Inventive policymaking has only made the problem worse, guaranteeing that any eventual restructuring will be all the more painful.
By Satyajit Das
Markets, to paraphrase Nobel prize-winning economist Thomas Schelling, often forget that they keep forgetting. That’s especially true when it comes to the intractable challenges posed by global debt.
Since 2008, governments around the world have looked for relatively painless ways to lower high debt levels, a central cause of the last crisis. Cutting interest rates to zero or below made borrowing easier to service. Quantitative easing and central bank support made it easier to buy debt. Engineered increases in asset prices raised collateral values, reducing pressure on distressed borrowers and banks.
All these policies, however, avoided the need to deleverage. In fact, they actually increased borrowing, especially demand for risky debt, as income-starved investors looked farther and farther afield for returns. Since 2007, global debt has increased from $167 trillion ($113 trillion excluding financial institutions) to $247 trillion ($187 trillion excluding financial institutions). Total debt levels are 320 percent of global GDP, an increase of around 40 percent over the last decade.
All forms of borrowing have increased — household, corporate and government. Public debt had to grow dramatically to finance rescue efforts after the Great Recession. U.S. government debt is approaching $22 trillion, up from around $9 trillion a decade ago — an increase of 40 percent of GDP. Emerging market debt has grown as well. China’s non-financial debt has increased from $2 trillion in 2000 (120 percent of GDP) to $7 trillion in 2007 (160 percent of GDP) to around $40 trillion today (250 percent of GDP).
U.S. non-financial corporate borrowing as a share of GDP has surpassed 2007 levels and is nearing a post-World War Two high. Meanwhile, the quality of that debt has declined. BBB-rated bonds (the lowest investment-grade category) now account for half of all investment-grade debt in the U.S. and Europe, up from 35 percent and 19 percent, respectively, a decade ago. Outstanding of CCC-rated debt (one step above default) is currently 65 percent above 2007 levels. Leveraged debt outstanding (which includes high-yield bonds and leveraged loans) stands at around $3 trillion, double the 2007 level.
Today, the world doesn’t have many options left. In theory, borrowers could divert income to pay off debt. That’s easier said than done, given that very little of the debt assumed over the last decade was put to productive uses. As wages stagnated, households borrowed to finance consumption. Companies borrowed to finance share buybacks and acquisitions. Governments borrowed to finance current expenditure, rather than infrastructure and other strategic investments.
A sharp deleveraging now would risk a recession, making repayment even more difficult. Shrinking the pile of public debt, for example, would require governments to raise taxes and cut spending, which would put a damper on economic activity.
In theory, strong growth and high inflation should reduce debt levels. Growth would boost incomes and the debt-servicing capacity of borrowers. It would reduce debt-to-GDP ratios by increasing the denominator. Where real rates are negative (with nominal rates below the level of price increases), inflation would reduce effective debt levels.
Since 2007, however, attempts to increase growth and inflation have had only modest success. Monetary and fiscal measures, however radical, have their limits. They can minimize the effects of an economic dislocation but can also damage long-term growth prospects. Since the 1990s, too, much economic activity has been debt-driven. Credit intensity is rising: It now requires increasingly higher levels of debt to generate the same level of growth. Efforts to reduce that debt risk an economic contraction, rather than a boom.
Finally, where debt is denominated in a national currency but held by foreigners, countries could slash that debt by devaluing their currencies. The problem is that everyone knows this: Since 2007, a multitude of nations have sought to engineer cheaper currencies in order to boost their competitive position and devalue their liabilities. That’s produced a stalemate, constraining this option.
The only other way to reduce debt levels is by default. This can either be done explicitly — through bankruptcy or write-offs — or implicitly, using negative nominal interest rates to reduce the face value of the debt. Default is almost certainly the likeliest long-term option.
In a default, debt investors as well as banks and depositors suffer losses of savings and income. Financial institutions and pension funds may become insolvent. Retirement income and public services that are paid for by household taxes and contributions won’t be delivered. In turn, this will reduce consumption, investment and the availability of credit. Depending on the size of the write-offs required, the economic and social losses could be considerable.
In 2007, policymakers passed up the opportunity to devise a slow, controlled correction because it would have necessitated defaults and creditor losses. That might at least have allowed an equitable sharing of losses, with the most vulnerable protected. Instead, leaders arrogantly gambled that their policy toolbox would make their debt problems disappear. The breathing space they purchased was wasted. Sovereign states used interest rate savings to finance increased expenditures rather than debt reduction.
Now time is working against them. Previous restructurings show that early default helps cauterize the wound, minimize loss and facilitate recovery. The longer the delay, the higher the cost and bigger the adjustment necessary.
Not wanting defaults on their watch, policymakers have been less than honest, including with themselves, about the options to deal with unsustainable debt. They’ve effectively transferred the costs to the next generation.
One way or another, though, those costs will have to be paid.