The debt mountain

The debt mountain

Western growth rates have slowed appreciably since the turn of the century. Given the scale of the shocks the West has endured, it is perhaps surprising that there has been any growth at all. First came the financial crisis of 2009-10, then the pandemic and then, in 2022, the energy crisis that followed Russia’s invasion of Ukraine.

• The fact that economies avoided Depression-style economic damage is partly due to the response of governments. They successfully shielded households and businesses against the worst effects of these shocks through vast programmes of public assistance. The worst of the fallout was contained, mitigating the loss of GDP, income and jobs.

• In doing, risk has shifted from the private sector, through sharply increased levels of debt, to the public sector. Fighting crises doesn’t come cheap. In the UK public sector debt has risen from 36% of GDP before the financial crisis to around 100% today. Levels of public sector indebtedness have also risen sharply in the US, Japan and France. (Some countries have bucked the trend, with Germany and Canada, for instance, significantly reducing levels of public debt since 2006.) 

• By and large, politicians and voters seem fairly relaxed about government borrowing. In the US, with elections due later this year, neither party emphasises debt reduction. One can see why. Soaring levels of US public debt have had no obvious negative effects for voters. On the contrary, voters have benefited from lower taxes, strong government spending and good growth. Financial markets have not balked at financing unusually large US deficits. So why worry?  

• First, high levels of debt leave governments with less leeway to respond to future crises and shocks. The next time a major crisis hits, markets may be less willing to finance the deficits of more indebted nations. On this view when economies are posting growth, as is the US today, they should pay down debt to provide more of a buffer against future shocks. The heartwarming analogy is of repairing the roof while the sun is shining.

• Second, the cost of servicing debt mounts. For much of the last 15 years concern over high debt levels was tempered by the fact that low interest rates kept repayment levels manageable. This is no longer true with interest rates around the 5.0% mark. In 2023, the UK government spent the equivalent of 3.9% of GDP on servicing the national debt, the highest level since the aftermath of the second world war and three times as much as in 2020. Debt interest is now the fourth largest item of public expenditure in the UK, larger than defence, transport, housing or the police. High interest costs can, perversely, end up driving yet more borrowing. In the US, the independent Congressional Budget Office estimates that over the next 20 years, interest payments will account for two-thirds of the budget deficit.

• Third, high levels of debt may become unsustainable, with governments unable to pay interest on their debt or raise new debt. The result is a debt default, with holders of government debt losing most or all of their money. Such an outcome is highly unlikely for a country, such as the US or the UK, which issues its own currency. They can, should it be needed, print extra money to repay bonds as they come due. This is no free lunch. Although investors get their money back, the resulting inflation from firing up the money-printing presses erodes the purchasing power of their investment. Given the option, people will not lend to a government that is engaged in such deficit financing other than at high interest rates needed to protect them against inflation. At an extreme the economy enters a doom loop. Soaring debt costs spread to the private sector, strangling growth and weakening the public finances still further.

• You only need to look at the euro crisis of 2009-10 or the chaos in the UK gilt market following the Liz Truss budget of 2022 to see how bond markets can sell off, causing interest rates to surge, in response to fears of excessive government borrowing. Those episodes were contained by aggressive central bank action to buy government bonds. It would be unwise to assume that markets can always or endlessly be placated in this way.

• But in that case why have the last 20 years seen rising government debt levels accompanied by ever lower interest rates? That improbable combination was made much easier by low inflation and by central banks buying up vast amounts of government debt through quantitative easing programmes. Neither of those conditions hold now. Inflation is running at higher levels and central banks are selling bonds, not buying them. With public debt at multi-decade highs this is a more difficult environment for government borrowing. 

• Governments have achieved major reductions in debt levels in the past. The US did so in the early 1990s, but that was helped by exceptionally strong growth and the winding down of defence spending after the collapse of the Soviet Union. America’s growth rate is lower today and defence spending is rising, not falling.  

• The US and UK also achieved massive feats of debt reduction after the second world war. In the UK debt peaked at 252% of GDP in 1946. Debt reduction then was achieved through strong economic growth and artificially low (in fact negative) real interest rates. Governments also used ‘financial repression’, forcing banks to hold public debt, implementing capital controls and fixing exchange rates. Some observe that rules requiring financial institutions to hold more government debt, though designed to strengthen the financial system, also help governments in accumulating more public debt.

• Where does this all leave us today? Levels of public debt in many western countries are running at multi-decade highs. Meanwhile, the cost of servicing that debt has risen and the rate of GDP growth has fallen. Ageing populations and the rising cost of welfare and health will exert powerful upward pressure on government spending over coming decades. No one expects a quick return to lower levels of debt. On the contrary, in the US, the Congressional Budget Office estimates the debt will rise from about 100% of GDP today to 166% over the next 30 years.

• The IMF says America’s borrowing is so vast that it endangers global financial stability. It may look unsustainable, but no one knows if, or indeed, when, it will go wrong. What is clear is that things cannot go on as they are.

PS: Last month we wrote about recent setbacks on the path to net zero and highlighted reasons for optimism. Here is another such story. The EU has announced that it reduced carbon emissions by a record 15.5% last year compared with 2022 levels. The decline was “due to a substantial increase in renewable electricity production (primarily wind and solar), at the expense of both coal and gas," the European Commission said. Emissions from industries covered by the EU’s Emission Trading Scheme (around 45% of total EU emissions) are now 47% below 2005 levels, when the scheme was introduced, and are well on track to achieve the 2030 target of a 62% decline. The price of emitting one tonne of carbon has risen from €20 before the pandemic to around €65 today, incentivising firms to move to renewable energy sources. The reduction in emissions has also been helped by firms being forced to cut gas use following Russia’s invasion of Ukraine, and by the availability of cheap solar panels from China.

OUR REVIEW OF LAST WEEK’S NEWS
The UK FTSE 100 equity index ended the week up 0.9% at 8,213.

Economics

• The euro area economy expanded by a stronger-than-expected 0.3% in the first quarter, the fastest expansion in over a year, recovering from a contraction of 0.1% in the fourth quarter of 2023
• Germany’s economy grew by 0.2% following a contraction of 0.5%. France, Spain and Italy also posted higher-than-expected growth
• The US Federal Reserve left interest rates unchanged and chair Jerome Powell said there had been “a lack of further progress” towards its 2% inflation target in recent months
• The US economy added 175,000 jobs in April, the smallest increase in six months and well below analysts’ expectations, signalling a cooling of the labour market
• The OECD said that UK growth will be “sluggish” this year, lagging most of its peers, alongside higher levels of inflation 
• The disruption to shipping in the Red Sea could last until next year, according to the chief executive of shipping giant Maersk, Vincent Clerc
• UK house prices fell 0.4% in April, the second consecutive monthly decline, reflecting the recent rise in mortgage rates, according to Nationwide
• UK mortgage approvals rose to an 18-month high in March
• UK supermarket prices rose by 0.8% in April from a year earlier, the slowest increase since 2021 while the price of non-food items fell 0.6%, according to the British Retail Consortium’s shop price index
• Turkish exports to Russia fell sharply at the start of the year, indicating the increased pressure on governments and firms that are trading with Russia from the US and partners may be starting to have an impact
• The EU would need to impose tariffs of about 50% to discourage Chinese EV exporters, according to Rhodium Group, ahead of the release of the European Commission’s anti-subsidy investigation
• The number of births in Germany fell to the lowest level for a decade last year, highlighting the demographic challenges the country faces from an ageing population

Business

• Universal Music Group agreed a new licensing deal with TikTok, with “improved remuneration for Universal’s songwriters and artists” after the music group told the social media firm to remove its music from the platform at the end of January
• US law firm Mayer Brown is to split its China operations from its global business, as tensions between the world’s two largest economies continue to pose issues for businesses
• UK chancellor Jeremy Hunt warned the Financial Conduct Authority against its plan to “name and shame” companies under investigation, saying it isn’t “consistent with that secondary growth duty they have”
• Exercise bike manufacturer Peloton’s chief executive Barry McCarthy is to step down as the firm embarks on a restructuring plan which will cut its workforce by 15%

Global and political developments

• The Conservative Party suffered significant losses in the UK local elections, losing nearly half of the council seats they were defending. The Labour Party gained the most seats
• Political scientist Sir John Curtice said that the “big message from the local ballot boxes is that the Conservatives remain in deep electoral trouble”
• Humza Yousaf resigned as Scotland’s first minister ahead of a no confidence vote after scrapping a coalition agreement with the Scottish Greens
• Former cabinet secretary John Swinney was named the new SNP leader and is expected to be confirmed as first minister as early as Tuesday
• US police raided camps set up by pro-Palestinian students protesting against the war in Gaza at the University of California, Los Angeles and Columbia University in New York. Pro-Palestinian students have also occupied some university campuses in the UK
• Turkey stopped all trade with Israel as it accused the country of stoking a “humanitarian disaster”
• German foreign minister Annalena Baerbock said there would be consequences after its intelligence services concluded that Russia was behind the 2023 cyber-attack targeting the party of chancellor Olaf Scholz

And finally… a 13-year-old boy found a ‘holy grail’ Lego octopus piece from a shipment lost at sea in 1997. The shipment contained five million pieces, but only 4,200 octopus pieces, making them the most prized objects among collectors. Nearly three decades on, Liutauras Cemolonskas found a rare octopus piece on a beach in Cornwall after two years of searching – ink-redible