The Debt fueled growth of the world
For the past decade, government debt increased manifolds but at the same time, the interest rates were at an all-time low. Due to lower real interest rates, investors were prompted to look for riskier and more rewarding investments.
The US borrowed nearly $3 trillion during the pandemic. Overall, public debt around the world soared to an all-time high to sustain the growth levels of an economy and maintain the living standards in the economy. All this prompts us to question – is it sustainable?
Public debt is not a seldom occurrence. Countries have always sought out public debt to cover their deficits. At the end of the Napoleonic wars, debt of Britain was at 165% of its GDP. During World War 2, it was at, almost, 260% of its GDP. So, if we analyze this behavior, traditionally, countries have borrowed to finance wars.
But in the past 100 years or so, governments borrowed to keep their economy on track. For example, the borrowing of the Japanese government in the 1990s to dilute the effects of the Plaza Accord on their economy.
Before moving further, it is important to understand the mechanisms of sovereign debt. Countries borrow to expand their fiscal policy by increasing government expenditure levels. For this purpose, they issue bonds. Now a country can issue different kinds of bonds, such as a bond in their currency or a Eurobond (bond in another currency). Countries that have better credit standing and bigger economies, like the US, Japan, India, and China issue bonds in their currency. Whereas countries like South Africa, Ghana, and Egypt prefer to issue Eurobonds.
If a country takes up a lot of sovereign debt by issuing bonds in its currency, then it can always pay it back, as it can always print more money. But in this situation, the supply of their currency increases, which leads to a depreciation in its value. As the money supply increases, two effects follow. Firstly, due to a drop in the value of the currency, the international creditors get less in terms of the international currency, and secondly, the increase in money supply leads to inflation. Not to mention, the impact that it would have on the country’s creditworthiness.
For the past decade, government debt increased manifolds but at the same time, the interest rates were at an all-time low. Due to lower real interest rates, investors were prompted to look for riskier and more rewarding investments. They invested in the bonds issued by the corporates. During the pandemic, this situation was further aggravated. Due to increased government debt levels and even lower interest rates, these companies raised further capital.
When the going gets tough, the highly leveraged situation of these companies leads them to default on their interest and principal payment. A similar situation transpired in the case of Evergrande in China. So, for corporates it is simple. There is a threshold to their borrowing capacity.
But what about countries and governments? Where is the threshold for sovereign debt? Does the threshold even exist?
At this point, it is tough to identify the threshold of public borrowing. The CRCC (China Rail Construction Company) raised around $850 Billion to build China’s high-speed rail network. A debt-fueled growth like this is a time bomb, just like the housing bubble of China (Evergrande) and the US (the GFC). At the same time, if we look at the current GDP to Debt ratio of the developed world, most of them exceed the 100% mark. The US stands at 130%, around $30 Trillion in debt.
To further elaborate, after the 1970s American economic crisis, countries were wary of taking up a huge amount of sovereign debt and slowly the use of public borrowing as a macroeconomic tool slowly faded in relevance. But then the 2008 Financial crisis happened.
To close the recessionary gap created by the 2008 financial crisis, the governments in the west borrowed more, a lot more. The public debt levels were pushed from 75% to 105% in the decade following the financial crisis. In addition to the increased borrowing levels, interest rates were also remarkably low, as had been the trend since the 1980s. But, to the bafflement of many, there were no unprecedented levels of inflation or overheating of the economies. Due to the lack of sufficient increase in investment demand and consumption levels, there has been a general trend to save worldwide. This tendency to save has for so long kept the interest rates low.
But borrowing at this scale is a risky game for everyone. The threat of interest rates rising again is always a very real possibility.
Former IMF Chief Economist, Olivier Blanchard delivered a speech in 2019, that gave rise to new thinking. As per him, governments could borrow far more than previously believed. The gist of his argument was that, in a world of low-interest rates, governments can borrow more than perceived, if the interest rates are lower compared to the growth rate of the nominal GDP of a country. He observed that, with lower interest rates, some governments were able to borrow at a cheaper rate and if the real GDP growth percentage was higher compared to the interest rate, the economy could simply grow its way out of its debt.
The problem with this theory of Olivier Blanchard is that it is extremely narrow in its definition. Countries that do not have a lot of experience in raising international capital or are not very big economies, won’t be able to borrow at the same interest rate as the bigger players. This would end up being a source of significant inequality as some countries can borrow as much as they want to support their economies, but others cannot.
The debt-fueled growth of the world is thus, a grey area. It is not absolutely bad or absolutely good but the overall change in the consensus regarding public borrowing is a cause of concern for many.
Shubhaansh Kumar is a student of BSc (Economics and Analytics) at Lavasa, Pune Campus.
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