The case for raising Bermuda's debt ceiling

WEDNESDAY, MARCH 21: St Augustine, an African philosopher and Christian theologian from the first millennium, asked God for chastity, but not just yet. The same can be said of populist calls for budgetary or fiscal consolidation: cutting government spending and/or raising taxes in a desperate attempt at reducing the debt, presently at $1.2 billion.

Whilst fiscal sustainability is key to economic health over the medium to long term, it is undesirable for the immediate future, the next 18 to 24 months.

The economy will likely contract by three to five per cent in 2012. The main leading indicators are mostly down: the Bermuda Stock Exchange index (BSX), money supply, planning permits issued, construction projects put into place, and new orders for consumer goods. Others are up: social assistance claims and non-performing loans, which doubled last year and are likely to double again this year.

Focusing on fiscal consolidation runs the risk of lengthening and deepening the recession. Having said that, there are significant cost savings associated with, say, eliminating the Post Office ($14 million); or outsourcing elements of the Departments of Corrections ($30 million) or Statistics ($3 million) to a lower cost jurisdiction; or privatising the Departments of Tourism ($28 million) or Works and Engineering ($33 million). Full disclosure: I am an employee at Bermuda College, which receives an $18 million annual grant.

Might it be more economical to outsource education and training to colleges in the UK, US, Canada and Caribbean where faculty salaries and operational costs are lower?

There is little doubt that the civil service is bloated. However, public sector jobs cuts of the UK magnitude (470,000 job cuts from a 6 million strong public sector — an eight per cent cut) would add around 500 people to joblessness over the next 18 to 24 months. The direct, indirect and induced effects of such a cut would amount to around $50 million (500 job cuts times $65,000 median Government salary times a 1.5 spending multiplier) or lower the growth forecast by 0.8 per cent.  

Government spending is like a cruise ship or a lumbering beast: once it gets going, it’s difficult to stop or change course. Capital projects are expensive to cancel; it isn’t easy to cut jobs; and most public services are unprofitable.

Tax revenues, on the other hand, are more like a speedboat: they move in direct proportion to GDP, which has been volatile of late. Unfortunately, governments treat unanticipated increases in tax revenues as permanent.  In short, the revenue stream is iffy whilst the spending is constant. Debt is the natural result of spendthrift governments.

To a degree, the present debt is the result of short-term political gains beating out fiscal sustainability. So, the next time a politician promises free this or free that, voters are duty bound to ask, ‘how it will be paid for?’ Because we didn’t ask that question, we’re faced with an increased debt burden. Fool me once it’s on you, fool me twice it’s on me.

Taxpayers face a trade-off. Obsessing over debt sustainability can prolong a recession by at least a year, and deepen it by an additional three or more percentage points. Stimulus risks exceeding the debt default threshold: that level of debt, which at first pass seems quite manageable, but following a loss of market confidence, rising interest rates and political resistance to paying down the debt, leads to sovereign default.

Debt threshold

Our Government’s debt default threshold depends not only on its own debt, but also on the level of private domestic debt (BD$3,500 million) and private external debt (US$1,700 million). When we consider all domestic and external debt, Bermuda’s debt-to-GDP ratio is around 115 per cent, a dangerously high number.  

Over the next year, the Government proposes to issue IOUs, in the form of bonds to cover the shortfall of tax revenue in 2012-2013. These IOUs or debt instruments will draw on the local loanable funds market. This mildly expansionary fiscal policy will provide some stimulus, but there are hidden costs.

Previous fiscal expansions were financed through external borrowing. By borrowing locally, the Government will adversely affect national saving: the sum of private and public saving and net exports, the surplus/deficit on the current account of the balance of payments. As a result, we should see interest rates rise because the supply of loanable funds will decline.

More importantly, the reduction in the size of the savings pool will drive the real exchange rate higher at a time when the self-correcting mechanisms emanating from the economic contraction are trying to lower costs and prices, which are key components of the real exchange rate.  The importance of the real exchange rate cannot be overstated.

As an export driven economy, one important element of our competitive advantage is the cost of our hospitality and financial services relative to other destinations and jurisdictions, such as Cayman, Barbados, the City of London, New York City, and so on.

As is the case with most economic policymaking, there are trade-offs. By providing mild stimulus, public debt will inch closer to the debt threshold; deficit financed government spending will crowd-out some private investment spending; and the process of market correction will face some headwinds.

The alternative, fiscal chastity would add unnecessary social costs to the economic contraction, which is why I argue ‘but not just yet’.