As the COVID-related, worldwide death toll has exceeded two million and economies are suffering ever more extended lockdowns, unimaginable amounts of money have been injected into households and enterprises to prevent a 1920s-style collapse.
According to 2020 IMF statistics more than $12 trillion have been spent by governments worldwide already and much more money is on its way. As a result, public coffers were never more depleted. Data published by the IMF and the UN in September last year and then again in October showed national debt for some countries increasing as much as 25 per cent – in one month. Countries are calmly adding to their stock of arrears, which in the case of Greece (206%) has doubled from levels once considered untenable, demanding a bailout. The sudden insolvency of countries like Portugal, Spain and Ireland in 2010 was caused by investors scared by the level of debt. This triggered a crisis which almost toppled the euro.
Leading industrial nations have amassed liabilities of staggering dimensions; Japan (266%), Italy (162%) and the United States (131%) are salient examples. For ordinary people who would never qualify for a bank loan in a similar state of indebtedness, such arrears seem highly alarming. How could we as taxpayers ever ‘repay’ such mind-boggling sums? Bankruptcy must surely follow, and years of poverty.
But economists have always pointed out the quintessential difference between private budgeting and the public purse, which enjoys a tax and money creation monopoly. Former Federal Reserve chairman Allan Greenspan had once famously remarked that a country like the US, printing its own money, cannot possibly default on its debt. Such a country may debase its currency, but it can never become insolvent.
While admitting that high, absolute debt levels are hard to compare, and in some instances, may even be beneficial, economists have nevertheless voiced warnings. Comparing economic data of 44 countries since 1946, academics Carmen Reinhart and Kenneth S. Rogoff in 2010 published their seminal paper Growth in a Time of Debt, which somewhat apodictically argued that once public debt has reached the threshold of 90 per cent, economic growth as a consequence will dwindle.
Many economists have joined the chorus since, agreeing to various degrees on a ‘danger cliff’ for state indebtedness. According to their theory, most industrialised countries would have lacked by now the capacity to ever escape the downward trajectory of debt. Based on a multitude of historic data, they try to explain why high public debt is negative for growth and therefore dangerous for public solvency: a shrinking economy will have insurmountable difficulties to ever repay its debts.
For already highly indebted countries to raise more debt they would have to offer foreign and domestic investors higher incentives in the form of higher interest rates. This in turn would raise finance costs for private enterprises and hence diminish investment, growth and tax revenue. Higher finance costs for the state will curb public investment and public expenditure, as ever larger amounts of the budget will be eaten up by debt servicing. In an economic downturn little is then left for fiscal stimuli. Any attempts to increase tax intake may damage the economy even further.
While such observations sound logical and can be exemplified in the real world, they nevertheless lose significance in their generalisation. First it is very hard to read from data as to what came first: stagnating growth or mushrooming debt? Just because both growing debt and diminished growth can be observed at the same time is not enough to conclude causality. Right now we see governments raising money in staggering amounts because the economy has stalled, not vice versa.
What altered the picture over the last 10 years are interest rates hovering close to, and in cases even below zero
It is also very difficult to compare countries. While Japan, the owing world champion, is getting away with baffling levels of debt, countries like Argentina, with relative debt levels at a fraction of Japan’s (74%) have defaulted multiple times. If the theory of absolute debt thresholds held true, countries like Afghanistan (6.88%) would be more credit worthy than Canada (114%), and Zambia (50%) would never have defaulted.
It also makes a difference if countries finance themselves in their own currency, like the US or Japan, or in a foreign currency, necessitating a comfortable cushion of foreign currency reserves to sooth investors’ nerves. With such reserves quickly drained in times of economic stress, exchange rates will worsen fast, calling for ever more crippling interest rate hikes ‒ leading to the dire scenarios described by aforementioned economists. It also makes a difference if a country depends on nervous, foreign investors or if its obligations are predominantly owned by domestic savers, as is the case in Japan. A sovereign has legislative leeway towards its subjects.
What altered the picture over the last 10 years are worldwide interest rates hovering close to, and in many cases even below zero. When countries like Germany and Austria can raise money not only free of cost, but even at a profit, rising debt levels become a boon rather than a curse. Governments, spoiled today by a massive, international savings overhang and unfettered central bank support, can raise money limitless and cost-free. Even overpriced public investments can thus be profitable.
While the theory of absolute danger levels for public debt looks outdated by now, the peril of chronic budget shortfalls is less easy to debunk. A government which year after year overspends its tax intake still looks dangerously reckless to most investors. Such a practice may not in every instance necessitate painful interest rate hikes, but it will certainly weigh on exchange rates – one of the reasons for the current dollar weakness. A weaker exchange rate either reflects already manifest inflation risks or will soon cause inflation by making imports more expensive. This can in extreme circumstances indeed dampen growth as consumers retreat.
Today’s altered economic circumstances have engendered a new breed of economists, adherents of the Modern Monetary Theory. They draft a rosy scenario for some privileged countries, wealthy and well anchored in financial markets. The ability of such countries to create money out of thin air, according to these economists, should practically be limitless. Taxes are not needed to finance public expenditure anymore, but only to counter inflation and to dampen demand.
While I am not sure how long such a practice can survive market scrutiny, it remains a fact that eye-watering debt looks less critical when all peers sit in the same boat. Compared with Japan, the US can expand bond selling for years to come.
Can we as retail investors be certain that we will live for much longer in this topsy-turvy world of negative, nominal and real interest rates, which support today’s lofty valuations of bonds and hence growth stocks, and the shares of highly leveraged corporations? The meteoric rise of Tesla and Bitcoin and the stock markets at large since March 2020 depend not only on central banks acting as investors of last resort, but also on political calm.
Events like the recent storming of the US Capitol, supply shocks or climatic cataclysms have the potential to alter our rosy world in an instant. A debt tower for governments can suddenly prove to be a crowded place.
The purpose of this column is to broaden readers’ general financial knowledge and it should not be interpreted as presenting investment advice, or advice on the buying and selling of financial products.
andreas.weitzer@timesofmalta.com
Andreas Weitzer, independent journalist based in Malta