Does our national debt matter?

In September 2008, MarketWatch was on a plane to London.  Earlier in April, a US bank called Bear Stearns which had pioneered the selling of securities back by sub-prime house loans, had incurred so many losses on the product, that it failed and was bought by a bigger rival at a knockdown price.

By the time MarketWatch landed in London, Lehman Brothers, another US bank with exposure in the same type of market, had collapsed.  The Global Financial Crisis (‘GFC’), and the worst recession in 80 years, had begun.

Since 2008, it is estimated that, internationally, governments have spent about US$12 trillion on injecting funds into the economy to provide a boost to pull away from the black hole called the GFC.  And where did the money come from?  It was borrowed.  Debt got us into the GFC and creating more debt dug us out.  But economies never fully recovered.

Hard on the heels of the GFC came a global pandemic.  Probably for the first time ever, governments across the world, with a few notable exceptions such as Brazil, made a conscious decision to inflict horrendous damage on their economies to try and mitigate the effect of COVID-19.  Quite naturally, governments came up with various support packages to nurse people and businesses through the crisis.

The increase in government debt internationally as a result of the pandemic response is estimated at about US$17 trillion.  Given the US$12 trillion has not been repaid, countries have an awful lot of debt and much media space has been devoted to the drag this will have on the wealth of future generations.  MarketWatch had to pause here.  He has no idea what US$29 trillion looks like but has no doubt it would fill several large swimming pools.  Just thinking about it made him very thirsty.

Given the size of the numbers how can we measure debt to understand whether or not it represents a threat?  The conventional way of doing this is to compare the size of government debt to the value of a national economy.  Economic value is called Gross Domestic Product (‘GDP’).  GDP is the value of all goods produced and services delivered.  Services are anything from restaurants to education to professional services.  The idea is that the bigger the economy, the better able a country is able to cope with debt.

But there is a catch.  Even big economies can take on too much debt and find that, sometimes, size really doesn’t matter as you fall off a cliff.

So what is a “good” level of debt?  There is no hard and fast rule here.  Generally speaking, for developed countries, a level of 60% of GDP is often noted as a prudential limit.  A study by the World Bank found that where this level rises above 77%, economic growth slows.

On this basis, the Japanese, with a debt ratio of 228%, and the United States at about 104%, should be basket cases.  In Japan’s case, the debt is owed to the Japanese public through public bonds bought by the people.  To that extent, they can live with a higher level of debt, even if the interest payable is significant.  The US, on the other hand, is more upfront.  It simply can print more money to offset any payment issues.  At some point, US debt is going to be a significant economic issue both for the Americans and the rest of the world.  But not yet.

Australia, by contrast, is in a relatively good place.  At the end of 2019, its debt level was about 45% although its probably in the 50%-60% range now after the pandemic funding.

Why all the fuss about debt levels then?  Why can’t we sustain this level?  Will there be a problem repaying the debt?

One approach being used by our Reserve Bank, and under consideration by the US Federal Reserve, is yield curve control.  This is fancy was of saying we’re going to cap interest rates by buying enough bonds to drive down the yield.  Theoretically, lower rates feed through into cheaper mortgages, car loans, a cheaper currency (encouraging exports) and a range of other investments.  It also helps limit the amount of interest paid by government on its debt.

One problem is that those people living on fixed incomes, such as pensioners, are condemned to a long period of low interest rates and thus low, or no, income growth.  The second is the Reserve Bank is making a commitment to low interest rates to encourage spending but at the same time that spending might increase inflation.  This puts pressure on the Bank either to abandon its cap or not holding to its inflation objective.

Much of the increased borrowing has not been directed to investments which would lift productivity and investment.  It has been to sustain businesses and people through a crisis.  Making an economy actually grow requires further investment and borrowing which pushes us further into dangerous territory.  Australia is a small to mid-size economy.  Despite its much-vaunted AAA credit rating it simply does not have the credibility of the really big economies, and is much more hostage to world economic swings because of the lack of economic diversity.  We are already facing a range of risks with our main trading partner, China.  We cannot print money to the same extent as others because we aren’t big enough and we would lose credibility with lenders.

At the same time, investment risk might escalate as the search is on for higher-yielding investments.  There is a direct link between risk and reward; the higher the risk the better the reward.

The game plan appears to be to keep inflation and interest rates at a really low level of, say, 1%-1.5%.  At the same time the idea is the economy will grow at about 3% each year.  On that basis, our debt relative to GDP reduces and we can breathe more easily.  We just need the rest of the world to recover as we can’t do this on our own.

But.  The belief that ever-increasing debt can be made manageable because servicing costs are low, is not sustainable.  There is a tipping point in the future where either interest rates are forced upwards, or economic growth falters, or a number of other variables come into play.

Whatever the reason, yes, the size of debt does matter and do not be taken in by those who say otherwise.

To fortify us as we endure these headwinds, MarketWatch has turned his attention back to the vineyards and winemakers of Western Australia.  He was much taken at the weekend by an offering from Wills Domain, an enterprise located in the Gunyulgup Valley in the northern Margaret River region.  He sampled with quite some enjoyment the 2014 Cabernet Merlot.  Most enjoyable and highly recommended.  Guaranteed to lighten your spirits.

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