High public debt loads run stubbornly against the grain of a global economy that teems with positive trends. Existential risks are arguably shrinking, and growth prospects are improving, but public debt continues to mount.
The bulk of the world’s developed nations now sag under large amounts of gross governmental debt, clustered around 80 to 120 per cent of gross domestic product. As this debt rises, it is beginning to trigger alarm bells. Investors and ratings agencies are usually content with public debt below 60 per cent of GDP. Levels beyond 80 per cent are regularly linked to subpar economic growth. Plowing past 100 per cent is a sure way to kick-start insolvency rumours.
Something clearly needs to be done. Fortunately, there are six ways to tame these high public debt burdens.
The first and most drastic option is simply to repudiate the debt. Defaulting looks attractive on the surface, but the wrath of bondholders is not something to be taken lightly. Russia was effectively barred from the bond market for a lengthy 12 years after its 1998 default. Argentina’s 2002 default has resulted in repeated – and ongoing – attempts to claim overseas Argentine assets. Private sector borrowing costs tend to soar after a public default, and a nation may find itself in critically short supply of international goodwill.
With the exception of Greece – which has defaulted twice in recent years and is likely to succumb yet again – no other major developed nation seems bound for this fate.
The second option is to inflate away the public debt. The nominal value of the debt remains unchanged, but its real value helpfully declines. Inflation has averaged about two percentage points higher than normal during past episodes of serious public debt reduction in the U.S., U.K., Japan and Canada.
However, higher inflation is economically costly, and there is a risk that investors demand higher interest rates. Successful implementation requires that the additional inflation be unanticipated, short-lived and abetted by artificially low bond yields. This was managed in the 1940s and 1950s; the sustained blast of 1970s inflation was less helpful.
Despite repeated odes to low inflation over the past two decades, several major central banks have lately demonstrated a diminished fealty to the principle. Consequently, a pip of extra inflation may well figure into debt-reduction strategies.
The third option is to outgrow the debt through a stronger economy. This is easier said than done. Policy makers were just as desirous of fast growth when public debt loads were low. Still, we wonder if there may be scope for a little more growth than conventionally imagined, if only because countries will eventually reabsorb their billowing economic slack, and several are making long-overdue structural reforms.
The fourth option is to repress borrowing costs, minimizing the rate at which sovereign debt compounds. This is a well-worn strategy, used to particular effect around the Second World War. Holding rates down today isn’t much of a challenge given slow growth and low central bank rates. Holding them down for a decade or longer is clearly tougher sledding. But there is a surprisingly feeble link between high public debt and high interest rates, and policy makers have many tricks up their sleeves if the bond market proves reluctant to oblige, ranging from explicitly capping government borrowing rates, to ongoing quantitative easing, to obliging banks to buy more government bonds (as Basel III effectively does).
The fifth option is to run budget surpluses and to pay down the debt. This is the most obvious and reliable path back to normalcy, although it has more than its fair share of brambles. Not only is fiscal consolidation politically difficult to stomach, but it is economically costly. Perversely, most of the pain is felt up front while deficits are being wrestled to the mat, whereas the debt reduction itself occurs only later, with little adverse consequences for growth.
The sixth and final option is to ignore the problem. Japan’s debt has mushroomed for two decades without a peep from the bond market. Ultimately, this fungus usually proves poisonous, subtly depressing growth, limiting the response to shocks and leaving a frightening vulnerability to a sudden debt crisis.
The most practical and likely strategy combines several of these tactics, striving toward a moderate budget surplus while simultaneously holding down interest rates, and securing additional crumbs of economic growth and inflation wherever possible. Several countries are already pursuing variations of this.
Even with this plan, years of battle must be waged to reclaim normal-sized debt loads. The Netherlands, Germany and Canada could declare victory by decade’s end if they really buckled down, but France, Italy, the U.K., Spain and the U.S. will need to fight well into the 2020s. Poor Japan, Portugal and Ireland must sustain their efforts all the way into the 2030s.
Eric Lascelles is chief economist of RBC Global Asset Management
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