In memory of Dr. Andreas Höfert

The couch potato option to public debt

| Posted by: Andreas Höfert | Tags: Follow UBS, Andreas Höfert

Industrialized countries’ public debt-to-GDP ratios have increased since the financial crisis to levels last seen right after World War II. In the years to come, addressing this issue will be an important task for governments. How they do it will be paramount for investors assessing the financial environment.

Greek’s roughly 180% public debt-to-GDP ratio is the tree hiding a forest. Western public debt exploded after the Great Recession, and G7 debt-to-GDP ratio is estimated on a GDP-weighted average at over 120%, while that of the OECD stands above 110%.

Few economists are arguing that high debt-to-GDP ratios might be positive or even neutral for growth. The higher the debt is, the larger the debt burden bulges, meaning that taxes (or the likelihood of higher ones) to serve the debt must also swell, weighing on investment activity and growth potential. Moreover, heftier public debt shrinks governments' room to manoeuver in the area of public infrastructure.

We've argued before that save defaulting, governments have only three ways to reduce their debts. First, governments can adopt austerity measures (taxing more and spending less). Eurozone policies in recent years showed how this can harm growth in the short to medium run, and risk swirling economies in a vicious circle. This occurs if reducing the numerator in debt-to-GDP via austerity then causes the denominator (GDP) to shrink so far that the debt-to-GDP ratio actually rises.

Second, governments can boost inflation, expanding the denominator (nominal GDP) and thereby reducing debt-to-GDP ratios. However, central banks, which through their monetary policies can achieve this, are usually “independent.” And although they have worked hand in hand with governments since the financial crisis and currently have explicit (Japan) or more implicit (US, Eurozone) mandates to “boost” inflation, success has been meager of late.

Finally, governments can implement financial repression measures. The most widespread means are to keep interest rates on cash and on the servicing of the public debt below inflation, implicitly taxing the governments’ creditors.

The “waiting-for-growth-to-come-back” strategy is the one, politicians usually favor. Sit out the high public debt-to-GDP until growth comes back and takes care of it. Lately this argument has been backed by a rather intriguing study from economists at the International Monetary Fund (see: Ostry, et al. (2015): “When should public debt be reduced?”, IMF Staff Discussion Note, June), “if fiscal space remains ample, policies to deliberately pay down debt are normatively undesirable. The reason is that for such countries, the distortive cost of policies to deliberately pay down the debt is likely to exceed the crisis-insurance benefit from lower debt. In such cases, debt-to-GDP ratios should be reduced organically through growth, or opportunistically when less distortionary sources of revenue are available.”

I find this argument very dangerous for at least two reasons. First, it gives ammunition to politicians who follow Ronald Reagan's famous quid, “I am not worried about the deficit. It is big enough to take care of itself.” This sort of airiness led industrialized economies to profligate public debt-to-GDP ratios even before the financial crisis hit. Second, it doesn’t take into account the future burden of aging and demographics, which might rapidly shrink the “ample” fiscal space. In my view, austerity in times of sub-trend growth is nonsense, but so is insouciance about the public debt, when growth comes back.