The Debt Shackles Return
The only sustainable debt burden is one that can be managed even during cyclical downturns. Yet governments continue to repeat the same mistakes, treating debt as a boon for long-term growth, rather than what it is: a source of massive long-term risks.
MUNICH – Global growth is accelerating. But before we break out the champagne, we should acknowledge the long-term risks to sustained expansion posed by rising private and public debt.
Market analysts view the uptick in private lending in most emerging and some developed economies as a sign of higher demand and a precursor of faster growth. But, while this is true in the short run, the relentless rise of overall debt remains among the most serious problems burdening the global economy.
Despite years of deleveraging after the 2008 global financial crisis, debt remains very high – and yet we have now returned to an expansionary credit cycle. According to the Bank for International Settlements, total non-financial private and public debt amounts to almost 245% of global GDP, having risen from 210% before the financial crisis and around 190% at the end of 2001.
General government borrowing in the United States may reach 5% of GDP this year, pushing total public debt to about 108% of GDP. In the eurozone, public debt stands at about 85% of GDP; in Japan, the debt-to-GDP ratio registers close to an eye-popping 240%. Globally, private non-financial debt is growing faster than nominal GDP.
These trends are set to continue, as many major central banks – including the European Central Bank and the Bank of Japan – have not just welcomed the recovery in lending, but are even aiming to stimulate more credit-financed growth. Only the US Federal Reserve and the People’s Bank of China are taking steps to rein in bank lending.
The world has endured enough economic crises to know that high debts create serious risks. Nominal debt is fixed, but asset prices can collapse, generating huge balance-sheet losses and causing risk premia – and thus borrowing costs – to rise. A mere decade ago, when a credit-fueled financial boom turned to bust, the financial sector was pushed to the brink of collapse, and a years-long recession followed in much of the world.
The only sustainable debt burden is one that can be managed even during cyclical downturns. Yet governments continue to repeat the same mistakes, treating debt as a boon for long-term growth, rather than what it is: a heavy burden and a source of massive long-term risks.
It is time for policymakers and their economic advisers to recognize this, and abandon the assumption that more debt always leads to more growth. Though there are times when governments need to borrow to stimulate the economy, deficit spending cannot lift growth in the long term. And at times when growth rates and private-sector borrowing are rising – times like now – governments should be working to reduce their own deficits. This is relevant for the US and Japan, but also for European Union countries, which should take advantage of today’s recovery – the strongest in the decade – to bring their public finances in line with the Stability and Growth Pact.
Governments should seek to prevent the buildup of unsustainable debt by stimulating long-term, non-debt-financed growth, using a combination of regulation, trade agreements, investment incentives, and educational and labor-market reforms. In a low-inflation environment like the one prevailing today, central banks can cushion the impact of such reforms through expansionary monetary policies.
But central banks must calibrate their interventions carefully, to ensure that monetary expansion does not encourage the buildup of even more private-sector leverage. This means thinking twice before enforcing negative deposit rates, designed to pressure banks to lend more, or liquidity operations conditioned on bank lending.
A better approach would emphasize the use of forward guidance to influence interest-rate expectations and bond yields. Low yields can fuel asset-price increases and stimulate demand in a range of areas, not only through higher corporate leverage. That said, with asset prices already high and economies growing at a healthy pace, central banks should follow the Fed’s lead in gradually unwinding the stimulus programs they initiated after the 2008 crisis.
Moreover, regulators should do more to ensure that private debt is channeled toward productive uses offering decent longer-term returns. This is the lesson from previous debt crises, including the subprime mortgage bubble that triggered the meltdown a decade ago, with devastating consequences for growth and employment.
For example, regulatory authorities can employ macroprudential policies to impose limits on segments of financial markets that are overheating, thereby improving the allocation of capital and stabilizing investment returns. They should take particular care to prevent real-estate bubbles, because real estate constitutes a huge share of overall wealth and a key source of collateral in finance. But the strong rise of low quality leveraged loans should also be a concern.
None of this will be easy for governments, regulators, or central banks. Monetary tightening may slow growth temporarily; preventing the growth of bubbles is notoriously difficult; and the types of structural reforms needed to secure a shift away from debt-fueled growth are hardly ever popular. Today’s febrile political environment certainly will not simplify matters.
But the consequences of shying away from such choices could be devastating. The financial cycle will continue to gain momentum, eventually causing asset prices to overshoot fundamentals by a wide margin; leverage ratios will rise even further, and demand will outstrip capacity, spurring inflation.
At that point, an external shock or a decision by central banks to apply the monetary brakes – an inevitable response to mounting exuberance and rising inflation – will lead to a potentially ruinous crash. Financial markets, hopped up on low interest rates and ample liquidity, would take a major hit. Private leverage and public debt levels would suddenly look a lot less sustainable.
Times may be good, but good times are precisely when risks build up. Policymakers cannot say they have not been warned.
Is Another Debt Crisis On the Way?
The world does not seem to face much risk in the short term. But in the medium to long term, rising income inequality, exacerbated by the mismatch between skills and jobs in the digital age, will become a significant impediment to growth, unless policymakers implement a wide array of difficult structural reforms.
WASHINGTON, DC – Economic growth is accelerating across most of the world. Yet the world’s total gross debt-to-GDP ratio has reached nearly 250%, up from 210% before the global economic crisis nearly a decade ago, despite post-crisis efforts by regulators in many important economies to drive the banking sector to deleverage. This has raised doubts about the sustainability of the recovery, with some arguing that a rise in interest rates could trigger another global crisis. But how likely is that to happen?
To answer this question, one must recall that debt is both a liability and an asset. In a closed economy – and we don’t owe anything to non-Earthlings – overall debt and the corresponding assets necessarily cancel each other out. So what really matters is the composition of debts and liabilities – or, to put it simply, who owes what to whom.
High public-sector debt, for example, signals the possible need for tax increases – the opposite of the tax legislation being advanced by Republican legislators in the United States – and/or higher interest rates (real or nominal, depending on monetary policy and inflation). If debt is owed largely to foreign lenders, interest-rate risk is compounded by exchange-rate risk.
For private-sector debt, much depends on its type: the hedging sort, where a debtor’s cash flow covers all obligations; the speculative type, where cash flow covers interest only; or the Ponzi kind, where cash flow does not even cover that. As the late American economist Hyman Minsky explained, the higher the share of debt that falls into the speculative or Ponzi categories, the higher the risk that a confidence shock will trigger a sudden wave of deleveraging that quickly morphs into a full-blown financial crisis.
For both public- and private-sector debt, maturities also play an important role. Longer maturities leave more time for adjustment, lowering the risk of a confidence shock.
Yet while it makes little sense to focus on simple aggregate figures, both public institutions and private researchers tend to do precisely that. Consider the coverage of the Greek debt crisis. Headlines tracked the debt-to-GDP ratio’s climb from 100% in 2007 to 180% this year, yet little attention was paid to private-sector debt. And, in fact, as foreign public creditors replaced private debt holders and interest rates were lowered, Greece’s overall debt, while still high, became more sustainable. Its continued sustainability will depend partly on the trajectory of Greece’s GDP – the denominator in the debt ratio.
A similar mistake is made in assessing China’s debts, about which the world is most concerned. The figures are certainly daunting: China’s debt-to-GDP ratio now stands at about 250%, with private-sector debt amounting to about 210% of GDP. But about two-thirds of the private-sector debt that is defined as bank loans and corporate bonds is actually held by state-owned enterprises and local-government entities. The central government has considerable control over both.
For China, the biggest risk probably lies in the shadow banking sector, on which reliable data are not available. On the other hand, a significant share of the growth in private debt ratios in recent years may be a result of the “formalization” of parts of the shadow banking system – a trend that would bode well for economic stability.
And there is more good news for China. Most Chinese debt is held in renminbi; the country possesses massive foreign-exchange reserves of close to $3 trillion; and capital controls are still effective, despite having been eased in recent years. The country’s leaders thus have a public-policy war chest that they can use to cushion against financial turmoil.
Among the rest of the emerging economies, there are some sources of concern. But, overall, the situation is relatively stable. Though private-sector debt has lately been rising, its levels remain tolerable. And public-sector debt has been growing only moderately, relative to GDP.
As for the advanced economies, there is little reason to believe that a debt crisis is around the corner in Japan. In the US, public debt is set to increase, thanks to the impending tax overhaul; but the blow will be cushioned, at least for the next year or two, by continued growth acceleration. And though low-quality assets held by the banking system are likely to impede Europe’s recovery, they are unlikely to spark a financial crisis.
In short, the world does not seem to face much risk of a debt crisis in the short term. On the contrary, the stage seems to be set for continued increases in asset valuations and demand-driven growth.
That said, geopolitical risks should not be discounted. While markets tend to shrug off localized political crises and even larger geopolitical challenges, some dramas may be set to spin out of control. In particular, the North Korean nuclear threat remains acute, with the possibility of a sudden escalation raising the risk of conflict between the US and China.
The Middle East remains another source of serious instability, with tensions in the Gulf having intensified to the point that hostilities between Iran and Saudi Arabia and/or turmoil within Saudi Arabia are not unthinkable. In this case, it is Russia that might end up clashing with the US.
Even barring such a major geopolitical upheaval, which would severely damage the global economy’s prospects in the short run, serious medium- and long-term risks loom. Rising income inequality, exacerbated by the mismatch between skills and jobs in the digital age, will impede growth, unless a wide array of difficult structural reforms are implemented, including reforms aimed at constraining climate change.
As long as the geopolitical situation remains manageable, policymakers should have time to implement the needed structural reforms. But the window of opportunity will not stay open forever. If policymakers waste time on trickle-down sophistry, as is happening in the US, the world may be headed for severe economic distress.
Managing the Risks of a Rising Dollar
Some may view the US dollar’s appreciation as consistent with a longer-term rebalancing of the global economy. But, as Argentina’s recent request for IMF financing starkly demonstrates, a sharp and sudden dollar appreciation risks unbalancing things elsewhere.
NEWPORT BEACH – Argentinian President Mauricio Macri’s government has asked the International Monetary Fund for a loan that it hopes can stem a peso rout that has driven up interest rates, will slow the economy, and threatens the reform program. This reversal of fortune for the economy partly, though far from fully, reflects broader pressure created by the US dollar’s recent appreciation – a process that is set to accelerate, because both monetary-policy and growth differentials are now favoring the United States.
For a while now, the US Federal Reserve has been well ahead of other systemically important central banks in normalizing monetary policy – that is, raising interest rates, eliminating large-scale asset purchases, and starting the multi-year process of shrinking its balance sheet. This was amplified this year by another catalyst of the dollar’s recent appreciation; a growing, and less favorable, divergence between economic data and expectations in the rest of the world.
During most of 2017, markets were scrambling to catch up to indications of growth outside the US that were markedly more favorable than anticipated. As a result, the most widely followed measure of a trade-weighted dollar index depreciated by 10% last year. Capital flows into Europe and major emerging economies picked up, as investors sought to benefit from the expansion, while enjoying both higher yields and the possibility of capital gains from currency moves.
But, in recent months, measures of economic “surprises” have turned negative, as growth momentum has weakened in Europe and beyond. To cite one dramatic example, declining economic indicators caused the implied market pricing of an interest-rate hike ahead of the Bank of England’s policy meeting this month to plummet from over 90%, or a near-certainty, to 20% in just a few weeks.
Now, there is less external capital chasing returns in Europe and the emerging economies, and some that was there has already flowed back home. So economic and financial factors can be expected to continue to fuel the appreciation of the US dollar. The only way to ease that upward pressure, and to mitigate spillovers, is with effective policy responses.
The good news is that there are sufficient tools to reduce the risk of dislocations. But there is a need for broader implementation within individual economies, and better coordination across borders.
To be sure, some may view the US dollar’s appreciation as consistent with a longer-term rebalancing of the global economy. But, as Argentina’s situation demonstrates, excessively sharp and sudden appreciation of such a systemically important currency risks unbalancing things elsewhere.
Emerging markets have long been particularly vulnerable to this phenomenon. In the run-up to the Asian financial crisis of the 1990s, many emerging economies kept their currencies rigidly pegged to the dollar, and governments tended to borrow heavily in dollars, despite generating most of their revenues in the domestic currency (what economists labeled “original sin”).
As the dollar appreciated in international markets, these economies became less competitive and experienced sharp deteriorations in their current-account positions. Actual and potential capital outflows forced central banks to raise local interest rates, intensifying economic contractionary pressures and undermining the creditworthiness of the domestic corporate sector. Currency devaluation was not an easy option, either, as it would boost inflation and send the costs of servicing external debts soaring to prohibitively high levels.
Many developing countries now have flexible exchange rates, and, by shifting to domestic sources of borrowing, they have reduced the currency mismatches associated with their liabilities. Yet two vulnerabilities remain.
First, the recent extraordinary period of repressed volatility in financial markets, ultra-low interest rates, and dollar weakness unleashed another surge of capital flows to emerging countries, including “tourist dollars,” which tend to flow right back out at the first sign of trouble. Second, empowered by exceptionally generous global financing conditions, a growing number of emerging-market corporates have resorted to external dollar borrowing, materially increasing their financial vulnerability to higher interest rates and adverse currency moves.
Externally driven changes in financial variables have thus become a source of serious risk, especially in countries, like Argentina, with a history of economic mismanagement, large current account deficits, other financial imbalances, and a habit of pursuing too many objectives with too few instruments. With the emerging-market economies still structurally subject to short-term risks of contagion, it is usually just a matter of time until a few countries’ problems result in a tightening of financial conditions for the asset class as a whole.
Beyond challenging emerging markets’ stability, a sudden and sharp appreciation of the US dollar – and, specifically, the losses in trade competitiveness that it causes – threatens to complicate already-delicate trade negotiations. In particular, efforts to modernize the North American Free Trade Agreement (NAFTA) and to establish fairer trade relations between the US and China could be put at risk.
Against this background, policymakers should be implementing measures that take pressure off foreign-exchange markets. This includes, first and foremost, pro-growth policies, particularly for Europe, which, despite recent economic gains, faces significant structural headwinds. Emerging economies, meanwhile, should focus on maintaining solid balance sheets, improving their understanding of market dynamics, and safeguarding policy credibility.
Country-level measures should be reinforced by better global policy coordination, especially to help avoid or break vicious cycles. The IMF, which may soon face more requests for financing, has an important role to play here. Using a bit of extra precaution now is obviously preferable to risking a mess that will need to be cleaned up later.
Recovery is Not Resolution
Last week, the IMF revised upward its growth projections for the eurozone and Asia’s advanced economies, including Japan, with the US Federal Reserve’s ongoing exit from ultra-easy post-crisis monetary policy adding to the growing sense that normal times are returning. But are they?
CAMBRIDGE – Earlier this year, the consensus view among economists was that the United States would outstrip its advanced-economy rivals. The expected US growth spurt would be driven by the economic stimulus package described in President Donald Trump’s election campaign. But the most notable positive economic news of 2017 among the developed countries has been coming from Europe.
Last week, the International Monetary Fund revised upward its growth projections for the eurozone, with the more favorable outlook extending broadly across member countries and including the Big Four: Germany, France, Italy, and Spain. IMF Chief Economist Maurice Obstfeld characterized recent developments in the global economy as a “firming recovery.” Growth is also expected to pick up in Asia’s advanced economies, including Japan.
As I noted in a previous commentary, Iceland, where the financial crisis dates to 2007, has already been dealing with a fresh wave of capital inflows for some time, leading to concerns about potential overheating. A few days ago, Greece, the most battered of Europe’s crisis countries, was able to tap global financial markets for the first time in years. With a yield of more than 4.6%, Greece’s bonds were enthusiastically snapped up by institutional investors.
Greek and European officials hailed the bond sale as a milestone for a country that had lost access to global capital markets back in 2010. Greek Prime Minister Alexis Tsipras said the debt issue was a sign that his country is on the path to a definitive end to its prolonged crisis.
In the US, the Federal Reserve’s ongoing exit from ultra-easy post-crisis monetary policy adds to the sense among market participants and other countries’ policymakers that normal times are returning.
But are they? Do recent positive developments in the advanced countries, which were at the epicenter of the global financial crisis of 2008, mean that the brutal aftermath of that crisis is finally over?
Good news notwithstanding, declaring victory at this stage (even a decade later) appears premature. Recovery is not the same as resolution. It may be instructive to recall that in other protracted post-crisis episodes, including the Great Depression of the 1930s, economic recovery without resolution of the fundamental problems of excessive leverage and weak banks usually proved shallow and difficult to sustain.
During the “lost decade” of the Latin American debt crisis in the 1980s, Brazil and Mexico had a significant and promising growth pickup in 1984-1985 – before serious problems in the banking sector, an unresolved external debt overhang, and several ill-advised domestic policy initiatives cut those recoveries short. The post-crisis legacy was finally shaken off only several years later with the restoration of fiscal sustainability, debt write-offs under the so-called Brady Plan, and a variety of domestic structural reforms.
Since its 1992 banking crisis, Japan has suffered several false starts. There were recoveries in 1995-1996 and again in 2000 and 2010; but they tended to be cut short by the failure to write down bad debt (the so-called zombie loans), several premature policy reversals, and an increasingly unsustainable accumulation of government debt.
The eurozone emerged from the financial crisis in 2008-2009 with some economic momentum. Unlike the Federal Reserve, however, the European Central Bank hiked interest rates in early 2011, which contributed to the region’s descent into a deeper crisis.
History, therefore, suggests caution before concluding that the current recovery has the makings of a more sustainable and broad-based variety. Many of the economic problems created or exacerbated by the crisis remain unresolved.
All of the advanced economies (to varying degrees) have significant legacy debts (public and private) from the excesses that set the stage for the financial crisis, as well as from the prolonged impact of the crisis on the real economy. Low interest rates have eased the burden of those debts (in effect, negative real interest rates are a tax on bondholders), but rates are on the rise.
Political polarization in the US and the United Kingdom is at or near historic highs, depending on the measure used. As a result, many critical but politically sensitive policies to ensure future fiscal sustainability remain unresolved in both countries.
The UK’s withdrawal from the European Union – and Brexit’s medium-term impact on the British economy – is another source of risk that has yet to be tackled. How Japan will resolve its public and private debt overhang is yet to be determined. I have argued elsewhere that inflation will likely be part of that resolution, as it is improbable that an aging population will vote to raise its tax burden and reduce its benefits sufficiently to put Japan’s debt trajectory on a sustainable path.
In Europe, the high level of non-performing loans continues to act as a drag on economic growth, by inhibiting new credit creation. Furthermore, these bad assets pose a substantial contingent liability for some governments. Target2, the euro’s real-time gross settlement system, has emerged as the eurozone’s mechanism for financing the emergence of widening structural balance-of-payments gaps, whereby capital flows out of southern Europe into Germany. For Greece, Italy, Portugal, and Spain, public-sector debt must now also include the central bank’s sharply rising debts.
Perhaps the main lesson is that even more caution is warranted in deciding whether the time is ripe to “normalize” monetary policy. Even in the best of recovery scenarios, policymakers would be ill-advised to kick the can down the road on structural reforms and fiscal measures needed to mitigate risk premia.
The Quiet Demise of Austerity
LONDON – It has been several years since policymakers seriously discussed the merits of fiscal austerity. Debates about the potential advantages of using stimulus to boost short-term economic growth, or about the threat of government debt reaching such a level as to inhibit medium-term growth, have gone silent.
There is no mistaking which side won, and why. Austerity is dead. And as conventional politicians continue to take rearguard action against populist upstarts, they will likely embrace more fiscal-policy easing – or at least avoid tightening – to reap near-certain short-term economic gains. At the same time, they are not likely to heed warnings of the medium-term consequences of higher debt levels, given widespread talk of interest rates remaining “lower for longer.”
One way to confirm that an international fiscal-policy consensus has emerged is to review policymakers’ joint statements. The last time the G7 issued a communiqué noting the importance of fiscal consolidation was at the Lough Erne Summit in 2013, when it was still the G8.
Since then, joint statements have contained amorphous proposals to implement “fiscal strategies flexibly to support growth” and ensure that debt-to-GDP ratios are sustainable. Putting debt on a sustainable path presumably means that it will not increase without interruption. But in the absence of a definite timeframe, debt levels can undergo lengthy deviations, the sustainability of which is open to interpretation.
Objections to austerity were understandable in the period following the 2008 financial crisis. Fiscal policy was being tightened when growth was languishing below 2% (after bouncing back in 2010), and sizeable negative output gaps suggested that overall employment would be slow to recover.
In late 2012, at the peak of the post-crisis austerity debate, advanced economies were in the midst of a multi-year tightening equivalent to more than one percentage point of GDP annually, according to cyclically-adjusted primary balance data from the International Monetary Fund.
But just as fiscal policy was being tightened when cyclical economic conditions seemed to call for easing, it is now being eased when conditions seem to call for tightening. The output gap in advanced economies has all but disappeared, inflation is picking up, and world economic growth is forecast to be its strongest since 2010.
In 2013, Japan was the only advanced economy to loosen fiscal policy. But this year, the United Kingdom appears to be the only one preparing to tighten its policy – and that is assuming recent political ruptures haven’t altered its fiscal orientation, which will be reflected in the Chancellor of the Exchequer’s Autumn Statement.
Most observers would agree that government debt levels are uncomfortably high in many advanced economies, so it would be prudent for policymakers to discuss strategies for bringing them down. Moreover, there are several options for doing this, some of which are easier or more effective than others.
In the end, government deleveraging is about the relationship between economic growth and interest rates. The higher the growth rate relative to interest rates, the lower the level of fiscal consolidation needed to stabilize or reduce debt as a share of GDP.
As economic growth continues to pick up while interest rates lag, at least outside the US, fiscal authorities will have further opportunities to reduce debt, and create fiscal space for stimulus measures when the next cyclical downturn inevitably arrives. But policymakers are not doing this, which suggests that they have prioritized largely political considerations over fiscal prudence.
After the recent elections in the Netherlands and France, a growing chorus is now proclaiming that “peak populism” has passed. But one could argue just as easily that populist ideals are being absorbed into more mainstream political and economic agendas. As a result, politicians, particularly in Europe, have no choice but to favor inclusive growth policies and scrutinize the potential impact that a given policy could have on the income distribution.
This political environment is hardly conducive to fiscal consolidation. Any tax increases or spending cuts will have to be designed exceptionally well – perhaps impossibly so – for leaders to avoid a populist backlash. Some people will always lose more than others from fiscal consolidation, and deciding who those people are is never a pleasant exercise.
So far, those decisions are being delayed on political grounds. But the economic implications of high government debt cannot be ignored forever. Monetary policy is already starting to change in the US, and it could be on the verge of changing globally. One way or another, fiscal authorities will have to confront challenging tradeoffs in the years ahead.