The Decisive | Season 5 Ep.1 - Fiscal Fragilities in the Global Economy

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Kristen Hallam

Welcome to this episode of the Decisive podcast. I'm your host, Kristen Hallam. And today, we're talking about a topic that's very important but not very popular, public debt. Public sector debt to GDP ratios have generally risen markedly since the mid-2000s, reflecting a series of adverse shocks and persistent large budget deficits. The problems associated with high debt include vulnerability to sudden shifts in financial conditions, constraints on fiscal stimulus and the crowding out of private sector economic activity. Joining me to discuss this important but underappreciated topic is Ken Wattret, Vice President of Global Economics at S&P Global Market Intelligence. It's great to have you back on the Decisive, Ken. Thanks for joining us.

Ken Wattret

It's great to be here. Thank you for inviting me.

Kristen Hallam

Your recent report on fiscal fragilities highlights significant increases in public debt-to-GDP ratios. What are the main drivers behind this trend?

Ken Wattret

We'd identified 2 key factors. The first is the provision of huge government support to mitigate the negative effects of various adverse shocks over the past couple of decades, specifically the financial crisis of 2008, '09 and then 2011, '12 and the COVID-19 pandemic from 2020. The second factor is the persistence of unusually large government budget deficits in many economies in the years since the pandemic. Budget deficits soared as economies were shut down. I mean

that's inevitable if economic activity grounds to a halt, fiscal revenues decline, but deficits have generally remained very high despite economic conditions returning to normal, and that's a real source of concern.

Kristen Hallam

How do these drivers vary across different economies?

Ken Wattret

Well, on the first issue, the adverse shocks most economies around the world were impacted by the financial crisis and the pandemic. But in some instances, the policy responses were quite different. For example, some economies with relatively large banking sectors provided very large levels of financial assistance at the height of the financial turbulence to try to prevent the collapse of key institutions. During the pandemic, some countries opted to keep their economies relatively open, reducing the amount of financial support that was required to keep businesses afloat. Regarding the second issue, the running of persistent large government budget deficits, that depends in part on the economic and political circumstances in each country. The countries in Europe, for example, which were most negatively impacted by the spillover effects of Russia's invasion of Ukraine, they've struggled to generate the growth required to boost their tax revenues. In other countries, growth rates have actually been relatively strong, but the political appetite is just not there to take the difficult decisions required to bring budget deficits down, in other words, to reduce public spending or to raise taxes. And on that latter issue, the U.S. is a really good example. We have the U.S. unemployment rate currently very close to its historic lows, around 4%, yet the federal budget deficit still exceeds 6% of GDP. That's a really unusual situation.

Kristen Hallam

What are the primary challenges that governments face in achieving fiscal consolidation amid high debt levels? And how do political factors play into this, Ken? You've just hinted at it. Please tell us more.

Ken Wattret

To put it simply, spending cuts and tax increases are not popular and electoral cycles are relatively short. So there's very little short-term political incentive to do either. And that's where financial market pressure comes in. That matters because if governments find it increasingly expensive to issue debt as their debt burdens increase, the yields on sovereign bonds rise, then they feel a cost of the high debt burden in the form of higher interest payments, which impacts their ability to spend money in other areas. In an extreme case, a government may struggle to fund itself at manageable interest rates and therefore, could be forced to tackle its elevated budget deficit and its high debt burden. It would either seek financial assistance, for example, to go to the IMF and agree to a program, receive financial assistance in exchange for a commitment to measures designed to improve the public finances or it will need to get its fiscal act in order unilaterally passing legislation to raise tax revenues or cut spending. It's likely to take considerable market pressure to force a government down either route. For many advanced economies, that pressure was almost completely eliminated following the financial crisis by the huge asset purchase programs introduced by central banks at the time, deflationary risks. Some of those asset purchase programs were reintroduced during the pandemic, including in the U.S. and the euro area. That allowed their governments to provide huge financial support again to their economies, but at relatively low interest rates. Now they're left with larger debt burdens as a consequence, with those purchase programs unwinding and inflation having returned, interest rates are now much higher. So the challenge for governments is much bigger in terms of sustaining those debt burdens.

Kristen Hallam

A lot of memory is coming back here from the era of the financial crisis and the pandemic. This is an interesting walk-down memory lane that we're taking, Ken. But coming back to the present, given the current economic indicators and challenges, what are your forecasts for debt trajectories in major economies over the next few years?

Ken Wattret

It won't surprise you to know that they vary depending on national economic circumstances. The common theme of our forecast for most of the world's largest economies is that public sector debt to GDP ratios are going to continue to rise from already elevated levels. Budget deficits are forecast to persist because there's no real political incentive as yet to bring them down markedly. And there is a bit of market pressure here and there, but it's not sufficient to lead to significant corrective action in the immediate future. That could change. We've seen U.S. treasury yields rising, particularly at longer maturities due to concern over the longer-term trajectory of U.S. public sector debt and in part due to some of the implications of the current administration's new tax bill. But the rise in yields just doesn't look big enough or painful enough to prompt a different approach to the large budget deficit. Now it's important to stress that this isn't just an issue for the U.S. Public sector debt-to-GDP ratios are much higher in Japan and parts of Europe, but those countries tend to be less dependent on foreign ownership of debt than the U.S., and that's a potential source of vulnerability. The main problem all of the highly indebted economies face in lowering their debt-to-GDP ratios is the increasingly unfavorable combination of levels of nominal growth and interest rates. Essentially, it's about doing the math. If growth in an economy exceeds the interest rate on the outstanding debt, then the debt ratio will fall as long as the primary budget deficit, that is the deficit, excluding interest rates, does not exceed the difference between growth and interest rates. And we've seen historically, if we go back a few decades, countries achieve major reductions in their debt ratios in the past through that route with very strong nominal growth and interest rates being held down. The U.K. is an example of

that, following the second World War, different to the circumstances now. The issue is that nominal growth rates in most advanced economies are already much lower than in the past and are likely to be lower in the future, demographics and in part also because inflation should be held down by central bank inflation targets. And the other thing to bear in mind is as nominal growth prospects are becoming more challenging. Interest rates have been on an upward trend since the pandemic. Pre-pandemic, we had extremely low levels of bond yields in most advanced economies, in some cases, negative. But we've seen over recent years, clear upward trend, which we think is likely to persist. And that reflects various factors, disinflationary forces, higher equilibrium levels of central bank policy, the unwinding of asset purchase programs and also higher term premia. So that combination of nominal growth and nominal interest rates looks like being a very big challenge for governments going forward.

Kristen Hallam

Now I don't mean to sound flip, Ken, but why should businesses and consumers care about these fiscal fragilities, especially if there's not going to be any action taken on fiscal consolidation in the near term as far as we can tell.

Ken Wattret

Well, I think the reason is that they have the potential to materially alter future growth prospects. And in the worst case, could cause another global crisis and severe recessions. If we assume that we avoid a full-blown crisis, it's likely that persistent large deficits and high debt burdens will keep sovereign yields elevated. And those levels of sovereign yields have an impact on interest rates across the wider economy with bond yields remain quite high, then borrowing costs for businesses and households are also likely to be impacted. If market pressure builds and governments find it increasingly difficult to finance these deficits, then governments are going to have to bring those deficits down either via lower public spending or increases in taxes or both, and that will have an adverse impact on demand prospects, slowing economies down. And I think the thing to bear in mind is that would probably be in the form of a pro-cyclical fiscal

tightening. Fiscal consolidation would be taking place when economic conditions are probably already weakening because of that sense of alarm in financial markets and rising yields. So the adjustments in budget deficits would come at a time when economic conditions are already deteriorating. Now as I mentioned, the worst-case scenario would be a full-blown crisis, and that's not our base case, but we need to think about these kind of risks. So if interest rates were to spike higher and governments were forced to slash the budget deficits, then we'd see unemployment rising, businesses failing, asset prices plunging and some financial institutions probably getting in trouble. But it's not inevitable that a crisis like that will occur. There is scope to do something about it beforehand. But the longer the current situation of high budget deficits and high debt burdens continues, the greater that risk of a crisis becomes.

Kristen Hallam

So, Ken, you mentioned the crowding out effect of high debt on private sector activity. Could you elaborate on how elevated borrowing costs impact investment and economic growth?

Ken Wattret

That's a really important point because you don't have to have a crisis to have a negative impact on economic activity. So the simplest way to think about crowding out is that the risk associated with the high level of government borrowing results in investors requiring a higher interest rate on the bonds that the government issues to finance its budget deficit. And that rise in what we call the risk-free rate acts as the benchmark for market interest rates and the cost of private sector borrowing rises accordingly. Other things equal, if interest rates are going up, that will reduce private sector activity. One simple example to illustrate that point is that if it becomes excessively expensive for a business to borrow funds to finance an investment, investment won't happen.

Kristen Hallam

Thank you for listening to The Decisive podcast from S&P Global. Please subscribe and join us for next week's episode -- until then stay curious and stay informed.