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The world after the pandemic: will the wall of debt finally topple?

The fiscal response to Covid-19 across many countries is set to increase debt-to-GDP ratios across the world and has prompted some staggering headlines.

Three areas of concern have been raised: whether growing debt will (i) increase the cost of future borrowing, (ii) impair growth, and (iii) be generally sustainable. However, current economic thinking and history shows us that the worried response in the press can be questioned; at least for developed economies.

Does growing debt increase the cost of borrowing?

As Adam Tooze has recently reminded us: governments are not households. While it seems intuitive that more borrowing must cause higher interest rates, historic evidence calls this into question.

Comparing the development of the UK’s debt burden and its long-term interest rate shows, if anything, a negative correlation:

On a global scale, studies by the OECD have not found a clear-cut positive causality either, at least in developed counties. In ‘emerging markets’ the relationship is more telling, given the combination of a typically higher reliance on foreign-currency debt and the more volatile nature of their currencies on the foreign exchanges.

Do higher debt levels impair growth?

In the years since Reinhart and Rogoff’s ‘This Time Is Different’ the notion that debt over a certain threshold impairs growth has also been called into question.

Recent studies have not found a clear causality between these variables, suggesting that a third – ‘unobserved’ – factor could be causing both high debt and low growth. Moreover, the fact that attempts to measure the relationship have come to the fore at the same time as growth itself has become harder to measure due to the rise of the service sector and rapid technological innovation, has added to the difficulty in drawing any firm conclusions.

Is the debt sustainable?

Three features are held up to be critical to the extent to which debt is sustainable: trust, ownership, and trajectory.

Trust

The sustainability of debt often rests in perceptions and ‘trust,’ which drive a sovereign’s ability to raise the funds for debt servicing. Understanding what causes trust to wax and wane goes further than standard economics. Just like a bank-run, the ultimate triggers of a loss of trust are not often detectable in the data beforehand.

Recent experience in the Eurozone has only highlighted how perceptions can shift rapidly. In Greece, trust evaporated once the European Central Bank’s strict mandate was seen as preventing it from acting as a lender of last resort. And yet the very strictness of the mandate is designed to engender trust in the solvency of member states.

Much of the story of European bond yields in the last decade has been the swings between these two positions: with Greek ten-year yields falling from 8% to less than 2%, and sudden rapid shifts along the way.

The erosion of trust can also go hand-in-hand with faith in a government’s general statistics. The falsification of Greek data was well telegraphed before the financial crisis ignited the crisis in the Eurozone.

In emerging markets there is also a long history of such concerns. Ahead of its ninth default since independence, Argentina was accused of ‘purposefully forecasting low growth in order to get away with paying creditors less.’ This follows a long history of accusations and mistrust, as Sachs et al. (1995) have found that a long history of “populist fiscal policies repeatedly undermined the currency.”

Does the pandemic (and policy responses to it) seem likely to destroy trust in global sovereigns? Thus far, actions have generally been interpreted as necessary evils for some, and long overdue for others. How national finances are interpreted in ‘more normal’ times remains to be seen.

Ownership

Ultimately for many emerging markets, the main issue for debt sustainability is less about trust in data, and more about who owns the debt and how it is denominated.

Usually one would expect a domestic government to raise some or – in the case of Japan – quite a significant proportion of its debt in domestic currencies. In Argentina however, the domestic demand for debt is low and the government has to rely on international capital markets to provide the necessary liquidity. So while Japan has a far higher debt-to-GDP ratio than Argentina, that debt is perceived as more sustainable since it is payable in a currency that the sovereign can print:

In Japan, not only does the strong domestic ownership of government debt increase its sustainability, but the involvement of the central bank cannot be underestimated. If one were to deduct the debt owed to the central bank (ultimately itself), as well as the debt that can be netted off against the government financial assets, Japan’s actual debt-to-GDP ratio would be below 90%, greatly lowering the risk of a ‘run’ on sovereign debt.

Trajectory

Despite Japan’s greater levels of trust and the composition of its bond holders, the IMF’s latest Article IV consultation declared the debt as unsustainable (as indeed they have since at least 2011).

On the surface, levels of Japanese debt were already astonishing (224.7% of GDP in 2018) and, post-pandemic, it is expected increase even further; Prime Minister Shinzo Abe has committed $1tn deficit spending to protect the $5tn economy.

Yet this has not and is not expected to increase the borrowing costs, i.e. the interest rate. Rather, interest rates have stayed low, the Bank of Japan has not needed to buy the ¥80tn in government bonds it committed to in 2016, and inflation has not picked up.

Indeed, the trend since 1990 has been a consistent downward trajectory of the differential between interest rate and growth, i.e. the debt is becoming more sustainable, even when faced with a growing overall amount.

Furthermore, a recent OECD report suggests that the conditions behind this supportive trajectory in Japan are likely to continue, particularly due to sustained low policy rates and credible inflation targeting monetary policy.

A long-term hit to growth from the pandemic would challenge these trends, of course, and the sheer enormity of the post-crisis stock of debt may itself introduce unintended and unknowable consequences.

Conclusion

The fiscal response to Covid-19 across many countries is set to increase debt-to-GDP ratios across the world. And yet the above has illustrated the ambiguity of simplistically comparing debt ratios when seeking to understand potential impacts on borrowing costs, growth, and sustainability.

Experience and theory suggests that the alarmist response in the press can be questioned; at least for developed economies. Rather than the level of debt, the ability to service it is of greater importance, and the impact of the pandemic upon this variable is likely to be more about perceptions than levels of debt themselves. As can be seen in current MMT debates, a key issue behind this will be inflation (the driving forces of which Alex Houlding discussed recently), and for investors it will be this variable which largely determines whether we can expect government bonds to play a diversifying role when growth assets are threatened in the future.


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