With public debt ratios at their highest levels in two centuries, financial repression has become inevitable, representing the single viable alternative to default. Moreover, global fiscal tightening is still far from complete. Fiscal restriction will probably diminish in coming years if economic growth is exceeding real interest rates, but may come back with a vengeance if not.

The below is an update of the summary page “Government Finances” of this blog.
It is based on a number of posts, with the links given below.
Further research and thoughts on this subject would be highly appreciated (rjsueppel@gmail.com)

Government debt ratios have reached a 200-year high watermark, rising to almost 110% of GDP in the developed world. A combination of sub-par growth, persistent budget deficits, and high future and contingent liabilities from aging populations and weak financial sectors has added to concerns about the sustainability of public finances. Public indebtedness is part of an overall global leverage expansion in the wake of declining interest rates over past decades (view post here).

The precarious state of government balance sheets constitutes systemic financial risk for several reasons. 

  • First, there is little “credible buffer” left for fiscal policy to stabilize developed economies in case of future recessionary and deflationary shocks. This is of particular importance, since monetary policy, the main tool of counter-cyclical policy in the past, is also being impaired by the zero lower bound of interest rates (view post here). 
  • Second, some countries could actually opt for default or expropriation of investors with repercussions for a broad range of financial markets and sectors. Investors in developed market easily overlook that default is a risk even if governments have access to monetary financing (view post here). 
  • And third, public finance pressure often gives rise to distortionary taxation, regulation, and interference with the functioning of markets

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

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 to fiscal tightening in the developed world. Thus, the structural general government deficit of the world’s advanced economies peaked at 6.6% of GDP in 2010, up from 3.8% in 2008, and has since been reduced to an estimated 3.0% at the end of 2014 (view post here).

Discretionary fiscal tightening has probably been a cumulative  3.2% of GDP over the 4 years since 2010, suggesting that governments have diverted a large proportion of national incomes to public budgets through higher taxes and lower spending. The reduction in real government bond yields in many countries reinforces this effect. Moreover, IMF estimates suggest that more restrictive fiscal policies has to come at some stage, in order to secure fiscal sustainability. For illustration: an additional fiscal tightening of 4.4% of GDP would be required by 2020 in order to meet long-term debt targets by 2030. If, over and above that, governments also wanted to compensate budgets for increasing age-related spending, the required tightening measures would have to add up to over 8% of GDP.

The need to reduce government deficits arises from the precarious state of public debt. The IMF estimates that the general government debt stock of the advanced economies will peak at 106.5% of GDP at the end of 2014, up from below 80% at the end of 2008. Public debt levels are unlikely to recede much in coming year, implying the governments’ financial situation is critically exposed to increases in real interest rates or sovereign credit spreads. A particular concern is Japan, whose gross government debt ratio probably hit 245% of GDP in 2014 and whose cyclically-adjusted general government deficit is still 6.7% of GDP.

Fiscal challenges often reach further than official numbers suggest. Many governments, including 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. If one includes the balances of Chinese local government financing vehicles, the county’s “augmented” fiscal deficit is probably close to 10% of GDP, versus just above 2% as officially reported (view post here). The total public debt stock could be over 60% of GDP rather than the official 20-25% (view post here).

Consequences of high public debt

The predicted fiscal tightening required to restore debt sustainability after the great financial financial crisis has been, and still is, daunting. The IMF diagnosed in 2011 that the developed world currently was running a cyclically-adjusted primary deficit of 3.8% of GDP. In order to achieve a debt-to-GDP ratio of 60% by 2030 it would, however, need a primary surplus of 4% of GDP. This implied a shift in the global fiscal stance of 7.8%-points by 2020. Over and above this, the required adjustment in age-related spending was estimated to amount to another 11.7% of GDP between 2010 and 2030.

Most economists agree that high government indebtedness implies increased financial vulnerability and pressure to secure to debt sustainability. However, economists do not agree on the broader economic consequences. Carmen Reinhart and Kenneth Rogoff popularized the view that high public debt, particularly when exceeding a 90% of GDP threshold, is bad for growth. Yet their empirical findings failed to find broad support in the academic world, and a number of studies suggest that high debt, on its own, has not usually preceded weaker activity (view post here). However, there is evidence that high and rising public debt has often led to lower and more volatile economic growth (view post here). The broader point is that a sovereign’s financial vulnerability can team up with economic uncertainty raising fears about debt sustainability and and precipitating negative market momentum.

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 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 directed lending to government by captive domestic audiences (such as pension funds), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and (generally) a tighter connection between government and 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).

Government bond investor base

Investor composition of government securities in advanced G20 countries show country-specific patterns. Canada, the UK, and the US exhibit a diversified investor base. European countries show deep ties with non-resident investors. In contrast, Japan and Korea have a low share of non-resident holdings but sizable holdings of government entities and state-owned enterprises.During the last decade, the share of non-resident holdings has markedly increased in all countries with the exception of Canada and Japan and often makes up the largest share of the investor base. Prior to the 2008 crisis, global imbalances and reserve flows were key factors behind the increase in non-resident holdings. Financial regulation further catalyzed financial integration, for instance by applying a zero risk weight under bank prudential rules for all government bonds in the Eurozone.The crisis has slowed or even reversed this trend. Reserve accumulation has ceased to act as the main driver of non-resident government bond holdings for reserve currency issuers. In other, riskier markets, the crisis triggered a marked pullback of foreign investors, repeating the typical pattern of increased home bias in the aftermath of crises. As result, non-resident holdings have stagnated in many countries, and have fallen in Greece, Ireland, Portugal, and Spain. The recent tightening of prudential rules may have cemented this development.