A deeper understanding of global debt

Ferdinando Giugliano

The International Monetary Fund warned last week that global debt has reached $164 trillion, the highest level on record. Does this mean the world is about to go bankrupt? Not at all. But high debt levels still matter, since they make it harder to run a sensible and equitable economic policy.

The relationship between debt levels and debt sustainability appears straightforward. The higher a debt pile, the more money it will take to pay it back in the future. Of course, a company or a government can rely on future growth to make good on their promises. But there is a point where investors no longer believe in this pledge and stop refinancing the debt – causing a crisis.

However, this analysis is also simplistic. There are several factors that determine whether a given level of debt is sustainable. In the case of governments, the most obvious one is the future path of four variables: growth, inflation, interest rates and the difference between revenues and spending. With central bank rates at record-low levels, for example, the global debt pile emphasized by the International Monetary Fund has been more sustainable than the whopping headline number would suggest.

Of course, interest rates are beginning to rise, as the global economy is finally expanding and inflation has slowly returned. But rising rates on their own should not create panic about debt. Take for example the U.S., where the ratio between government debt and gross domestic product is set to increase sharply as a result of President Donald Trump’s flagship tax reform. The U.S. enjoys what Valery Giscard d’Estaing, the former French finance minister and later president, called the “exorbitant privilege” of having the world’s reserve currency: Since investors want to hold assets denominated in dollars, including U.S. Treasuries, Washington can rack up debt in a way that other governments just can’t.

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It is also important to ask who holds the debt. Since the Great Recession, central banks have amassed large holdings of government and – in some cases – corporate bonds. Some of the monetary authorities, including for example the European Central Bank, have made it clear that they will continue rolling over these holdings well into the future, which will help to keep a lid on interest rates. Moreover, it is not just central bank holdings that matter. Japan’s sovereign debt stood at a 236 percent of gross domestic product last year, but most of it is held by domestic institutions, which are generally less volatile investors than fickle foreigners.

Finally, there is really no point in discussing debt without the context of how the money is spent. The IMF underlines how most of the debt accumulation since the financial crisis has occurred in emerging markets and China in particular. Companies and governments in developing countries have particularly good reasons to borrow, since they need to invest in the necessary capital or infrastructure to catch up with the rich world.

This does not mean, however, that we should dismiss the Fund’s calls to reduce indebtedness. For a start, there is an issue of intergenerational equity. Any borrowing entails an opportunity cost, since interest payments cannot, by definition, be spent on something else. This is why borrowing to invest is so important: A dollar spent on building a faster telecoms network will help to lift productivity, which will justify the cost of future interest payments. Unfortunately, in the case of many low-income countries, the IMF has found that extra deficits have not been used to boost long-term growth.

Furthermore, timing really does matter when it comes to accumulating debt. The U.S. is increasing its budget deficit just as the economy has approached full employment. This is a problem, since pro-cyclical fiscal policy can easily lead to overheating. The Federal Reserve may have to tighten monetary policy faster than it would otherwise. As a result the U.S. economy would first push hard on the accelerator and then even harder on the brakes – which is not the best way of driving.

Lastly, many countries simply cannot dismiss the risk of an outright fiscal crisis. This is particularly true for a string of low-income countries in sub-Saharan Africa, where falling commodity revenues and depreciating currencies are proving a lethal combination. But this threat is equally important for some countries in the eurozone, such as Portugal and Italy, which have learned the hard way during the eurozone crisis what it means to carry an excessively high sovereign debt.

There was some method, then, to the IMF’s madness. The scary-sounding global debt numbers were a bit of a publicity stunt; they got our attention, even if they were intellectually misleading. But if that helps to raise awareness of the risks attached to excessive borrowing, perhaps it’s worth the exaggeration.

Ferdinando Giugliano writes columns and editorials on European economics for Bloomberg View. He is also an economics columnist for La Repubblica and was a member of the editorial board of the Financial Times. © 2018, Bloomberg View.

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