The systemic risk of highly indebted governments

Public debt ratios in the developed world have soared past 200-year record highs. Sustainability of public finances relies on negative real interest rates. This poses a lingering systemic threat to the global financial system for at least three reasons. First, governments’ capacity to stabilize financial and economic cycles has been compromised, which matters greatly in a highly leveraged world that has grown used to public backstops. Second, many countries have taken recourse to mild forms of “financial repression”, which puts pressure on the financial position of savers and related institutions, such as pension funds. Third, future political changes in the direction of populist fiscal expansion can raise the spectres of old-fashioned inflationary monetization or even forms of debt restructuring.

The debt issue

Elevated public debt ratios

The ratio of general government debt to GDP in the developed world has risen above 120% of GDP in 2020, from 100% in the 2010s, and less than 75% prior to the great financial crisis. It thereby exceeded its two-century high watermark. Meanwhile, budgets have broadly remained in deficit even before the COVID-19 crisis and surged to an average of 11% of GDP in 2020. Moreover, off-balance quasi-fiscal debt and high future pension and health care liabilities from ageing populations pose serious challenges to the long-term sustainability of public finances. The IMF estimates that advanced economies’ public debt including contingent liabilities stands at over 200% of GDP.

The rise in public indebtedness has been part of a broader global expansion of financial leverage that has been spurred by a secular downward trend in interest rates (view post here) and a deepening of the global financial system. Easy financial conditions for most advanced economies’ governments have allowed elevating debt stocks in a step-like pattern, rising in recessions but not retreating in recoveries.

The sustainability of such high public debt ratios is a valid concern, even in large developed countries. Indeed, falling potential growth and inflation have undermined debt servicing capacity (view post here) and left budgets reliant on persistently low interest costs. This precarious state of government balance sheets constitutes systemic financial risk for several reasons.

First, the higher public debt and deficit ratios, the more limited is the “credible buffer” left for fiscal policy to stabilize economies and support financial systems in case of future recessionary and deflationary shocks. This is of particular importance because monetary policy, the main alternative counter-cyclical policy, has also become constrained by bloated balance sheets and the zero lower bound of interest rates (view post here).
Second, public finance pressure often gives rise to distortionary taxation, biased regulation and legal changes that interfere with the functioning of markets. Financial repression, as explained below, and discussions about financial transaction taxes are past examples of this.
Third, future economic and political pressures can give rise to more aggressive effective debt reduction policies, such as monetization or even forms of restructuring. The euro area sovereign debt crisis has proven that sovereign credit risk is not mere an issue for emerging markets. Moreover, default is a possibility even if governments have access to monetary financing (view post here). This risk arises if the balance of the central bank becomes a concern for stability or if the political costs of high inflation and debasement of money are greater than those of debt restructuring.

Historically, both emerging and developed countries have taken recourse to drastic measures to reduce excessive public debt burdens in the past, including “financial repression”, outright debt restructuring, and acceptance of higher inflation (view post here).

Insufficient fiscal consolidation in the 2010s

According to IMF estimates the great financial crisis 2008/09 caused a drastic deterioration of developed countries’ public balance sheet that subsequently led to an aggressive fiscal tightening in the 2010s. Discretionary fiscal tightening has probably been in excess of 4% of GDP between 2010 and 2015, meaning that governments have diverted a large incremental portion of national incomes to public budgets through higher taxes and lower spending. The combination of fiscal tightening and cyclical recovery in the 2010s has reduced the advanced economies’ average general government deficit ratio from a peak of 8.7% in 2009 to an estimated 2.6% in 2017.

However, the post-crisis reduction in headline government deficits ended in the late 2010s and has been a necessary rather than sufficient stage in fiscal consolidation.

The advanced economies’ government debt stock seemed stuck at over 105% of GDP, up more than 30%-points from its pre-crisis ratio and 50%-points compared to the early 1990s. It is not expected that government debt ratios will decline much in coming years. The fundamental mechanism of public debt ratios ratcheting up sharply in bad times and not receding much in good times has not been broken. A particular concern is Japan, where the government’s gross debt exceeds 235% of GDP with no meaningful reduction in sight.
The financing of government debt hinges on low or negative real interest rates in the developed world. Interest payments have been limited to just 1.5% of the outstanding liabilities in recent years. The combination of positive real growth and negative real interest rates means that high debt ratios can temporarily be sustained even without outright budget surpluses or even primary surpluses (that exclude interest costs).
Considerably more fiscal tightening would be required to secure fiscal sustainability that would be robust to changing interest rate conditions. For illustration: IMF estimates suggest that the developed countries would need an additional reduction in the ratio of the fiscal deficit to GDP of 4%-points in coming years in order to meet long-term debt targets of 60% or less by 2030. If, over and above that, governments also wanted to allow spending as a result of ageing to continue without alteration in age-dependent entitlement programmes, the required reduction in the ratio of other fiscal spending to GDP (for the purpose of achieving the target for the ratio of debt to GDP) would be as large as 8 percentage points.

Fiscal challenges often are more daunting than official numbers suggest. Many governments, including in the U.S., are burdened with unfunded future social security and health care obligations, as well as contingent liabilities from financial guarantees (view post here). Other countries have cumulated hidden debts and deficits through off-budget activity, the most prominent case being China (view posts here and here).

Economic and systemic consequences

Impact on financial and economic stability

Elevated government indebtedness and delayed fiscal consolidation implies increased vulnerability of the financial system. In particular, large sovereign debt compromises governments’ capacity for supporting private balance sheets and stabilizing economic growth in future crises (view post here). Historically, such support has been critical for containing the mutually reinforcing dynamics of deleveraging and economic recessions. In the current highly leveraged global economy the fragility of such support weighs heavily.

Plausibly, high government debt ratios are also a risk for economic growth. Carmen Reinhart and Kenneth Rogoff popularized the view that high public debt, particularly above a threshold of 90% of GDP, has historically been followed by lower economic growth. Yet their empirical findings have failed to find broad support and a number of studies suggest that high debt, on its own, has not usually led to weaker activity (view post here).

However, there is evidence that high and rising public debt has often led to lower to softer growth. Also, on its own high government debt does often entail greater output volatility. (view post here). The broader point is probably that a sovereign’s financial vulnerability can easily team up with economic uncertainty, stoking fears about debt sustainability and precipitating negative economic and market momentum.

Finally, fiscal policy can have a powerful impact on inflation trends, in particular if monetary policy has to protect the sustainability of public finances. Since the global financial crisis and, particularly, the euro area sovereign debt crisis, central banks had to give greater consideration to public finance risk. The “fiscal theory of inflation” suggests that if monetary policy effectively protects public debt sustainability, fiscal easing is inflationary and fiscal tightening disinflationary or deflationary (view post here). In past years this mainly contributed to the risk of mutually reinforcing dynamics between deflation, debt problems and fiscal tightening. In the future, if fiscal policy should become expansionary again and monetary policy subservient to fiscal or political objectives this could lead to similarly reinforcing dynamics between fiscal expansion, rising inflation and a real erosion of debt stocks.

Risk of restructuring and repression

A 135-year study on public debt reduction strategies by the IMF (view post here) showed that debt stocks of over 100% of GDP have not been uncommon and do not necessarily lead to restructuring or default. Indeed, in the developed world out of 26 episodes only three ended in default (Germany and Greece). Successful debt-reduction strategies typically require a combination of fiscal tightening and growth-enhancing measures, as well as accompanying easy monetary policies.

A more subtle type of debt restructuring is “financial repression.” Financial repression is a set of policies that channel cheap funding to governments, typically supported by accommodative monetary policy (view post here). After the global financial crisis various forms of financial repression have prevailed in most developed and many emerging countries. These policies have been effective in compressing real interest rates (view post here) and in containing public debt service costs, at the expense of savers and investors.

Financial repression typically includes one or more of the following measures

The government channels lending to itself by creating “captive domestic audiences”, such as mandatory regulated pension plans.
Public authorities impose explicit or implicit caps on interest rates, as has long been the case in China (view post here),
Regulation that favors holdings of domestic government bonds; recent examples include the “Solvency II” European insurance regulation (view post here) or the preferential treatment of government bonds for banks’ capital and liquidity requirements (view post here).
A tighter connection between government and banks, informally or formally through state ownership of banks (view post here).

Financial repression is particularly effective when combined with more elevated inflation than priced in by markets. Government debt in developed markets is mostly long-term, not indexed to inflation, and denominated in local currency. Hence, under-predicted and high inflation (say around 6% for the G7) would produce a significant erosion of the real value of public debt, while deflation would raise debt-to-GDP ratios (view post here).

Compared to default and outright taxation, financial repression is viewed as a less disruptive means to shift wealth from savers to governments. However, the resulting compression in real yields and large holdings of sovereign risk by systemic institutions can become a serious risk for financial stability. The business models and sustainability of pension funds and life insurances are being questioned. Meanwhile, governments and highly-indebted private institutions find it easier to delay balance sheet repair and structural reform. There is evidence that duration risk in the financial system has increased in recent years, making it more vulnerable to future yield increases, a peril that is aggravated by biased regulation (view post here).