- High public sector debt levels are set to remain at the core of the economic policy debate.
- Periods of elevated and rapidly rising debt are rarely reversed without some form of default.
- This need not be explicit. It can be more subtle and covert.
- It can take the form of inflation, regulation, and the creation of ‘captive markets’ for bonds.
- The stage is set for an extended period of financial repression.
The latest IMF Fiscal Monitor tentatively estimates that the average gross public sector debt ratio for the advanced economies as a group will increase this year to more than 122% of GDP. 1 For the G-7, the figure is closer to 140% of GDP, while for Japan (259%) and some euro-area economies (e.g. Italy at 156%, and Greece at 201%), the figures stand to be substantially higher. Moreover, there is the possibility of yet further increases, should the COVID-19 pandemic, like many of its predecessors, have a second wave of infections. 2
Although there have been instances in the past of similarly lofty public debt levels (the UK, for example, exited both the Napoleonic Wars and World War Two with gross liabilities exceeding 200% of GDP), such figures are historically uncommon and, in the eyes of many economists, well beyond the level at which growth potential is likely to be damaged. What is more, in such circumstances it becomes much more likely that the debt ratio will explode upwards, in the event that the average interest rate exceeds the growth rate of nominal GDP
Not only may the COVID-19 crisis-related escalation of sovereign debt extend into 2021; there is also likely to be strong pressure on governments to spend more – to address socially and politically divisive inequalities and, finally, on starting to tackle climate change. And all this at a time when ageing population structures stand to put significant additional pressures on public sector balance sheets in the form of pension- and healthcare-related outlays over the decades ahead.
The requirement to manage, and if possible reduce, these onerous financial obligations is therefore likely to remain a public policy priority for as far as the eye can see.
A number of lessons to be learned from the long and often fraught history of public debt management:
- Persistently robust nominal GDP growth is the key to bringing a public sector debt ratio down in a sustained manner. The preference should be for real growth, but a little inflation can go a long way towards encouraging the process.
- Deflation, in contrast, renders the process of debt diminution much harder: central banks should do much to avoid it.
- Programmes of fiscal consolidation, and especially aggressive programmes of fiscal austerity involving large cuts in public spending should be confined to periods when an economy is well established on a recovery trajectory, and when private sector balance sheet adjustment is not a major constraint on growth.
- Seeking precipitously to reduce a budget deficit and stabilise the government debt ratio in a downturn and/or when other sectors of the economy are deleveraging can prove highly challenging, if not self-defeating. It can also encourage social distress, political turbulence, and can easily leave the burden of public debt higher than it was before.
- ‘Hard’ and inflexible balanced budget rules, depending on how they are defined, can prove inherently pro-cyclical when deficits are so clearly endogenous to the business cycle.
- The central bank’s monetary stance and the related value of the exchange rate can provide a powerful offset to the deflationary effects of fiscal contraction. But such counterbalancing effects are necessarily weakened when fiscal adjustment is commonplace, and in particular within a close-knit trading bloc, and when nominal interest rates are adjacent to the zero bound.
- It can take decades, and numerous set-backs, before high public sector debt ratios are finally brought to heel.
It remains to be seen whether these lessons have been learned by latter-day policymakers. There remains a significant risk that policy ends in failure and that the debt restructuring seen over the past decade in Greece is the first of several. After all, another historical observation is that sovereign defaults tend to occur in temporal and regional clusters.
The default option
It seems likely that not all of today’s public sector obligations will be paid back in full. Large debt accumulations have rarely been addressed without some form of default.
Default can however be manifested in a number of ways. It can be explicit; it can be coercive; it can be negotiated; it can be the result of an acceleration of inflation; it can reflect financial repression, or it can be some combination of these alternatives.
Nowadays, naked and unilateral sovereign debt repudiations, such as instigated by Russia in 1917 or China in 1949, are rare. With the world economically, financially, and politically interconnected, the ability of a country subsequently to isolate itself from other nations is constrained, and the potential consequences of such extreme responses to a debt crisis would be serious and long-lasting.
On the other hand, currency redenominations, de-indexation, or coercive exchanges of sovereign debt remain relatively common. But for more advanced economies, the most likely form of explicit default is probably a negotiated exchange of debt or restructuring in the manner of that undertaken by Greece in February of 2012 and June 2018. That is not, however, to understate the impact of such responses on bond holders. The net present value of the losses on Greek sovereign holdings as a result of the first of these episodes is put at some 75%.
Sovereign defaults do not have to be overt, however. They can be altogether more subtle, falling into the category of financial repression.
Financial repression can be defined as the creation of a pool of captive investors who are encouraged, if not compelled, to hold certain assets, and in particular government debt, at interest rates that are lower than they would be were they set by the free interplay of market forces.
- Financial repression can come about as the result of implicit or explicit interest rate caps. These can be directly imposed on government debt; they can take the form of fixed-term nonmarketable debt; they can be imposed on banks’ lending rates so as to provide a subsidy to the government where it borrows directly from the banks; they can also be maintained via explicit or implicit central bank interest rate targets achieved through open market operations, such as already formally employed in Japan and in Australia, and implicitly elsewhere.
- Alternatively, financial repression can be encouraged through layers of regulation. Capital account restrictions and exchange controls can create an enforced home bias for investment. High reserve commercial bank requirements, especially where no interest is paid on reserves, can provide cheap funds to governments and reduce the need to issue interest-bearing debt. Also, supposedly ‘prudential’ regulations can be manipulated so that domestic institutions such as banks and pension funds are forced to hold a high proportion of their assets in government bonds of one form or another. Equally, transaction taxes can be imposed on non-government debt or equities, or limitations placed on gold or other precious metal transactions.
- Finally, financial repression can be expressed through the direct ownership, or extensive control, of banks and other financial institutions, which thereby do the government’s bidding, and via associated barriers to entry into the financial sector.
Through these various mechanisms, governments can exploit their monopolistic powers in regard to savings vehicles and greatly expand the financial resources available to them.
The primary attraction of financial repression is that it is more politically appealing than years of grinding, voter alienating, fiscal austerity. The pain of adjustment can, at least to some extent, be concealed, although such policies are not without costs. Channelling wealth into relatively low yielding government bonds can lead to serious misallocations of resources that encourage macroeconomic and financial imbalances, and undermine longer term growth potential. Furthermore, if an element of the policy is to manipulate pension fund investments, it will still act as a tax increase on savers and amount to a fiscal tightening.
Thus, depending on how far the policy of repression is taken, it can nonetheless be recognised as a form of default, damaging a government’s reputation and raising long-term risk premia.
Back to the future?
The government debt that accumulated during the course of World War One and the two deflationary decades that followed was essentially resolved by outright default, explicit restructurings, and the forcible conversion of domestic and external debt (together with the odd dose of hyperinflation). By contrast it was a combination of financial repression and moderate inflation that did much of the heavy lifting of public sector deleveraging in the wake of World War Two.
The Bretton Woods system of fixed exchange rates, which operated from 1945 until the early 1970s, was sustained by a complex web of trade and capital controls, while governments dismantled their war-time structures of domestic financial sector regulation only slowly and piecemeal. Meanwhile, with policymakers more closely focused on the maintenance of full employment than hitherto, persistent, if rarely virulent, inflation became the rule rather than the exception.
Hence, real interest rates were kept low, indeed well below real GDP growth, if not negative. An NBER paper by Carmen Reinhart and Belen Sbrancia suggests that, between 1945 and 1980, real rates were below zero 25% of the time in the US, and nearly half of the time in the UK and Australia. 3 In this way, debt service costs were constrained, and the real value of debt was eroded.
For the decade after 1945, public debt liquidation through the combination of outright financial repression and inflation is estimated to have run at an average of 4.5 percentage points of GDP per year in the US, 6.3 percentage points in the UK, and 6.2 in Australia. By 1955, their 1945 debt burdens had been reduced by getting on for half. And the mixture of financial repression and inflation continued to reduce public debt ratios throughout the 1960s and 70s, such that they became of relatively little consequence to policymakers.
So what next?
This begs the question of whether or not inflation and financial repression will re-emerge as the policy weapons of choice to address the post-COVID-19 public sector debt issue. After all, the enormous costs of more orthodox fiscal consolidation strategies have in the wake of the Global Financial Crisis become all too obvious to politicians and electorates alike.
Clearly, the world is a very different place from 1945. Even if it has latterly retreated somewhat, globalisation has been an over-riding theme of the past four decades. Markets are more open and recourse to international capital controls has diminished sharply, especially outside the developing world. Central banks are more independent, while their stated primary policy priority has been more commonly the control of inflation rather than the maintenance of full employment, to the extent that they are typically mandated formerly to target some definition of relative price stability.
What is more, OECD populations have become used to the benefits of more stable prices. For inflation to play the sort of role in reducing public indebtedness it enjoyed in the 1940s, 50s, 60s and 70s, central banks would probably need to lose some of their independence and/or see their mandates explicitly adjusted. Attitudes towards inflation would also have to change significantly.
There is already some evidence that such developments may be gaining traction. The blurring of the lines between fiscal and monetary policy since 2007, and especially over recent months, has resulted in some de facto loss of central bank autonomy, while a number of well-regarded economists and commentators, not least Nobel Laureate Paul Krugman, former IMF Chief Economist Olivier Blanchard, and former Fed Chair Ben Bernanke have at different times publicly put the case for temporarily higher inflation targets.
In addition, it can be argued that central banks are themselves no longer so religiously wedded to narrow inflation goals. Rather, they are taking a more holistic approach to policy at a time when high debt is an issue not just for for public sectors, but right across economies. And this is a key point. In the earlier period, private sector debt burdens were not remotely the constraint on demand growth (both nominal and real) that they manifestly are today.
That said, there are technical constraints on the ability of inflation to decrease debt burdens. A significant number of governments, including those in the US, UK, Canada, Germany, France, Australia, and Greece, index-link a portion of their debt to aggregate price indices. In the UK around a quarter of outstanding public debt falls into this category. For the other major economies, the figures range from around 13% in France, down to 4% in Germany. The US figure is about 7%.
There is also the matter of debt maturity. To facilitate the erosion of debt by inflation, the optimal situation would be one in which all outstanding debt was perpetual, and there would be no requirement to finance existing debt at higher, inflation-influenced, interest rates. But in the major economies the average maturity of outstanding debt is quite short at around 7 years. Only in the UK, where the figure is close to 15 years, does the environment appear conducive to an inflationary solution. In the US, for example, the figure is 5.8 years, in Canada 5.4 years, and Germany 5.9.
What then of contemporary financial repression? It is already easy to find evidence that financial sectors have become more tightly controlled, and that macroprudential frameworks have been skewed towards helping governments fund their budget deficits. Mechanisms to encourage pension funds to invest in safe asset are common. Various Basel financial sector protocols, meanwhile, provide for the preferential treatment of government debt in bank balance sheets via substantial differentiation in capital requirements. Then there is the fact that the sovereign debt markets are increasingly populated by non-market players, as unconventional monetary policy, and variations on the theme of quantitative easing, have become commonplace. Indeed, they are now being employed not just in the advanced economies but more widely in the developing world.
Prior to unconventional monetary policy being expanded to address the impact of the COVID-19 pandemic, the asset holdings (mostly sovereign bonds) of central banks that had resorted to asset purchase programmes amounted to the equivalent of more than 35% of GDP. In Japan, the figure was in excess of 100%. These holdings have increased sharply since March, both absolutely and relative to national output and, on the basis of current central bank strategies will continue to do so.
Hence extremely low, or even negative, real interest rates have, as they were in the 1940s, 50s, 60s, and 70s, increasingly become the norm, and these traits are observable not just at the short end of the yield curve, but for longer dated maturities as well.
Given the extent and the enduring nature of the advanced economies’ public debt burden, our sense is that the creeping financial repression of recent years is likely to gather momentum following the COVID-19 pandemic, as governments search out more socially and politically palatable means than further explicit budgetary surgery to control their huge debt burdens. Perhaps those countries that have travelled a long way down this road before, and those characterised by dyspeptic electorates ̶ the US and the UK spring to mind ̶ will be the most likely to repeat the experience, although countries like France, which have been sceptical of the sovereignty of markets are also candidates.
The precise role of inflation in all this is more debateable. After all, over recent years inflation has proved hard to generate, and inflation targets hard to hit. But it is reasonable to assume that, whatever the public rhetoric of central bankers and policymakers in general, there will, at the very least, be a greater willingness to over-ride, and take greater risks with, existing low inflation mandates. The era of narrow inflation targeting is probably over.
There will probably be more explicit debt restructurings as well. Latin America obviously has lots of form here. But for now, at least among the advanced economies, Europe is probably likely to remain the most conspicuous sovereign risk hotspot. But if debt continues rapidly to accumulate such a tendency may spread further afield, including to some of the other larger economies.
- The management of government debt burdens remaining at the core of the policy debate.
- Central banks continuing to increase their holdings of government bonds.
- The dilution of central bank independence and narrow inflation targeting.
- Further regulatory changes to create a captive market for government debt.