Why Europe Is Drowning Beneath a Tidal Wave of Debt

lt;pgt;If you want to know what it looks like when a country drowns in its own debts, there are few better examples in history than the hair-raising spectacle unfolding in the south-eastern corner of the eurozone. Greece#039;s figures are extraordinary. By the end of last year, the country#039;s public debt in nominal terms stood at 177% of its annual economic output and it was relying on the life support of regular cash infusions from the European Union, European Central Bank and the International Monetary Fund.lt;/pgt; lt;pgt;Although critics of Athens argue that the true value of its debts is much lower because the country has been given decades extra to pay and the interest rate on its borrowings has been cut, there are nonetheless few countries in the world that have managed to run up a comparable mountain of borrowing. Unfortunately, several of those that do exist happen to be in Europe: Italy had government debts of 132% of gross domestic product by the end of last year; Portugal was on 130%; Ireland 110%, and Spain 98%. Of the leading nations, only Japan surpassed them all with a whopping 230%.lt;/pgt; lt;pgt;In Greece#039;s case, however, you have to scratch the surface of this astronomical 177% to see what has actually happened. Data from the European Commission and the bloc#039;s statistical service, Eurostat, show that Greece owes around €320bn. But although this figure has gone up a lot since the financial crisis (in spite of the first debt write-off in 2012), Greek public debt is no longer exploding. In fact, it#039;s been relatively stable for the past couple of years. Instead, the economy that has to carry its weight is imploding – it#039;s the relentless draining away of Greek economic activity that has pushed the debt burden close to 180%, not the accumulation of yet more borrowing. In 2011, Greece#039;s public debt was €356bn and its debt to GDP ratio was 171%. Three years later, the debt pile had been reduced to €317bn, but the ratio had climbed to 177%.lt;/pgt; lt;pgt;Arguably, then, Greece is not drowning in debt. It has already drowned. It may seem fanciful to suggest that other countries could be in danger of a similar fate, but equally, it is probably dangerous to assume that Greece is unique: a spectacle we can observe from a safe distance with a mixture of voyeurism and horror.lt;/pgt; lt;pgt;A borrowing binge Writing in the Daily Telegraph recently, Jeremy Warner recalled returning to Greece just before the financial crisis and being amazed at the number of people driving new German cars in a country that had been obviously poor when he was last there in the 1970s. quot;How was it possible to cram so much development into such a short space of time?quot; Warner asked. We now know it wasn#039;t possible, but the path that Greece followed in the decade or more leading up to the financial crisis, although extreme, was by no means unique – many countries in the developed world saw big build-ups of debt, whether by households, companies, financial institutions or governments.lt;/pgt; lt;pgt;Consumers in the US, UK, Ireland and Spain in particular went on a borrowing binge as their property markets boomed, while the construction sectors in all these countries also loaded up with borrowed money to fund ever more speculative development projects. It also became clear during the crisis that banks all over the world were employing far more debt in their activities than regulators now believe is safe. Many of those debt-fuelled booms have now subsided and in some cases, such as US and UK households, the debt burdens have actually gone down a bit as people have repaid or defaulted on part of their borrowing – also known as deleveraging.lt;/pgt; lt;divgt;lt;!--0--gt;lt;/divgt; lt;pgt;But that is not to imply that the world#039;s debts peaked with the financial crisis and are now subsiding. Quite the opposite. In a study published this year entitled Debt and (not much) Deleveraging, the McKinsey Global Institute (MGI) pointed out that the world#039;s debts had carried on growing very rapidly even after the financial crisis. At the end of 2000 as the credit boom gathered pace, the global debt pile stood at $87trn, MGI reported. By the end of 2007 the binge was reaching its peak and global debt had jumped to $142trn – an increase of 63% in just seven years. Then the financial crisis struck, but the rise carried on regardless. Another seven years on at the end of 2014, global debt had grown by a further by $57trn (or 40%) to reach $199trn.lt;/pgt; lt;pgt;If this sounds worrying, the MGI paper highlighted another reason for concern: the world#039;s debts continue to expand more rapidly than its economic output. In 2000, world debt was 246% of GDP; in 2007, 269%; and by 2014, the ratio had grown another 17 percentage points to reach 286% of GDP. The world is a long way from turning into a larger version of Greece, admittedly, but the direction of travel is clear. Our debts are growing faster than the ability of our economies (at a given level of interest rates) to service and repay them.lt;/pgt; lt;pgt;lt;stronggt;The critical distinctionlt;/stronggt;lt;/pgt; lt;pgt;quot;We should be very worried about it,quot; says George Magnus, a leading economic commentator. quot;It#039;s not unprecedented: if you go back hundreds of years there have been previous occasions when national debt levels have risen even higher than they are in Britain, the US or elsewhere today, but never in peacetime.quot; This distinction is critical, he argues, because in previous high-debt episodes, such as in the West during the aftermath of the Second World War, the resumption of normal civilian activity resulted in a pick-up in economic growth and, eventually, enabled the debt piles to come down again.lt;/pgt; lt;pgt;Arguably, we should not be surprised that the debt figure has continued to climb since the financial crisis and recession that followed. During the boom years leading up to 2007, the private sector – households and businesses – borrowed very heavily to expand, acquire assets, particularly property, and to consume. As boom turned to recession, they slowed their rate of borrowing and in some cases, particularly US households, even reduced it by a combination of default, bankruptcy and repayment.lt;/pgt; lt;pgt;This is part of a well-understood pattern that follows a debt-fuelled financial crisis, says Richard Dobbs of the MGI. quot;Typically debt goes up after the crisis hits and [government] debt rises even if the consumer deleverages. What happens is that as the economy slows down welfare payments go up, tax revenues go down and the government delivers fiscal stimulus to the economy so the debt level for the government sector grows.quot;lt;/pgt; lt;pgt;for the government sector grows.quot; In previous episodes, he says, consumers and businesses have pulled in their horns and government borrowing has carried on rising for a few years to help cushion the impact of the slowdown until an eventual rebound in economic activity allows welfare payments to fall, tax revenues to increase and the debt pile to stabilise and start declining.lt;/pgt; lt;divgt;lt;!--1--gt;lt;/divgt; lt;pgt;The big question is whether we can expect this pattern to repeat itself and to what extent debt burdens will eventually be reduced. The answer to this question naturally depends on a wide variety of factors. First, as Dobbs points out, different considerations apply in different parts of the world economy. A large proportion of the increase in debt that has occurred since the crisis has happened in emerging markets and is a normal part of the quot;financial deepeningquot; that we should expect to see as their economies develop and demand for credit and the ability to service it both increase. quot;Irrespective of this crisis, emerging markets are on a path to more debt and that#039;s perfectly normal,quot; he argues. However, others are alarmed both at the rate at which debt has risen in some emerging countries since the crisis, especially China, and at the extent to which emerging market borrowers are taking on debt denominated in dollars rather than their own currency, which will make these debts harder to service should the dollar exchange rate move against them.lt;/pgt; lt;pgt;lt;stronggt;A vicious circlelt;/stronggt;lt;/pgt; lt;pgt;Aside from the tendency of emerging economies to increase their appetite for borrowing as their economies develop, there is a range of forces at work that suggest the level of private and government borrowing in the developed world is unlikely to stop growing in the foreseeable future.lt;/pgt; lt;pgt;Charles Dumas, chairman of the macro-economic forecaster Lombard Street Research, points out that the world#039;s growing stock of debt must be viewed as the flipside of another phenomenon, the world#039;s quot;excess savingsquot;. On this analysis, a huge and continuing abundance of savings, especially among countries in Northern Europe and East Asia, has produced unparalleled quantities of money available to lend. This pushes down the cost of borrowing and encourages borrowers, both the private sector and governments, to take on more debt.lt;/pgt; lt;pgt;This trend of falling interest rates has been running for more than 30 years, and, having reached a crisis point in 2008, it received further impetus from the actions of major central banks, which cut their reference rates close to zero and instituted quantitative easing. quot;We#039;re living in a world with too much saving, which means too little consumer spending and too much debt,quot; says Dumas. quot;That tends to induce people to go for austerity, which reduces consumer spending and perpetuates the problem of too much saving. You#039;ve got a vicious circle here that I don#039;t think people have solved.quot;lt;/pgt; lt;pgt;Similarly, it appears that the measures taken to help cushion the impact of the financial crisis are also contributing to the problem. It is widely accepted nowadays that but for moves to cut interest rates to zero and make vast and growing piles of debt more sustainable, the world economy would have gone through a far deeper and more damaging recession than the one it suffered after 2007. But ultra-low interest rates also have unintended consequences, argues Magnus: quot;They don#039;t discourage the continued accumulation of debt.quot;lt;/pgt; lt;pgt;These steadily rising government debt burdens, however, face a series of long-term challenges that will ultimately call their sustainability into question. First, levels of debt that are manageable when interest rates are extremely low can become much less affordable should rates start to rise. Second, says Dobbs, many of the countries with high debt burdens are undergoing a transition to a period when their economic growth will be slower than in the past and therefore their ability to service rapidly growing levels of debt is likely to come under pressure.lt;/pgt; lt;pgt;quot;If productivity growth stays the same as it is now, the global economy is going to fall from growing at around 3.6%, which is the average of the past 50 years, to around 2% over the next 50,quot; he says. The rates of slowing will differ from one country to another, but the effects of this are likely to be very marked in some cases – there are projected to be 15 million fewer working people in Germany by 2050 than there are today and as a result McKinsey predicts that the country#039;s average growth rate will halve over the next 50 years.lt;/pgt; lt;pgt;A number of economies will therefore find themselves squeezed between static or declining populations of working-age taxpayers and the need to meet rising welfare obligations that date from an era that has gone – when growth rates were higher, working populations were larger and more generous welfare payments were affordable.lt;/pgt; lt;divgt;lt;!--2--gt;lt;/divgt; lt;pgt;Tackling this will demand a whole range of reforms, particularly the austerity involved in cutting welfare entitlements, but even so it is also likely to require a continued build-up of debt. For example, the Israeli finance ministry recently forecast that on that country#039;s current trends, government debt would rise from 67% of GDP now to 170% over the next half-century.lt;/pgt; lt;pgt;The challenge, therefore, is to ensure that the kind of ratio of debt to economic output that appears completely unrealistic for Greece today can become credible for other countries several decades from now.lt;/pgt; lt;pgt;lt;stronggt;Global pass the parcellt;/stronggt;lt;/pgt; lt;pgt;For the moment, it seems that the routes to escape a debt crisis that have usually worked in the past are not going to be available this time. In particular, countries that experienced debt crises in the 1990s such as Scandinavia and some East Asian economies were able to devalue their currencies very rapidly and export their way back to growth and debt sustainability thanks to buoyant demand in other regions.lt;/pgt; lt;pgt;But this is a much harder trick to pull off in the aftermath of a global financial crisis, when everyone is simultaneously trying to export their way out of the same hole, and it largely explains why major economies have all at different times attempted to devalue – a process resembling a global game of pass the parcel that Brazil#039;s then-finance minister, Guido Mantega, dubbed a quot;currency warquot; five years ago. quot;Japan has become a serious rogue factor in the world economy,quot; observes Dumas, quot;because their devaluations are part of what undermined the eurozone.quot;lt;/pgt; lt;pgt;One of the lessons of Greece#039;s economic debacle is undoubtedly that its membership of the eurozone has prevented it from taking a swifter route to recovery that would have involved a deep devaluation of its currency to make itself more competitive in world markets and enable export-led growth. Another, however, is that countries with very high levels of debt are particularly vulnerable to economic shocks, such as the one that hit Greece and the rest of the world in 2008. For other countries that are peering into a future in which their debt levels continue to rise, this has to be the biggest worry. Were something major to go wrong – such as a crisis in China, for example, where debt levels are rising at nearly 20 percentage points a year, more than twice as fast as its economy is growing – their ability to withstand the shockwaves might well be limited.lt;/pgt; lt;pgt;It is clear then that the quantity of debt in the world is far more likely to increase than to shrink in the decades ahead, and that therefore highly indebted countries are going to have to learn to live with much higher debt burdens than they have today. Ensuring interest rates do not rise too far or too fast will be critical and austerity in one form or another will continue to feature. There may be some respite if we can achieve a return to modest inflation that would help to erode the value of our outstanding debts and make them more manageable, points out George Magnus. But most agree that we will also have to find ways to avoid paying back all that we have borrowed.lt;/pgt; lt;pgt;lt;stronggt;Economic sleight of handlt;/stronggt;lt;/pgt; lt;pgt;Dobbs argues that quot;debt monetisationquot; is emerging as part of the answer to this problem. Already, the US, UK and Japanese central banks hold large chunks of their respective governments#039; debts and are returning the interest payments on these portions to their national treasuries – in effect, therefore, these governments are not servicing significant percentages of their outstanding borrowing. If these piles of debt on which the governments are paying no interest are excluded from the calculation, MGI says that the US#039;s debt to GDP ratio drops from 89% to 76%, the UK#039;s from 92% to 71% and Japan#039;s from 234% to 190%. Performing the economic sleight of hand involved in successful debt monetisation requires both luck and good judgment – if it goes wrong, the consequences could be dire, says Dobbs, invoking memories of the hyperinflation that ravaged Germany#039;s Weimar Republic. quot;That#039;s why I don#039;t think you#039;ll ever hear any policymakers talk about [monetisation] as a possibility. It happens, but I think that quite rightly there#039;s a fear that if you talk about it publicly too much you could be accused of doing something wrong and you could have a collapse.quot;lt;/pgt; lt;pgt;Given the trends that are under way, however, there may be little alternative but to make debt monetisation – and the test that it poses to the credibility of our monetary system – part of our long-term response. quot;We live in a world where debt ratios need to come down,quot; says Charles Dumas, quot;and there#039;s nothing on the horizon which is going to make them come down in a secular way. A small cyclical improvement is all that we can hope for.quot; With a few exceptions, such as Greece, we are not yet drowning in debt. But the levels will go on rising and we have no choice but to learn how to swim in it.lt;/pgt;