Peru’s supreme court is forcing the government to honor bonds issued 40 years ago, to compensate the victims of “land reform.” The government should welcome the opportunity. As Alexander Hamilton discovered in the 1790s, paying off dubious obligations of defunct government entities is one of the best ways to establish a state’s credibility with long-term investors. Of course, in the decade of Bernankeism such credibility is unnecessary; polities such as Jefferson County, Alabama are able to return to the bond markets within two years of filing for bankruptcy. But once the current bubble bursts Hamiltonian rectitude, accepting immediate pain to gain the market’s respect, will again be essential. It is to be hoped that the leaders of that period can rise above the usual political short-termism.

Governments naturally prefer policies which provide short-term gain at the cost of long-term pain – thus the adoption of Keynesian “stimulus” whenever there is half an excuse. The opposite kind of policies — which inflict short-term pain on the electorate but which have immensely beneficial long-term effects – are quite rare. Even in the southern European Eurozone countries, such policies are not being adopted voluntarily; it’s simply that German taxpayers refuse to provide large enough subsidies to avoid them. However after more than a decade of policies almost entirely oriented to the short term, and highly damaging in the long-term it seems reasonable to suppose that the reverse will be needed once the bubble bursts.

Alexander Hamilton was not a greater Treasury Secretary than Andrew Mellon, as was suggested during Mellon’s tenure. For one thing, his adoption of protectionism produced a U.S. industrial economy that was coddled and pampered behind high tariff walls, and was thus unable to compete after 1970, when the global playing filed became truly level. (To be fair, a policy that fails to produce its worst economic effects for 180 years is only mildly open to criticism. On the other hand, U.S. protectionism also bore a significant portion of the blame for the U.S. Civil War and World Wars I and II).

Still Hamilton deserves great credit for his insight that the debts of the Continental Congress and the individual states should be redeemed, and that their redemption by the Federal Treasury was worth putting the national capital in the fetid swamp of Washington (this being the deal he cut with Thomas Jefferson.) As a result of his debt redemption, which was economically both painful and unpopular (probably the reason the Federalists were voted out of office in 1800, having unanimously elected Washington in 1789 and 1792) the credit of the United States was established on a firm basis, able to withstand the defaults of no fewer than eight states in the 1840s and the financial stresses of the Civil War.

For Peru, the stakes are similar. The 1970s land reform was carried out by President Juan Velasco (President of Peru 1968-74), who occupied the uniquely unpleasant ecological political niche of a left-wing military dictator (unlike Venezuela’s Hugo Chavez, he never bothered to get himself democratically elected – it was less necessary for international legitimacy in those days.) The land reform broke up the large estates that in Peru were a relic of colonial times and replaced them with peasant smallholdings hopelessly below scale for modern agriculture. It was thus thoroughly economically damaging in its effects both on the losers from land reform and on the winners. The policy was a keystone of the lengthy period in Peru’s history when the population grew more impoverished and the rural security problem worsened.

Like many expropriators, Velasco compensated his victims with government bonds, denominated in a local currency that grew increasingly worthless through hyperinflation. The Peruvian courts ruled in 2001 that the government should pay up on an inflation adjusted basis, but the center-left Toledo and Garcia governments did nothing. Now the Constitutional Court has ruled again that Peru must pay — and given Peru’s healthy economy and high favor with international markets, it seems likely that it will do so.

In this respect, the United States was not perfect – Tory property that had been seized during the American Revolution was never restored. Similarly in Britain no proper restitution has been made for the Highland Clearances of the early 19th century – nor, more recently has there been any restitution to those unfortunate souls whose savings were destroyed after World War II by the government’s debasement of the currency.

When the Soviet Empire fell, the successor states attempted with various degrees of enthusiasm to restore some of the value of the property looted from the middle classes. These attempts were tied up with local privatization programs and in general were not very successful, although in central Europe the larger pre-war property owners got at least something back. However perhaps the best example of governments going out of their way to provide restitution when there was no legal obligation to do so came in former Yugoslavia after 1991. Yugoslav savers before 1991 kept their savings in foreign currency bank accounts with local banks, the foreign currency being re-deposited with Yugobanka, the central bank. When the country split up, Yugobanka kept the foreign currency, leaving the local banks with deposit liabilities and no assets, i.e. insolvent.

Depending on their means, several of the former Yugoslav republics took steps to restore their citizens’ savings, even though they had no legal obligation to do so. Slovenia, the richest ex-Yugoslav republic, recapitalized the local banks immediately, so its savers suffered no loss. Croatia, once the war within its borders had ended in 1995 and it had established a new currency, issued 10 year DEM bonds guaranteed by the local banks, which after a year or two traded at only a modest discount. Macedonia instituted a similar scheme in 2000 (which I helped design) – the bonds began trading on Skopje at 70% of their par value, allowing local savers to get most of their money back immediately. Only Bosnia, effectively run by the U.S. and the international community, did nothing for its savers, because the U.S. Treasury and the IMF deemed restitution not to be a priority.

The cost to Slovenia, Croatia and Macedonia of the savings restitution programs was considerable, but it was worth it. Through restoring most of their citizens’ savings, all three countries have enjoyed decent economic growth since the restoration, with Macedonian growth being notably rapid after 2000, having previously been sluggish or negative. Only Bosnia has remained mired in a 20-year depression, in spite of oodles of international aid cash poured in. But then, that’s not surprising – the Bosnian people have no confidence in their domestic banks or their government, and very limited savings from which small businesses can be started.

This history may seem irrelevant to today’s West, but the short-termism of recent policies has stored up long term problems that can only be solved by some up-front pain. It seems unlikely that policymakers will voluntarily undergo such pain in the current environment, in which the very modest “sequester” spending cuts were greeted with horror and predictions of an immediate government collapse. However the Detroit bankruptcy is indicative of a raft of underlying problems, stored up by poor and unaffordable policy choices in the past 30 years, which will require self-inflicted pain to solve. It’s at this point that the Hamiltonian hair-shirt approach to policymaking will become essential.

Among the items likely to require a high pain tolerance in the next few years are:

* State and municipal finances. The $1 trillion actuarial pension deficit in state and local accounts is if anything a substantial underestimate, which will grow hugely when the current stock market and asset bubbles burst. This will require hair-shirt policies of two kinds; substantial cuts in pensions (which may have to be achieved through bankruptcy) and chunky municipal tax increases (which in some cases will lead to Detroit-like outcomes).
* The Federal budget deficit. Each percentage point rise in interest rates will add about $130 billion to the federal budget deficit, quite apart from the effect of the inevitable recession. Tax rises AND spending cuts will be the inevitable result.
* The banking system. The rise in interest rates will cause the Fed and many banks to become technically insolvent, as their portfolios of long-term bonds decline sharply in value – the banks claim to be hedged against such moves, but will find they aren't, since their risk management doesn't work. Hair shirts will be especially necessary among the banking community, but the Feds will have to close a number of major banks, causing losses for their creditors and maybe even their depositors, if the Federal budget can't afford to bail them out.
* The social "safety net". Actuarial obligations are increasing every year; in addition the amount of low level fraud has soared, as the poor souls put out of work by irresponsible monetary, fiscal and regulatory policies have discovered that disability payments and food stamps provide a substitute for a proper job, albeit a miserable one.  Cuts to favored lobbies and elimination of much-loved but expensive regulations will help put the Federal budget back on track, but genuine hardship to the poor and feckless is also inevitable.
* Interest rates. These have to rise to give a supra-normal premium over inflation, to restore the U.S. savings base (this may also be necessary to put inflation back in its bottle.) The courage shown by President Reagan in accepting Paul Volcker's interest rate policies will be needed again.

The early United States was lucky enough to produce the original Alexander Hamilton. Today’s political system will need to produce another – and keep him in office long enough for his treatment to work. It seems unlikely, but one can hope.

-0-

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)