In a year in which governments across the world have either warned or been warned about debt sustainability, their electorates — many now conversant in everything from basis points to bond haircuts after years of credit crisis — have some right to puzzle on what point debts become too much.
Yet “debt sustainability” is a more slippery concept than many first assume. The difference in debt dynamics between creditor strikes across the euro zone, on one hand, and seemingly boundless lending to the United States, Japan and Britain shows that being able to print your own borrowed cash clearly makes a critical difference.
Being able to print one of five currencies in which almost $10 trillion of world central bank reserves are held helps.
Some now are asking whether the debt blowout on the euro zone periphery was just a particular set of circumstances that has distracted politicians elsewhere from a bigger danger of prolonged deleveraging and semi-deflation.
At its simplest, debts are sustainable only when projected primary deficits — a function of future spending plans and growth projections — and real market borrowing rates combine to at least stabilize outstanding debts in the future.
Debt-to-gross domestic product ratios cannot keep rising forever and for governments to cap that over the longer term they need some mix of spending cuts, higher tax revenues, faster growth or, crucially, cheaper borrowing rates.
Just ask Greece — or Ireland or Portugal. The point at which the euro crisis went into overload was when creditors refused to lend at rates that squared that circle. They lacked confidence in government budget and growth assumptions, and the political and central bank structures had no instant mechanism to restore it. The interest rate was the decider.
That seems to be how the United States and Japan are getting away with similarly scary — more scary in Japan’s case — deficit and debt projections than the euro zone casualties.
The U.S. Congressional Budget Office (CBO), for example, estimates U.S. federal debt as a percentage of national output could hit almost 200 percent by 2035 and 300 percent by 2050, leading to net interest payments of a whopping 20 percent plus of GDP.
That’s clearly not sustainable, given the scale of budget cuts and primary budget surpluses that would need to be generated to rein it back in.
“CHORUS OF REPETITION”
But liberal U.S. economist and University of Texas professor James Galbraith argues the key mistake made by the CBO is to assume the U.S. must offer a real interest rate on public debt higher than the projected real growth rate.
This, he wrote in a recent paper, is unnecessary for a country that will never default on debts denominated in the currency it can print — debt ceiling wrangles aside — and where average real returns on public debt were negative in 18 of 36 years from 1945 to 1980.
As runaway inflation is a “fringe fear,” it was possible for the U.S. to run modestly negative real interest rates on public debt while sustaining a large primary budget deficit almost indefinitely as long as Treasuries offer a liquid, safe market for the world’s monetary assets, Galbraith added.
“The concept of “sustainability” is often invoked, rarely defined, never criticized; things are deemed unsustainable by political consensus, backed by a chorus of repetition from the IMF, headline-seeking academics, think-tankers, and, of course, the ratings agencies,” he wrote in an angry response to Standard & Poor’s removal this month of the Treasury’s AAA credit rating.
Far from fleeing U.S. debt, investor behavior since the credit and growth downgrades have neatly introduced Galbraith’s negative real returns.
Ten-year U.S. debt yields fell almost a percentage point to just above 2 percent in a month — more than a point below the 3.3 percent headline inflation. At just 0.2 percent, two year borrowing rates are deeply negative in real terms.
Look at 10-year borrowing rates in Greece of 17 percent or even 5 percent in Italy to put that in context.
With U.S. growth forecasts slashed again, markets are now assuming more bond buying and dollar printing by the Federal Reserve, which already said it won’t raise rates for two years.
Yet 10-year German government borrowing is just as cheap as the United States. British yields too are only 20 bps higher.
And Japan, whose economy has stagnated for over a decade and already has a debt-to-GDP ratio more than twice the U.S. at near 200 percent, just saw its 10-year rate fall below 1 percent even though ratings firms and economists have for years claimed Japan’s debt is explosive and unsustainable.
Many feel the issue is now broader and the major western economies are facing a version of Japan’s lost decade. The long and deflationary deleveraging of the private sector following Japan’s asset bubble burst in the early 1990s forced an offsetting surge in government debt as growth evaporated.
Nomura analyst Bob Janjuah says a similar process is now at play across the Western economies, where trend growth could be as low as 1 percent for at least another couple of years.
In that world, debt sustainability is anyone’s guess.