After Countries Go Broke

Ray Dalio, one of the most successful macro hedge fund managers of our era, released a new book this year, How Countries Go Broke. This is an interesting topic, but an even more interesting topic is: What countries should do after they go broke.

It might be important someday.

For a country like the United States, with debt denominated in a local currency, “going broke” normally means that continued deficit spending can’t be financed by the bond market. Governments could, at this moment, reduce spending dramatically and basically balance their budgets.

Ha ha ha! Of course this never happens.

What they do instead is: print the money; or, one way or another, have the central bank buy the bonds or at least support the bond market somehow. Actually there is not so much of a clear delineation here. The US dollar has already been losing quite a lot of value vs. its old benchmark, gold. The Federal Reserve hasn’t been “printing money” to any degree, but the effect is similar – the existing debt is inflated away. This has already been happening.

This money-printing is fun at first, but soon becomes unpleasant. Basically, it is hyperinflation, to a greater or lesser degree. Eventually, this becomes intolerable. Then, a government is truly “broke.”

Then what?

It is good to have a playbook for that day, because it will be a time when you have to act quickly and decisively. It is not a time to debate various hypotheses and proposals.

Both Germany and Japan found themselves in this condition in 1949. It was already well after the end of the war. Both countries were under US military occupation. But the focus was shifting toward preventing local communist movements (happens when the economy is in shambles), and containing Soviet Communism. The US decided that it had to help Germany and Japan recover. One aspect of this was the Marshall Plan of 1948. But, it went beyond that.

In 1949, a Chicago banker, Joseph Dodge, was dispatched to help the German government get its act together. Working together with local leaders such as the exemplary Ludwig Erhard, Dodge made a simple plan. The government was to go cash-only. This is a little beyond a “balanced budget.” The government would spend nothing unless it had previously received payment of tax revenue. This relieved the central bank from government financing pressures, and allowed the German mark’s value to be fixed to gold. The hyperinflation ended immediately.

Then, taxes were reduced dramatically. This did not take the form of a reduction in tax rates (although Erhard argued for cutting rates by 50%), but rather, by boosting the tax brackets by multiples higher. The highest tax rate of 95%, which was reached at an income of 60,000 marks, was boosted to 250,000 marks, more than 4x higher. The income for the 50% rate was boosted from 2,400 marks to 9,000.

Erhard continued with this theme afterwards. By 1958, the top rate was 53%, and this was paid on income over 110,000 marks. The tax-free exemption tripled.

With a sound currency fixed to gold, and lower taxes across the board, Germany’s economy boomed. Tax revenues rose from 6.6 billion marks in 1949 to 36.3 billion in 1963 – all measured in marks fixed to gold.

You can read about it in my book, The Magic Formula.

This went well, so Dodge headed over to Japan to do the same thing.

Ikeda Hayato was made Minister of Finance on February 16, 1949. On March 7, he announced the “Dodge Line." Japan’s government was to go cash-only – a policy that it actually maintained until 1965. This relieved the Bank of Japan from financing needs. The yen was fixed to gold.

Just as in Germany, Japan’s leaders reduced taxes dramatically. In consultation with US advisor Carl Shoup, a national sales tax was abolished completely. The top income tax rate fell from 85% to 55%, while the income at which the tax applied was bumped higher from 300,000 yen to 500,000 yen. By 1957, the threshold of the 55% tax rate had risen to 10 million yen – thirty-three times higher.

In 1960, Ikeda Hayato ran for prime minister. He promised to “double incomes" in ten years – and won. The actual result, during that decade, was even better than promised. During every single year of the 1960s, taxes were lowered.

So we see a simple and proven strategy. It is:

The government goes “cash only.” This might mean huge spending cuts, and it might have to be done in a matter of a couple weeks – not after months of debate. Today, the sensible way for the Federal Government to accomplish this is to simply chainsaw all welfare-related programs, including Social Security, all healthcare, all means-tested Federal welfare programs, and a variety of other welfare-related programs such as in education. The Federal budget would be immediately in surplus. All welfare-related programs would be delegated to the State governments, to do as they see fit, which is the actual mandate of the Constitution today.

Of course this is not politically possible today. But, it would be possible in a hyperinflationary crisis, as Germany and Japan faced in 1949, or as Argentina faced recently.

Then, taxes should be reduced dramatically.

In 1949, Japan threw out its national sales tax, and kept the income tax. Today, I think it would be best to do the opposite – throw out the Federal income tax, repeal the 16th amendment, and instead introduce a single Federal value-added tax of about 10%. This would be more than enough to pay for all the Federal Government’s spending, after the welfare-related spending was terminated.

Just one 10% tax would be easy to administer. And, nobody would evade it, since who wants to become a criminal just to avoid a 10% tax? Businesses would pay the tax (including self-employed), but regular employees would face no direct taxes at all.

With the Central Bank now relieved of government financing pressures, it would be time then to again fix the dollar’s value to gold – just as Germany and Japan did in 1949. (China also had hyperinflation in 1949, and also went to gold in 1950.)

In more recent times, we’ve seen countries do almost exactly the same thing. In 1994, Estonia ended hyperinflation by fixing the value of the currency to the German mark (later euro) via a currency board – very similar to fixing the value of the German mark itself to gold in 1949. The government also introduced a 26% Flat Tax, which seemed radically low at the time. It later fell to 20%. Estonia’s economy boomed, and others noticed. Latvia, Lithuania, Bulgaria, Slovakia and others followed close behind, ending hyperinflation by fixing the currency’s value to the mark/euro (typically), and introducing a Flat Tax. Bulgaria has a 10% Flat Tax today, and so does Mongolia.

The Flat Tax was a great idea for the 1990s, but today I think a wholly indirect tax, such as the Value Added Tax, is even better. Then we could eliminate Income Taxes entirely, returning to the original pre-1913 Constitution with no direct taxes at all. Technically, a 10% VAT and a 10% Flat Tax are almost the same thing. But politically, it makes a big difference to eliminate the Income Tax altogether. Drive a wooden stake through its heart so that it will never return.