Tuesday 17 Jul 2018 | 00:30 | SYDNEY
Tuesday 17 Jul 2018 | 00:30 | SYDNEY

Debt: The gathering storm


Mark Thirlwell

3 June 2010 10:13

Hot on the heels of the euro area crisis and amid mounting fears about sovereign risk across the developed world, the latest OECD economic outlook warns:

Many countries are facing very unfavourable government debt dynamics, as rising indebtedness raises risk premia, which adds to the debt burden while holding back growth, with further adverse consequences on debt sustainability.

The OECD's prescription:

Exit from exceptional fiscal support must start now, or by 2011 at the latest, at a pace that is contingent on specific country conditions and the state of public finances.

The same report also suggests that 'monetary policy must be normalised', albeit after taking into account the relevant risks.

Not surprisingly, this advice has proved controversial: as the OECD itself notes, unemployment rates remain high and output gaps are large across most of the developed world. In such an environment, premature policy tightening risks undermining any chance of governments delivering a robust recovery. The reaction of some prominent financial and economic commentators has been scathing.

Yet the OECD has hardly gone out on a limb with its remarks: there is a widespread perception that the rich world's finances are in a dreadful state, and that remedial action is becoming urgent. Otherwise, the pessimists warn, today's Greece could be tomorrow's UK or US. Certainly European governments appear to be taking these warnings seriously, with promises of fiscal consolidation now multiplying.

It's also true that there has been a sharp deterioration in the health of government balance sheets. As the latest IMF Fiscal Monitor points out, the average gross general government debt-to-GDP ratio for advanced economies is projected to rise to 110% by 2015, which means an increase in that ratio from pre-GFC levels of a whopping 37 percentage points. 

As the IMF chart above shows, for the G7, the same ratio is now rising to levels exceeding those prevailing in the aftermath of the Second World War. It also shows that public debt as a share of household financial wealth is on the rise, following decades of relative stability.

Most of this increase in debt – about two-thirds – is the product of the recent collapse in economic activity (and hence government revenues). Fiscal stimulus only accounts for about one-tenth of the rise in debt. 

There is also a further, nasty complication. Age-related spending, especially on health care, is forecast to increase by between 4 and 5 percentage points of GDP over the next two decades, implying additional medium-term pressures on government fiscal accounts.

In its Monitor, the Fund warns that these projected increases in public debt could have several adverse consequences, including a reduced ability to respond to future economic shocks, higher interest rates (the Fund cites new research suggesting that, given the average projected increase in debt ratios in advanced economies, interest rates could increase by almost two percentage points over the medium term, all else equal) and lower potential growth (it also estimates that a 10 percentage point increase in the initial debt-to-GDP ratio is associated with a slowdown of around 0.15 percentage points per year in per capita GDP growth in advanced economies). Both of these last two effects would worsen a country's debt dynamics. 

Finally, the Greek experience shows that very high debt levels can raise questions about a country's willingness to pay, and so precipitate a debt crisis.

All of which suggests sound reasons for policymakers in the developed world to deliver fiscal consolidation over the medium term. But there's a big risk here, which I'll discuss in a follow-up post.