kemp, formerly an economist for RBS Sempra in London, has joined
Reuters as a columnist on commodities and energy markets.