Uncomfortable questions about debt sustainability have so far largely been avoided, thanks to vast (and in some still cases, still growing) quantitative easing programmes. But those questions will surely come. Developed countries’ debts have typically gone up by between 10% and 20% of GDP in 2020.
So what are the options? Apart from running a fiscal surplus, there are three main ones: economic growth, restructuring and inflation.
With vaccines on their way, growth will certainly bounce back. But, as Algebris Investments points out, over the last 20 years, developed economies’ excess of real growth to fiscal balances, while volatile, has averaged close to zero.
Meanwhile, restructuring would be catastrophic for Europe’s capital markets — a fact that did not stop Riccardo Fraccaro, Italian prime minister Giuseppe Conte’s closest aide, from floating the idea of the European Central Bank cancelling debt issued during the pandemic.
Algebris highlights an alternative — governments issuing very long-dated or perpetual debt with low coupons, using the proceeds to buy back higher coupon or shorter-dated debt. However, while this approach could reduce the NPV indebtedness and perhaps even lower interest costs, “ultimately it’s a kick-the-can approach which won’t help reduce the debt burden materially,” says the fund manager.
This leaves inflation, in the past the most consistent way of reducing indebtedness. But here Europe has a problem: its ageing population. As Lee Heathman of BlackRock says, “longer term, as fiscal and monetary policy tapers and the economy gets back to pre-Covid levels, we will be looking at a Japanese-style low growth, low inflation reality, due to the overpowering forces of demographics.”
So it looks like the debt’s here to stay. Perhaps it’s time to redefine what is sustainable instead. Japan’s government debt, after all, has been larger than its GDP since 2000 and is heading for 200%. Can Europeans and north Americans learn to be Japanese?
A new social contract
The short answer to making debt sustainable is to borrow less — or even, to repay debt. No one seems keen to talk about that at the moment though. Even the International Monetary Fund has urged governments to borrow more, pointing out that interest rates are low and restarting the economy is paramount.
Not only are economists leaning towards fiscal expansion at the moment — politics require it.
The social contract is back in fashion in a big way. G20 economies have delivered fiscal packages worth over $10tr this year, via huge subsidies for employment, housing and healthcare. As McKinsey points out, in real terms this is about three times the support provided during the 2008 financial crisis and 30 times the size of the Marshall Plan, which helped rebuild Europe after the Second World War.
In 2020 alone, governments in the European Union are expected to spend an additional $2,343 a person compared with 2019. In the US, spending will be $6,572 higher. Never before, in most countries, have governments gone so far to protect citizens from an economic contraction. Support for such measures has spanned the political spectrum from president Donald Trump in the US to left-leaning governments in Italy and Spain.
It would take a brave — even foolhardy — president or prime minister to start hacking back at this new consensus. The terrible social and health costs from Covid-19 have not suddenly stopped at the emergence of a series of effective vaccines. The effects will be felt for years.
The EU’s Next Gen initiative — $750bn, most of which will be spent on “cohesion, resilience and values” — is billed as temporary. But, as economist Milton Friedman was fond of saying, “nothing is so permanent as a temporary government programme”.
The new social contract is here to stay. Public sector bond markets had better be ready.