Fifteen Eighty Four

Global debt, public and private, is at record highs! But there is no agreement on whether we should worry about this much.

My new Cambridge Element, Debt Sustainability—A Global Challenge” argues that we should care. Debt does not only affect poor countries, but also the largest and richest economies. In many of today’s advanced countries, and in some of the biggest emerging ones, public debt has reached historic levels. People and firms are also highly indebted. Meanwhile, population aging will pose a huge additional fiscal burden, and global and geopolitical challenges will further weigh on budgets. Pertinent analysis finds that many advanced countries’ fiscal sustainability is highly threatened. But although ultra-low financing costs are coming to an end, many politicians, analysts and economists see no reason to act and some promote even more spending and debt.

Such an approach is risky even in the best of times and could lead to financial and fiscal crises, just as it did in the global financial crisis. Economic and financial interdependence would stoke international spill-overs and spill-backs. Only this time, the turmoil would likely be even greater as it might prompt fiscal crises in some of the largest economies.

Global debt will, therefore, have to come down, one way or another. Gradually, the rising inflation and interest rate environment should help refocus minds on re-building sustainability.

There are four scenarios by which public debt reduction can happen. The first is via growth‑enhancing policy reforms and better and lower public spending. There is considerable scope for that: Portugal, Spain and Ireland are recent examples where ambitious consolidation and reform have revitalised economies and restored confidence in public finances.

The second scenario is debt restructuring. Many poor and small countries have used it and will continue doing so. But that scenario is neither realistic nor desirable for over-indebted large economies. There would be too much risk of national problems turning into global instability.

The third scenario is one of hope — it is the one we live with in advanced countries currently. Negative real interest rates slowly erode the real value of debt (so-called financial repression). The money-holding lower and middle classes tend to pay as their nominal assets lose value. But it helps keep things stable and buys time for reform, at least for a while.

This is where scenario four could arise. External events (like oil crises or wars), mis-calculations (of growth or fiscal space) and policy errors (no reform or excessive stimulus) could result in a loss of control and confidence. This can happen even in the largest economies, as it did in the 1970s. Memories may fade, but this was a very difficult time, and it will certainly not be better if it happens again. The new Cambridge Element provides the facts, the analysis and the scenarios for how we can deal with the global debt challenge. Fiscal and economic reform is the most sustainable — and most social option — but it is also the most difficult one. For the sake of global stability, it is needed most in the large, advanced countries.