Germany’s GDP Linked Debt

A recent proposal from the Greek finance minister includes a debt for equity swap, replacing some of the existing bonds with growth linked bonds that will only pay coupons if Greece grows. The stock market certainly liked it. After the news was announced the Athens stock market shot up 11% and the country’s bank stocks were up 18%..

But Germany’s experience with GDP linked debt should give Greece some caution about the potential political ramifications of GDP linked debt. I am referring to, of course, is Germany’s reparations burden after World War II. The German experience should serve as a reminder that if GDP linked debt is to work, it requires the good will of both creditors and debtors to encourage macroeconomic policies that help the debt get paid.

After World War I, the treaty of Versailles imposed an extremely harsh reparations payment on the German government. The numbers make the Greek situation of having to raise primary surpluses by a few percent look trivial. As noted in Barry Eichengreen’s classic “Golden Fetters”, the total reparations bill for Germany totaled 132 billion gold marks — over 4 times national income at that time. Around 50 billion of that burden was to be paid unconditionally, with initial payments around 10% of national income.

The other 80 billion was linked to the economic recovery of Germany. As such, around 60% of the new external debt burden was GDP linked.

This created a poisonous dynamic in German politics as officials knew that much of the fruits of their economic reforms would be sent abroad. As Barry Eichengreen writes:

“By linking reparations payments to the condition of the German economy, the Allies diminished the incentive for German policymakers to put their domestic house in order. Hyperinflation was only the most dramatic illustration. Politicians were not encouraged to implement painful programs designed to promote growth by the knowledge that the fruits of their labor would be transfered abroad.”

The German situation was not helped when the allied nations raised trade barriers in the wake of World War I. By definition, if Germany was to run a capital deficit and pay these reparations, then by definition it must also run a trade surplus. But since Allied nations were unwilling to allow dramatically greater German competition in what were already intensely competitive industries, the only alternative for Germany was to endure a severe internal devaluation in an effort to restore competitiveness and have funds to send abroad.

Now, I am not trying to draw an equivalence between German reparations payments — which were forced upon the country—and the Greek government’s debt—which was voluntarily accumulated. But I do want to use Germany’s interwar experience to sound out two potential concerns about GDP linked debt:

1. It can have toxic effects on domestic politics. Politicians are unlikely to make sacrifices to shore up growth when a substantial part of the marginal benefit will be going to bondholders abroad.
2. It’s useless without supportive policies from abroad. Even when more than half of the reparations bill was at stake, Allied nations were unwilling to ease trade conditions to ease the German reparations burden. In the current context, unless there’s support from the ECB to raise nominal GDP across the Eurozone, Greece’s debt burden will continue to be massive relative to the underlying nominal size of the economy.