Public debt ratios in the developed world have plateaued at record highs. This has reduced governments’ capacity to stabilize financial and economic cycles in the future. It has also increased the dependence of sovereign debt sustainability on low real interest rates. Avoidance of excessively tight fiscal conditions and protection of sovereign solvency in developed economies partly relies on “financial repression”: a set of macroeconomic and regulatory policies that channels cheap funding to public budgets for a prolonged period of time.

The rise of public finance risk

The trouble with public debt ratios

The ratio of government debt to GDP in the developed world has reached a 200-year high watermark of over 107%. Persistent budget deficits, hidden quasi-fiscal debt and high future pension and health care liabilities from aging populations add to concerns about the long-term sustainability of public finances. The rise in public indebtedness has been part of a broader global expansion of financial leverage spurred by decades of declining interest rates (view post here) and limited efforts of macroprudential restriction. The step-like pattern of public debt – rising in recessions and not falling back in recoveries – reflects recurrent recourse to fiscal easing as a means to mitigate economic downturns.

High public debt ratios may not be easily sustainable. In particular, falling potential growth and inflation have undermined debt servicing capacity (view post here) and left budgets reliant on persistently low interest costs. The 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 real GDP and employment in case of future recessionary and deflationary shocks. This is of particular importance, since monetary policy, the main alternative counter-cyclical policy, has also become constrained, for example by the zero lower bound of interest rates (view post here).
  • Second, public finance pressure often gives rise to distortionary taxation, regulation, and other measures that interfere with the functioning of markets.
  • Finally, economic and political pressures could at some stage give rise to more aggressive effective debt reduction policies, such as monetization or even forms of restructuring, with repercussions for a broad range of financial markets and sectors. Investors in developed market easily overlook that default is a real risk even if governments have access to monetary financing (view post here).

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

“Advanced economies have experienced much larger shocks than was previously thought possible…This has led to reassessing what constitutes ‘safe’ sovereign debt levels for advanced economies and has prompted a more risk-based approach to analyzing debt sustainability.”

IMF Policy Paper, 2013

The momentous challenge of fiscal consolidation

The IMF’s fiscal monitors have documented how the costs of the great financial crisis triggered a drastic deterioration in public finances and – subsequently – an unprecedented shift towards fiscal tightening in the developed world. Thus, the general government deficit of the world’s advanced economies peaked at 8.7% of GDP in 2009. It has since been reduced to an estimated 2.9% in 2015.  Indeed, the IMF estimates that the structural (cyclically-adjusted) deficit of the developed world is yet a bit lower at 2.6% of GDP and has effectively returned to its pre-crisis level.

Discretionary fiscal tightening has probably been in excess of 4% of GDP between 2010 and 2015, suggesting that governments have diverted a large incremental portion of national incomes to public budgets through higher taxes and lower spending. The reduction in real government bond yields in many countries has also helped fiscal consolidation and reduced near-term concerns over fiscal sustainability. Nevertheless, IMF estimates suggest that still more fiscal tightening would be required to secure fiscal sustainability. For illustration: the developed countries would need an additional reduction in the ratio of the fiscal deficit to GDP of 4 percentage poinits by 2020 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 between 2014 and 2030 (required for the purpose of achieving the target for the ratio of debt to GDP) would be as large as 8 percentage points.

The urgency to reduce and contain government deficits arises from the precarious state of public debt. The IMF estimates that the general government debt stock of the advanced economies remains stuck at around 107% of GDP for now, up 35%-points from its pre-crisis ratio. Public debt levels are unlikely to recede much in coming years, implying the governments’ financial situation will remain critically exposed to increases in real interest rates or sovereign credit spreads. A particular concern is Japan, whose gross government debt ratio is approaching 240% and whose general government deficit is still above 4% of GDP, one of the highest in the developed world.

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

Most economists agree that high government indebtedness implies increased vulnerability of the financial system. In particular, large sovereign debt reduces 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.

However, published research does not agree on the consequences for the trend of economic growth in general. 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.

Fiscal policy also 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 the present context this may aggravate the risk of mutually reinforcing dynamics between deflation, debt problems and fiscal tightening.

“We…find evidence that the debt trajectory can be just as important, and possibly more important, than the level of debt in understanding future growth prospects. Indeed, countries with high but declining levels of debt have historically grown just as fast as their peers.”

IMF Working Paper, 2014

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 takes the form of “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 containing public debt but bear risks for future financial stability.

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.
  • There is generally 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. Also, the eventual inflation tax will create its own demand-management challenges at some point in the future. Moreover, governments and highly-indebted private institutions find it easier to delay balance sheet repair and structural reform. Duration risk in the financial system has increased, making it more vulnerable to future yield increases, a peril that is aggravated by biased regulation (view post here). And many pension funds’ and life insurances’ business models and financial sustainability are questioned.

“Financial repression occurs when governments implement policies to channel to themselves funds that in a deregulated market environment would go elsewhere. …Governments do not call these actions financial repression, of course, but characterize them as part of ‘macroprudential regulation’”

Reinhart, Kirkegaard, and Sbrancia, 2011