In memory of Dr. Andreas Höfert

Excessive public debt: the emerging market experience

The two last decades of the 20th century were characterized by a succession of emerging market crises. They started in Latin America in the 1980s and culminated with the Asian crisis more than 15 years ago.

In their now classic study, This Time Is Different: Eight Centuries of Financial Folly, US economists Carmen M. Reinhart and Kenneth Rogoff survey over 40 emerging markets that suffered currency, banking and sovereign debt crises between 1980 and 2002, the year of the Argentinean crisis. The causes and origins of the various crises were multiple and complex, but an extremely high public-debt-to-GDP ratio was at least partly responsible for the vast majority of them. According to Reinhart and Rogoff, the debt-to-GDP ratio of the emerging markets culminated at roughly 100% on average in the late 1980s before declining again.

Currently, the six largest developed economies - the US, Japan, Germany, France, the UK and Italy - sport debt-to-GDP ratios that on average surpass those of the emerging markets at their late-1980s peak. The ratios range from Japan’s 230% through the US’s 100% to Germany’s 80%. Hence it is not far fetched to use the emerging market experience as a sort of blueprint for what might happen to the largest developed economies.

The emerging market experience has taught us that there are only five ways a country can reduce its debt-to-GDP ratio: through
1) economic growth;
2) fiscal adjustment/austerity;
3) explicit default;
4) higher-than-normal inflation for an extended time coupled with financial repression; and
5) a burst of out-of-control inflation.

Economic growth is obviously what everyone wishes for. However, given the demographic drag that most developed countries are already enduring, it is illusory to think that growth alone can do the trick.

Austerity plans - the German solution - are the least acceptable to the societies that have to endure them. Nevertheless, looking at the experience of the South East Asia economies during their crisis and where they stand now, one can see the success of well-implemented austerity in the longer run, provided it is coupled with a significant depreciation of the currency. But the long run is usually not what politicians focus on.

Explicit default doesn’t need to occur in any country whose public debt is denominated in its home currency (solutions 4 and 5 are the alternative). However, as last year’s Greek default has shown, it might be the solution for some Eurozone countries.

Inflation and financial repression are in my view the most likely long-run scenario for the US, the UK and Japan. Though the central bankers in each of those countries have sworn the opposite, inflation can be considered the ultimate goal of all quantitative easing and asset purchase programs, which were launched at the outset of the financial crisis. Coupled with capital controls and captive investors in government debt, the pairing of inflation and financial repression is a rather powerful way to tackle the debt problem. The downside to this solution is a risk of drifting into solution 5 and seeing inflation spiral out of control.

All in all, the longer-run future for over-indebted countries is uncertain, if not bleak. Hence our view to not be a captive of the government bonds issued by those nations. The emerging market crises of the late 20th century demonstrated to us that, in at least three out of the five options for emerging from them, investors will lose purchasing power by holding the supposed safest asset.