More than a decade following the global financial crisis, we find ourselves recovering from a new recession - this time bringing different questions and new implications for the global economy. The world has never suffered such a precipitous drop in economic activity before. Much remains uncertain with regards to how it will play out. While the world appears to be tentatively getting back on its feet, the pace of full recovery has been hotly debated. Uncertainty around the progressive spread of the virus remains high.
The fiscal and monetary stimulus response has been substantial. Rapid action by policymakers seem to have prevented a worst-case scenario. However, these actions are likely to accelerate some of the trends that have been in place for a number of years. These include:
- continued debate around how high public debt levels will be addressed
- inflationary risks, and
- low global interest rates.
The three themes intertwine with each other in various ways. Each is discussed at length in the following article.
Public debt levels have been on the rise for decades in developed nations, in what has been termed “the Great Accumulation.” Governments have continually operated at a deficit, allowing spending to outpace revenue. Obligations around social programs have increased and governments have been reluctant to turn off the taps given the tenuous nature of their elected positions. At the same time, growth has moderated. This partly reflects an aging demographic which favours saving over consumption (see next chart). While increases in the absolute level of debt are less problematic, the debt-to-GDP ratio has been on the rise, meaning growth in the stock of debt has been outpacing growth of the economy. This puts upward pressure on interest charges. It also reduces the amount of capital available for productive pursuits.
Debt-to-GDP ratios increased as populations aged
Source: UN Dataset, IMF, RBC GAM. Based on population data from 1990-2012 and debt ratios from 1990-2018.
The main concern with higher debt loads is they can make economies less stable. Servicing costs funnel revenue away from what may otherwise be necessary and/or productive investments for the economy. These include infrastructure projects and investments in technology.
Higher debt loads can also constrain a country’s ability to react during a crisis. This has not acted as a binding constraint in recent downturns due to enormous monetary stimulus, a structurally declining level of interest rates and greater investor tolerance of high debt levels. However, while debt-to-GDP ratios and servicing costs are manageable today, the risk remains that a country might face rising risk premiums in the future should their ability and/or willingness to pay that debt come into question. This is more of a risk in emerging market nations, where borrowing conditions can be more varied. But, concerns are not irrelevant elsewhere.
A significant amount of research suggests that rising debt levels are detrimental to economic growth. A prominent paper by Reinhart and Rogoff highlights that a debt-to-GDP ratio in excess of 90% is associated with 1 percentage point reduction in economic growth each year.1 While the causal relationship is debated, this amounts to a substantial portion of annual GDP growth. Indeed, the speed limit for economic growth has been lower since public debt levels leapt higher after the global financial crisis.
This theme is not new to investors. High public debt levels were extremely topical in the aftermath of the global financial crisis as nations grappled with austerity measures to bring them down to more manageable levels. Not long ago, Greece experienced quite severe issues managing its inflated debt loads. This ultimately forced the nation to restructure its debts.
The headlines around public debt levels to some extent faded through the last decade as the economic recovery took hold and debt-to-GDP percentages stabilized. However, it has once again become top of mind. The International Monetary Fund (IMF) estimates that advanced economies will see enormous deficits of 11% on average in 2020. That’s not all. The median developed market public debt load could soar to 122% of GDP. Meanwhile, as the next chart shows, emerging market nations will likely see debt levels reach their highest levels in history by the end of this year.
Debt levels are surging around the world
Source: IMF, RBC GAM. Data as of June 2020 and uses IMF estimates for 2020 and 2021.
Whether sustainable, today’s increase in public debt loads seems justified. The economic shutdown created an enormous hole. The efforts of policymakers thus provided much-needed support to households and businesses. While the overall level of fiscal stimulus is an order of magnitude higher than it was during the financial crisis, economic policy has a very different role when a recession is intentionally triggered by the government. The output loss related to these containment measures is substantially higher than that of the global financial crisis. In fact, it approaches the losses seen during the great depression.
In the 1930s, the absence of central bank intervention arguably worsened and prolonged the decline. Stimulus measures this time focused on maintaining economic ties – keeping individuals employed, and businesses solvent throughout the duration of the shutdown. This has arguably helped the economy recover more quickly than it otherwise would have. However, continued measures to stem the spread of the pandemic will likely prolong recovery.
U.S. economic growth during recessions, past and present
Note: As of 7/31/2020. Medium scenario based on RBC GAM projections. Source: Haver Analytics, Macrobond, RBC GAM
The scale and validity of this response are not up for debate. Yet we are left with a number of questions around how these deficits and high underlying debt levels will be addressed. For example:
- Could they lead to further issues from a growth perspective?
- Will they lead to an inflation problem down the road?
For countries that have less sovereignty or lack credibility on the global stage, debt sustainability may become an issue. In some cases, it could force defaults. This is particularly a danger where currencies are not within the control of the borders, or if heavy amounts of the debt load is denominated in currencies other than their own – as in the Eurozone. However, in developed nations it’s unlikely we would see such a drastic outcome, particularly now that the Eurozone seems to be edging toward a form of debt mutualization.
Developed markets have experienced high debt loads before. Most of these episodes were quickly followed by a period of consolidation and reduction. The last time today’s levels were hit was during World War 2 (WWII). Debt-to-GDP levels shrank from 140% to 110% over the period of 1946-1974.2 Three-quarters of that decline came from the differential between growth and interest rates. In other words, a nearly 23% drop in debt-to-GDP came from countries growing their economy in excess of the debt service costs they were paying.
How to address high debt levels
There are a number of ways that governments can address high public debt loads. Some of these are more broadly accepted than others. The standard approaches include some combination of:
- running primary budget surpluses to bring debt loads down naturally
The straightforward way to decrease a debt-to-GDP ratio is to simply grow the economy. With faster real economic growth, total debt levels remain the same, so the debt burden as it relates to the size of the economy becomes smaller. Many would argue this requires a healthy growth rate that is difficult to obtain. But the important equation is that growth exceed interest rates. Any amount of economic growth beyond the prevailing rate of interest would reduce the overall debt-to-GDP ratio.
In this vein, provided no further deficits are required, governments can be patient. They can continue to roll over their debt, and expect that it will shrink relative to the size of the economy over time.
However, we’re in an era of slower prevailing growth. Each additional 1% of economic growth equates to a 1.4% reduction in the debt-to-GDP ratio, meaning it could take decades to bring debt ratios below 90%. Future recessions and crises are also a consideration – on average they typically occur once a decade and could further slow this progression. As a result, we may see countries look towards additional measures to reduce overall debt levels more quickly than through growth alone.
Primary budget surplus:
Governments can also attempt to reduce the overall size of their debt owing by running a primary budget surplus. For this, governments either increase their revenue through tax hikes or decrease spending through cuts. The additional revenue earned outside of non-interest payments is then directed towards paying down debt. This becomes a virtuous circle, reducing both the amount of interest owed as well as the overall debt-to-GDP ratio. Policymakers favour this method of reducing debt loads. It’s likely some will explore this in the aftermath of this recent crisis.
However, many developed nations run structural deficits. There is arguably less appetite for the austerity measures that are historically necessary to bring these structural deficits under control. In addition, factors like volatility around commodity prices can make it difficult for governments to continually run a surplus. This is particularly true whether they rely heavily on revenues tied to exports (like Canada) -- or on imports, where a sudden surge in prices could be devastating.
One way to attempt to run a primary budget surplus is by increasing taxes. For example:
- raising personal and/or corporate taxes to bring in more revenue, or
- instituting a wealth tax that is directly aimed at reducing inequality while paying for government spending. Indeed, this is the method the UK used during World War I to pay for the cost of war.
However, taxation comes with its own issues. On the surface, increasing taxes directly impacts government spending. Yet while government revenues increase, overall growth levels likely decrease. In addition, tax increases are difficult to achieve. Elected officials favour short-term fixes, and to some extent hiking tax rates is political suicide. The pain is often front-loaded, while the benefits are not seen for years. That can be an unhappy dynamic for elected officials whose tenure is often marked in years rather than decades.
Ultimately, tax increases are a question of political will. They could be enacted by almost any country if there were enough pressure to do so.
Higher inflation results in higher nominal GDP while overall debt levels are unchanged. As a result, the debt-to-GDP ratio declines. The temptation to inflate away debt certainly exists. It’s even more topical at this point in time given the extent to which central banks have grown their balance sheets through quantitative easing programs. However, as discussed later in this article, above-target inflation is not a necessary ingredient in the economic recovery and it may be tougher to come by than it appears at first glance.
The concern with using inflation to reduce the overall debt burden is that it’s bad for economic growth. It’s estimated that each 2% increase in the inflation rate equates to a 0.33% hit to the real economic growth rate. This is partly due to the impact it has on expectations, as inflation leads lenders to demand higher interest rates to prevent them from losing purchasing power. Borrowing then becomes just as – if not more – expensive than it was prior to the effect of inflation.
In general, inflation is best at reducing debt levels when it is unanticipated and temporary in nature. A small amount of inflation – perhaps through a target of 2.25% instead of 2% - could be a potential solution to help eat away at debt levels without leading to disruption in financial markets. Indeed, it’s possible that we’ll see modestly higher inflation levels in future.
Other less desirable methods of debt reduction include:
- Default: This would be a decision or inability to pay down debt, whether by restructuring (extending the term) or reducing the amount owed with creditors. Defaults are not out of the ordinary. A recent example is Greece during the European sovereign debt crisis. However, it’s extremely rare outside of emerging market nations because of the negative impact on capital markets and associated risk premia. Restructuring is also difficult in nations where domestic banks are the main lenders and debt is held in the local currency. In essence, insular economies would be damaged by their own actions.
- Privatization of government assets: A nation’s ability to privatize certain assets is often underappreciated. Many countries own numerous assets which could be quite lucrative and effective at reducing debt loads should the need arise. These assets include mineral rights, oil and gas reserves, buildings and strategic gold reserves. For example, a country like the U.S. has student loans that equate to nearly $1T of outstanding value. Not all of this is recoverable, of course. And it’s not a panacea. But it is an asset that could be sold off while also satisfying some of the demand that exists for income-oriented investments.
- Financial repression: In the post-WWII period, countries engaged in financial repression as a way to manage down debt levels. How? Countries artificially depressed interest rates. In some cases banks and other institutions were required to hold minimum levels of government debt as well. This was done through:
- applying domestic financial regulation
- imposing interest rate ceilings
- setting bank reserve requirements
- instituting floors on pension fund assets holding government securities
- regulating caps on bank deposit rates.
In addition, there were capital controls in place. These allowed inflation to run at a higher pace without seeing a flight of capital. Central bank asset levels were also high during this period. Arguably, the facilitation of inflation was in some ways a monetization of fiscal deficits.
Some would also say that today’s low prevailing rates of interest and the degree to which central banks are involved in the inner workings of financial markets are a form of financial repression. Beyond this, it’s unlikely financial repression would occur in a more explicit form, given that:
- Debt is much more widely held than it was in the post-WWII period.
- Further indication of financial repression would potentially lead to a flight of capital.
In addition, negative externalities would likely be persistent. For example, debt would require a higher risk premium if lenders questioned their ability to achieve normalized returns.
The path from here
We know that bringing debt loads back down is critical to promoting future spending on productive means. Yet, with rates as low as they are, some argue this is not the time for debt reduction, particularly combined with slower prevailing levels of growth. Without a signal or push for additional risk premiums from the bond market, policymakers lack the incentive to address today’s higher debt levels. Indeed, given that recessions and crises occur every decade on average, debt loads may be forced higher.
Instead, governments may prioritize stabilizing deficit spending rather than reducing debt levels. Modest economic growth alongside rates that are likely to remain low for an extended period of time should contribute to these efforts. Of course it’s possible that inflation could be allowed to run slightly higher temporarily.
The U.S. is in an advantageous position because the U.S. dollar is used as the world’s reserve currency. This creates an innate underlying demand for paper issued by the country. As a result, the U.S. may be less inclined to address their structural deficit position. However, as the world becomes more multipolar, this position becomes more tenuous. It’s difficult to see the U.S. gathering the political will necessary to take any strong measures against their debt levels at this time.
Europe has long been saddled with various issues related to the underlying countries in the Eurozone. This includes their ability and willingness to run debt levels up outside of those defined under the Maastricht Treaty. Recent moves towards some form of debt mutualization could further unify the countries, binding them not just by joint monetary policy, but by fiscal policy as well.
Meanwhile, emerging market nations face a different challenge. Many of them are tied to commodity prices. A challenging oil market could add an additional layer of pressure. The risk of default is considerably higher across many of these countries. However, it’s unlikely to be a systemic issue given their small size in the global picture.
Longer term, the consequences of a larger debt burden are more serious. Research continually shows that higher debt levels slow economic growth. At the same time, aging demographics may lead to increased government spending on entitlements. This in turn will continue to limit the amount of revenue that can be used to address debt burdens and spur productive growth. Stabilization may be as good as it gets for many countries.
While by no means a pressure point at this time, high levels of public debt and continual growth in entitlements are likely now careening towards each other. They may remain a drag on future growth for a long time to come.
Modern Monetary Theory
There’s a growing school of thought that when governments borrow in their own currencies, they have little reason to be concerned about budgetary constraints. They are limited only by the presence of inflation. Advocates argue that when sovereign nations can borrow in their own currencies, debt has no risk of default. Central banks can always print money to fund these deficits.
Some analysts believe this means that governments can ignore debt levels entirely. Governments can use fiscal spending to encourage growth. At the same time they can use tax increases to help control inflation.
However, opponents argue that it’s fiscally irresponsible to print money to fund government spending programs. The long-term impact remains uncertain. It’s tough to support this theory without further evidence of how economies and markets would respond, and whether inflation could indeed be reined in at appropriate levels.
On the other side of the stimulus equation we have monetary policy. This is the quantitative easing (QE) that many central banks have either instituted or expanded to restore liquidity to financial markets. Simply put, QE is when a central bank prints money or expands its balance sheet to put money into the system by buying financial assets. In the past, the main purchase has been government bonds and mortgage-backed securities. Now QE programs have added investment grade and high yield bonds, plus ETFs that invest in them.
The result: the additional money inserted into the financial system increases the demand for investment securities. This in turn lowers yields and reduces the cost of borrowing, providing liquidity throughout the system.
QE was initially introduced during the financial crisis in 2008. At that time, many feared it would lead to inflation, arguing that an increase in the money supply would increase prices. However, three main forces put downward pressure on potential inflation at that time:
- A drop in the pace at which money circulates in the economy in part prevented inflation from taking root.
- A high amount of uncertainty led to more saving and less spending – an inherently deflationary scenario.
- Damaged by the financial crisis, banks and other lenders were unwilling to take on additional risk by expanding their loan books. So the additional liquidity that came from central bank balance sheet expansion was largely held by banks, rather than being circulated in the economy. This also put downward pressure on potential inflation.
Quantitative easing today
Today it’s a different story. Concerns around inflation have reared their head once again as today’s QE programs are expanded or newly initiated. This time, the risk of inflation is arguably greater as central banks are not in a period of deleveraging. Instead, they’re being encouraged to support businesses by expanding credit lines and facilitating corporate loans. This pumps money back into the system and allows it to circulate more freely, theoretically stoking demand and ultimately inflation if demand is allowed to overheat. Will it happen? Here’s what we know:
- Central banks are explicit about their intentions to keep monetary policy exceptionally loose for several years to combat the current recessionary pressures. After years of sub-target inflation, this policy framework includes an inflationary bias.
- Central banks have rapidly grown the money supply. This heightens the inflation threat if QE programs aren’t unwound once money begins to circulate more quickly.
- It’s possible policymakers may lean towards leaving additional stimulus in the system for too long given their commitment to loose monetary policy. This could lead to an overheated economy with inflationary pressures.
Core inflation has consistently remained under 2%
Source: Bloomberg, RBC GAM. Data as of June 30, 2020.
Perceived government pressure to keep rates low is magnifying this concern, allowing inflation to erode the value of public debt and maintaining the cost of debt service at lower levels. However, as previously discussed, this route often backfires. Inflation must be unanticipated to prevent spikes in borrowing costs. In addition, central banks would be quick to dispel any notion that they are under the influence of government officials lest they lose the credibility and independence they have spent decades establishing.
At the same time, there is a greater risk than before that, given high debt levels, inflation targeting may be politicized. This is particularly likely in jurisdictions where central bank independence has lessened over the years. It would be of particular concern if the economy were to feel the sting of higher inflation and pressure to raise rates.
A number of other arguments that suggest a quickening of inflation include:
Supply chain disruptions and de-globalization:
A “reversal in globalization” has been an established trend for a number of years now. It is spawned by waning trade activity, converging production costs and the rise of populism. This trend could accelerate in the aftermath of this pandemic. Concerns around an over-reliance on China and other nations for personal protective equipment and pharmaceuticals came to the forefront at the height of this crisis, for example. It’s possible we may see nations look to onshore production of an expanded amount of critical goods. This could put upward pressure on the price of goods. Restricted trade could also lead to concerns about shortages, making ripe conditions for price expansion, at least in short bursts.
The higher costs associated with this pandemic:
As businesses begin to reopen their doors, it’s become clear that additional measures are vital to slowing the spread of the COVID-19 virus. This means businesses must now bear the cost of:
- Additional cleaning measures, safety equipment, and reduced capacity
- Safety compensation or “COVID pay” for employees.
Already devastated by forced shutdown measures, some businesses have pushed these costs onto the customer to maintain or lessen the impact on profit margins. These actions are inherently inflationary and may lead to permanent changes in the cost of goods and services. However, there are several important offsets that may limit the rise in inflationary pressures. These include:
A V-shaped recovery is unlikely
It’s steadily being recognized that a return to life as it was prior to the pandemic will likely be a long and drawn out process with some bumps along the way. Physical distancing may remain a necessity until herd immunity is achieved. This will restrict capacity in indoor facilities and prevent a full return to normal with regards to transit, offices, and restaurants. While demand popped in the immediate reopening period, a return to prior levels of GDP may take longer, leaving slack in the economy. This inherently prevents inflationary forces from grabbing hold, and could persist for quite a while should the recovery be prolonged.
Potential trajectories of U.S. economic growth
Note: As of 5/21/2020. Best-, middle- and worst-case scenarios are RBC GAM projections based on different assumptions on duration and depth of COVID-19 impact to economic activities. Source: Macrobond, RBC GAM
Despite all the efforts of policymakers to stimulate the economy, growth has remained stubbornly slow since the global financial crisis. This stagnation tends to lead to lower population growth and less immigration in a negative feedback loop that is self-reinforcing. When combined with a strengthening trend toward automation, it often results in a deflationary environment that lacks a strong wage push.
Developed nations continue to face a change in demographic profile, as their populations steadily age. This has had a substantial impact on financial markets. The change is being driven by declining fertility rates and rising lifespans. It’s most notably evident in the increased demand for yield, as investors demand more safety in their shift towards savings over consumption. This ultimately introduces deflationary characteristics, whereby there is less demand for goods and services.
Aging populations also tend to lead to moderating economic growth. As the working-age population shrinks, output drops. This force is powerful and puts considerable downward pressure on any inflationary forces. However, as populations age further, savings may be replaced by dissavings. This transition would ease the downward pressure on inflation and presents an upside risk over the long-term.
How does this net out?
Arguments can be made on both sides of the inflation ledger. Given high prevailing debt levels and the difficulty central banks have experienced in achieving inflation targets in recent years, policy makers may welcome a limited dose of extra inflation. The use of QE in this cycle likewise brings with it support for higher inflation. This is especially the case as banks are being encouraged to continue their lending practices and ensure that liquidity makes it into circulation. However, central bankers are unlikely to abandon their commitment to maintaining low and steady levels of inflation.
On balance, over the medium and long term, the risks of higher inflation appear to outweigh the risks of lower inflation. While questions remain around whether QE programs will prove inflationary, central bank deleveraging – which offset inflation risks during the financial crisis – is not present this time around. Meanwhile, the demand shock that came with this pandemic will fade, and oil prices will stabilize. These factors suggest that the risk of inflation clearly tilts toward the upside.
A word on monetary financing
Monetary financing is when a country runs a fiscal deficit which is funded by printing more currency rather than issuing interest-bearing debt. Some analysts have likened today’s QE programs to an implicit form of monetary financing. Yet the expectation remains that central banks will one day unwind this expansion of their balance sheet. This fuels investor confidence that QE will not drive permanent increases to money supply. Why is this important?
Many analysts view monetary financing as dangerously inflationary. Central banks have established their credibility as a distinct entity from the government. This is a key element in controlling inflation. If banks were regularly used to fund government deficits, that independence would evaporate. So too could the expectation that inflation levels are zero-bound. For these reasons it’s unlikely that central banks would abandon their decades-long commitments to inflation targeting at this point in time.
As bond yields and interest rates have steadily fallen over the last three decades, there’s been much discussion around how and when they will begin to rise again. However, if we look at the path of interest rates over the last 150 years, it becomes clear that the high yields experienced in the 1970s – 1990s were outliers. Instead, the prevailing rate has often hovered around 2-5%, only a few percentage points higher than today’s rates. This would suggest other factors are at work which may keep rates lower for longer.
U.S. 10-year bond yield
Note: As of July 22, 2020. Source: RBC GAM, RBC CM
A 2015 paper by economists at the Bank of England (“BoE”) suggests that secular factors have caused the fall in interest rates from the 1980s onwards – driven by a drop in the global neutral real rate.3 These secular factors include:
- slowing global growth
- an increased inclination towards savings rather than spending.
As discussed previously, much of this is the result of aging demographics. This trend is likely to continue to put pressure on global rates. Shifting preferences in emerging nations have also been a contributory factor. For example, family structures have evolved where the standard of living has improved, leading to smaller family sizes.
As we look forward, these trends are unlikely to reverse themselves any time soon, at least not in a powerful way. Prevailing rates of interest may rise modestly as economies recover from this current crisis. However, beyond normalization, there are limited ways in which rates could be pressured further.
Aggressive central bank buying could ultimately limit just how high yields will go. Heavy debt loads are also likely to exert more downward pressure, as every interest rate hike translates into higher debt service costs and acts as a self-limiting factor on the economy and rates themselves.
In a 2020 research paper, the Federal Reserve Bank of San Francisco also indicates that there are significant after-effects of pandemics.4 One of these includes pressure on real rates of interest for periods of up to 40 years. The authors suggest this a factor of labour scarcity and an increased preference towards precautionary savings. This has historically resulted in a real rate of interest that is about 150bps lower 20 years after the pandemic versus where it would have been otherwise. In an environment where pre-existing secular factors were already depressing real rates, this would appear to be another factor preventing the exertion of significant upward pressure.
Historical impact of pandemics on the real rate of interest
Source: Jordà, Òscar, Sanjay R. Singh, Alan M. Taylor. 2020. “Longer-Run Economic Consequences of Pandemics,” Federal Reserve Bank of San Francisco Working Paper 2020-09. https://doi.org/10.24148/wp2020-09
This results in some important implications for policymakers. As we saw with this most recent shock, there was little wiggle room for central banks to lower rates. Broad QE measures were quickly instituted, while fiscal measures were necessary to provide stimulus directly to businesses and consumers. Some may argue this shock was substantially unique to warrant such measures. But it does emphasize that without sufficient upward pressure on interest rates, policymakers may be more reliant on QE in the future.
High public debt levels, low prevailing interest rates, and their joint influences on inflation are likely to continue dominating conversation and investment decisions. Debt levels may remain high for a long period of time. Yet, without substantial upward pressure on rates, even low amounts of growth should be sufficient to slowly allow countries to manage in a steady manner. Central banks are unlikely to be aggressive about raising rates. This, combined with the secular forces preventing significant upward pressure, should keep service costs manageable, too.
Meanwhile, the debate around inflation is likely to continue. The unintended consequences of quantitative easing may set inflation in motion -- even in an environment of stagnating growth levels. But it’s hard to imagine a long-term inflationary path taking root without destruction in underlying demand, particularly if central banks maintain their inflation targets. A number of risks to the upside are in play, including the on-shoring of supply chains and the temptation to inflate away debt.
As a result, the outlook for inflation is biased slightly higher, though perhaps at acceptable levels from an inflation-targeting standpoint. This would help countries navigate their debt landmines, while allowing central banks to maintain rates at lower levels for a longer period of time.