Addiction to debt has left the global economy one shock away from disaster
Story by Jeremy Warner, 5/8/24
How much debt is too much? After three economic shocks in a row – the financial crisis, the pandemic and the energy price spike – the world economy is drowning in the stuff, with little sign of any life raft to the rescue.
It’s true that, relative to GDP, we’ve seen still higher levels of public debt in the past, the last such occasion as a result of the Second World War. It’s also true that the Japanese economy has managed to coexist with debt to GDP of more than 200pc reasonably well for many years now.
But don’t let these much quoted examples of “debt doesn’t matter” lull you into a false sense of security. High wartime debt was tolerated because everybody knew that military spending would fall significantly the moment the war was over.
What’s more, the post-war years saw an explosion in economic growth, together with the demographic dividend of a baby boom that greatly expanded the size of the workforce.
From the fall of the Berlin Wall onwards, moreover, Western economies enjoyed a pronounced “peace dividend”; defence spending plummeted as a percentage of national income.
No such benign combination of forces is in prospect this time around.
To the contrary, ageing populations threaten only to further dial-up the pressures on public spending. Growing geopolitical instability has meanwhile brought the post-Cold War peace dividend to an end.
As for Japan, there are countervailing factors in play, in particular very high levels of domestic savings and a usually buoyant current account surplus.
Historically, the tax burden in Japan has also been lower than other major high income economies, though it has admittedly crept up in recent years; in any case, there is a sense in which Japan borrows from its citizens rather than taxes them.
Throughout much of the rest of the world economy, we are both taxing more and borrowing more in equal measure. For how much longer can this continue?
There’s a particularly alarming graphic in the International Monetary Fund’s latest “Fiscal Monitor” which shows that, on unchanged policies, federal debt in the United States will soar over the next 30 years to around 160pc of GDP.
It’s even worse for China, where debt is projected to rise to 250pc of GDP. Nor does there seem to be any political appetite for reversing these trends.
If there is one thing that unites both candidates for November’s presidential election in the US, it is a complete disregard for high levels of deficit spending.
China likewise seems hellbent on fiscal oblivion; President Xi Jinping’s need for perpetual growth takes priority over any notion of fiscal discipline.
In both cases, to be running such huge deficits at the top of the cycle, with something close to full employment, is reckless in the extreme.
Unlike much of Europe, America managed to avoid a recession last year. The main explanation is now obvious; like others, deficit spending rose hugely during the pandemic, but unlike others, in the US it has stayed high ever since.
According to IMF estimates, the US ran a fiscal deficit of 8.8pc last year. Under IMF projections, it falls back a tad this year to 6.5pc, but then rises anew next year to 7.1pc, more than three times the average for other advanced economies. Small wonder the US economy is on a tear.
At its spring meeting last month, the IMF uncharacteristically named and shamed four countries that “critically need to take policy action to address fundamental imbalances between spending and revenue”.
Besides the US and China, the other two were the UK and Italy. There are questions to be asked about how it is that France has once again managed to escape the IMF’s strictures, given that its national debt is already quite a bit higher than the UK’s, and its ongoing borrowing needs are also expected to be higher.
Suffice it to say that France has always had the IMF sewn up; even when the managing director is not a French national, the chief economist generally is.
But the wider point about excessive public debt is well made. Stretched fiscal positions in the US, China, France, Italy and the UK have begun to pose a significant threat to the future of the world economy.
Years of money printing and ultra-low interest rates have enabled and normalised previously undreamt levels of indebtedness. But now the props have been kicked away, exposing the risks and associated costs, like a receding tide, in all their gruesome detail.
In the US, the Congressional Budget Office warns that “starting next year, net interest costs are greater in relation to GDP than at any point since at least 1940, the first year for which the Office of Management and Budget reported such data.”
The way things are going, the cost of servicing bondholders will soon outweigh US defence spending. Interest costs are also fast catching up with spending on Medicare.
It’s a similar picture in the UK, where debt servicing costs are already significantly higher than defence spending.
It should be obvious to all that things cannot carry on like this. Fiscal buffers are depleted to virtual non-existence; we are just one more economic shock away from being completely overwhelmed.
How does the world economy escape a mess as comprehensive as this one? There are only so many ways it can go. For now, financial markets remain remarkably unconcerned. They know there are lorry loads of debt issuance heading their way, but continue to buy as if there is no credit risk at all.
The UK Debt Management Office, for instance, has had no difficulty financing the Government’s borrowing requirements, despite the pressures of quantitative tightening from the Bank of England, which adds a further steady stream of gilts supply.
Similarly with other advanced economies. Higher interest rates obviously help by making government bonds relatively more attractive. But they also remind us that debt is no longer free, and that, by demanding more for their money, investors expect inflationary pressures to remain elevated long into the future.
Higher inflation helps erode debt over time, other things being equal, and can therefore be useful as a form of government default by stealth. Arguably, it’s preferable to actual default, which is always messy and almost bound to involve crippling austerity.
Or governments can act preemptively to bring revenues and spending back into line. The last time the US was in surplus was in President Bill Clinton’s second term. Similarly with Britain, which has not seen a budget surplus since 2001.
In both Britain and the US, this is an election year, so occasional lip service to the idea of fiscal prudence gets drowned out in the hunt for votes. But eventually someone will have to get a grip.
Whoever wins, higher taxes and lower spending are sadly a foregone conclusion, threatening a possibly quite serious global recession at some stage next year.