Monday, 6 January 2014

Debts Still Matter

The mind of George Osborne works in a strange and Machiavellian way.  His announcement today that austerity will continue unabated into 2016 - 17 was greeted with howls of protest from all sides, could it be that the British Chancellor knows something that we don't?  
which one is George?
Five years after the default of Lehman Brothers and three year since taking office the world is still a dangerous place even after years of pain.  What is now clear is the history of this crisis; and most developed countries have faced a number of distinct phases in this recession.

1. The credit crunch caused by a lack of liquidity in the banks 2008

2. Falling growth and a deep recession, caused by the banking failure and the subsequent free fall in asset prices in 2009

3. A false recovery 2009 – 2010 temporarily fuelled by growth in the Commodities, BRIC economies and emerging markets

4. The sovereign debt crisis triggered the very high public spending required to off-set recession (centred on the EuroZone) that rumbled on over 2011 -12

5. (Secular) Stagnation – weak growth in demand and GDP and deflationary pressure on prices in 2012-14?

As I have discussed in a recent blog there have been a number of strategies that have been deployed since 2008 with varying degrees of success.  These strategies (Abenomics, austerity, QE, etc.) have been blurred and muddled by the realpolitik of the day and no country has been able to pursue a fundamentalist approach, not even the UK under Osborne's guidance.  The main policy argument has been around the need for and the pace of debt reduction.  In a nutshell, can advance economies grow whilst carrying substantial levels of public (or private) debt?  There are good reasons for thinking that high levels of debt will be a drag on growth and these are pretty obvious:

First, debt creates interest payments. And higher debt interest means governments spend proportionately less on productive expenditure. Also if a significant share of debt is held overseas,  fewer resources are available for investment and domestic consumption. Depressingly the higher tax rates needed to service these debts further depress economic activity and growth.

Second, as debt rises, so do sovereign default risks. When rates of taxation or the economic effects of austerity go beyond sustainable levels countries will be forced to default.  This default might be actual or virtual (driven by hyper-inflation).  As the risk of such a default increases credits ratings will soar and higher borrowing costs will result.  This will lead to lower rates of investment and therefore lower growth in the long run.

Third, as debt rises, governments are unable to fund demand side policies (public spending on capital projects). The squeeze austerity puts on public resources results in lower growth.

A number of economist have stepped forward to confirm the link between high levels of public debt and below trend growth, most famously Reinhart and Rogoff  ( some claim that Osborne is a blind disciple of R&R) published their research in 2010. Their paper claimed that a 10 percentage point increase in the debt-to-GDP ratio is associated with a 13–17 basis point decline in trend per capita GDP growth for debt levels above about 80%.  This research has been refuted and now ridiculed (poor data in the key spreadsheet) by many left leaning economists, ably led by Paul Krugman.  Given the current state of public finances in many developed countries, it’s pretty important to understand who is right on this!

Bank of International Settlements - data public debts

 The table above shows us that all the major economies of the world with the exception of Japan and Sweden have taken significant strides in reducing their public finances between 2009 and 2013 but that the overall rate of indebtedness is still very high and with only Sweden under the magic 80% threshold.

In a sense there is some safety in numbers, as 14 of the 15 developed economies have public debts in excess of 80% of GDP so we are all somewhat insulated from the treat of downgrades and resulting increases in interest rates; this is further complicated by the fact that 10 of these economies share the same currency.  The problems of very high debts will only come home to roost when there is a stark 'Delta' in performance, most of these economies are currently in a ‘distressed but not too distressed economic block’.  But take a scenario where the US, Germany and the UK all start growing at near to trend this will obviously reduce the ratio of debts to GDP and increase tax revenues will also accentuate the positive impact.  Capital will then gravitated to these safe havens and the ‘block’ mentality will evaporate.  Once we have a small number of sovereigns back in safe territory the spotlight will increasingly fall on the laggards and this is the point of maximum danger.
So high levels of debt aren’t too important if you are a country at the vanguard of recovery but if you are at the back of the queue and as global interest rates rise the position could become very difficult.  The UK was a prime candidate for this uncomfortable spot but the surprising up-tick in growth and taxes in 2013 have probably saved our bacon, so who is in prime position now?  Well it’s a straight fight between Japan, France, Italy or Spain.  There are some grounds for optimism for both Japan and Spain but almost none for France and Italy and this could be the moment of maximum danger for the EuroZone!

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