In developed markets household indebtedness has dropped, just, from its 2009 peak. In certain countries that have seen house prices rally—Australia, Norway, Sweden, Switzerland, Canada, and the Netherlands—household debt has risen to a high level, which is typically a warning sign.27 In the United States, there are several debt stress points: corporate debt (relative assets) is now higher than in 2007, and at the household level overdue US credit card debt is at a seven-year high of $12 trillion. The Congressional Budget Office’s long-term outlook is depressingly bleak.28 It holds that the United States is on course to reach the highest level of debt relative to GDP in the nation’s history by far, whose implications, they very politely state, pose “substantial risks for the nation.” In general, in much of the rest of the developed world, especially Europe, debt levels are equally precarious.
Debt has been allowed to build because central banks have kept interest rates low. The trade-off they have made is for short-term stability in exchange for a rise in risk taking as debt mountains have grown. As we move through 2019, the combination of incrementally less quantitative easing and higher inflation could dramatically ignite this great debt burden. Historically, spikes in indebtedness are associated first with a rise in growth, followed by a sharp fall. In general, high levels of debt (from 80 percent debt to GDP upward) are associated with lower levels of GDP growth. For example, countries with debt to GDP in the 50–70 percent bracket tend to have GDP growth rates of 2 percentage points higher than those with debt to GDP in the 110 percent plus bracket. When interest rates are low, the risks associated with bad loans are less obvious, but as rates rise, default rates can climb quickly.
The tide of higher interest rates in the United States has been slowly creeping in since 2018 when the Federal Reserve made a series of rate hikes. With two-year US Treasury yields having pushed close to 3 percent, the pressure on indebted companies, emerging-market countries, and households will grow. Elsewhere across the world, interest rates are still abnormally low. In Germany, five-year interest rates are just popping above zero for the first time since 2014, despite very low German unemployment, which remains a sign that investors do not yet trust the recovery in the eurozone.
In emerging markets, government debt has risen, though only close to 50 percent of GDP, as compared to 90 percent for many large developed countries. The sharpest rise in government indebtedness has come from companies, predominantly in countries in China’s orbit (Singapore, Hong Kong, Chile, Thailand, and China itself). It is also worth flagging that China’s One Belt, One Road program is creating a trail of debt in the countries through which it passes—Pakistan and Sri Lanka, for example.
China, though its economic management has been miraculous at times, cannot avoid the effects of economic gravity. Its economy is vulnerable to several fault lines: the complex unprofitability and leverage of its state-owned enterprises, extremely high property prices, and the explosive wealth-management products in the financial services sector. The lessons of indebtedness are learned the hard way, but given that slower globalization implies lower growth, it is clear that the large world economies need to reduce debt levels and better manage risk taking.
One discussion to emerge from the eurozone crisis centered on how countries might reduce debt. The main options are growing their economies, allowing inflation to rise, and restructuring the debt (note that as the eurozone crisis deepened, the thinking of bodies like the IMF on debt forgiveness changed and it adopted a more pragmatic, favorable view of debt restructuring, albeit too late for the likes of Greece and Ireland). The solutions that the European Union and IMF had cooked up for the eurozone as a whole—austerity being the lead one—have not worked well in reducing the debt burden. In Europe today, debt levels in key economies—France (99 percent debt to GDP), Spain (99 percent), and Italy (132 percent)—are at multidecade highs and far above what is regarded as sustainable. Ireland has been a relative success, with debt to GDP falling from 119 percent in 2013 to 68 percent by 2018, though the impact of austerity on the country has been severe.
European debt levels are modest only in comparison to Japan’s government debt (229 percent). Japan, however, does have a large pool of household savings, which means that there should always be a buyer for its debt. Japanese households might find this an intimidating assumption. It should be mentioned that these figures do not account for household or corporate debt, which in some countries has reached gargantuan levels—notably China, where debt levels are topping those reached in Japan in 1989 (Japanese land prices today are still worth half what they were in 1991), Thailand in 1996, and Spain in 2009, and we know what happened next in those instances. We should, of course, add into this mix the sharp rise in US corporate debt, much of it taken on for the purposes of financial engineering.
In this context, a recession in the near future may well lead to an international debt crisis and a period of dislocation in debt markets. In response, governments may look to the two avenues of monetary and fiscal policy to steady economies. However, we have already seen that monetary policy, even in its most inventive forms, can be ineffective in the context of high debt, low potential growth, and unfriendly demographics because these dull the spark it provides. The best it can do is dull the pain of recession.
One idea that has been circulated among central bankers, especially those fond of quantitative easing, is that in highly indebted countries like Japan, central banks should simply swallow the government debt that they hold on their balance sheets. In central banker and accounting speak, this “monetization” of debt (the financing of government debt by central banks) sounds very attractive: governments print debt, then politicized or intellectually captured central banks swallow it and at most require governments to issue perpetual bonds to cover the accounting transaction on the central bank balance sheet. It is as elegant as a perpetual motion machine.
In reality this cannot work. Suppose that Japan were to do this. Given its recent financial history, households would smell a rat, become more risk averse, and expect that the value of their pensions could be endangered, and, arguably, deflation would take hold again. Then markets, equally suspicious of this monetary magic, would begin to rethink the creditworthiness of the entire Japanese financial system, the yen would collapse, and the yields on Japanese corporate debt would shoot higher, forcing many companies into bankruptcy. If other monetary jurisdictions followed the Japanese example, there would be massive currency volatility and very soon a loss of faith in central banks, with a resulting rush to gold and other proxy currencies (even bitcoin).
In time, further QE-based experiments may bring central banks to a fork in the monetary road in terms of their efforts to support economies. The presence of record amounts of debt in the world economy greatly complicates this. It may well lead to what we call “QE inequality,” where the prosecution of QE by diverse central banks will have increasingly variable results. There is a risk that for some central banks, the further deployment of QE will lead to a market backlash and become a policy error in that, for example, currency volatility and economic uncertainty easily offset any impact from asset purchases.
Magically monetizing debt will simply create new financial problems. Fiscal policy might help indebted economies in certain cases, but those that need it most will run into trouble as higher fiscal spending typically means higher borrowing. I might as well also mention structural reforms to labor markets and in general a resetting of incentive structures, but the reality is that in the countries that have the highest debt levels, borrowing represents an easier road than politically difficult reforms. In this context, and barring wild currency depreciations as means of fixing debt burdens, a gloomy scenario is that by 2021 the world economy could be mired in low growth and the three major regions congested with debt. We need to ask whether there are any solutions to this.
Brady Plan and Denial
At some stage economic historians may cast their minds back to debt restructurings of old. Here, the
Brady Plan for the Latin American countries comes to mind. The plan, introduced in 1989, was named after Nicholas Brady, the US treasury secretary at the time, who led the effort to restructure the debt of a range of Latin American countries following the Latin American economic crisis of the mid 1980s and the subsequent debt default by many Latin American countries such as Mexico and Argentina. The achievement of the Brady Plan was to break the ties in the original debt chain by making liquid the Latin American debt held by banks. It also provided some forms of guarantees and restructuring options so that the interest rates charged on the new restructured debt could fall and the debt could be widely traded. Without the backing of the US Treasury, international investors would probably not have bought the debt of Latin American countries, making it nearly impossible for them to finance themselves.
The Brady Plan did not happen quickly. It took seven years, from the beginning of the Latin American debt crisis in 1982 to its resolution, which may be indicative of the time it takes for governments to fully recognize the problems that debt presents and to accept the necessity to take difficult policy action to resolve it. David Mulford, the former undersecretary of the US Treasury, has remarked that the Brady Plan was only agreed to once all the participating governments fully recognized the economic truth that lay ahead of them: without a restructuring and the economic medicine that it entailed, their countries would be bankrupt.29
All this suggests that a new debt crisis may soon be on the horizon. The facts that the world economy is in the very late stages of a business cycle expansion, that it is lugging around the biggest debt burden in modern times, and that interest rates are beginning to rise point to a precarious start to the next decade. What is troubling is that debt crises can last for some time. The examples of the euro crisis and Latin America’s debt restructuring suggest that a debt crisis that starts in, say, 2020 will really only end up being addressed after a lag, once things get really, really bad. That could be in 2024. Serendipitously, that would be the centenary of the 1924 International Debt Conference that produced the Dawes Plan to lessen the burden on Germany of the economic consequences of the First World War. Prior to 1924, the German economy had slowed, inflation had picked up, and its currency (the reichsmark) had collapsed. A new parallel currency, the rentenmark, was introduced. It was backed by land, which effectively provided a store of value. After nearly nine months of negotiations—and following collateral damage to the French franc—a deal was struck. The Dawes Plan reduced the burden of reparations on Germany, funneled US-backed loans to Germany, and produced a temporary uplift in its economy. The Dawes Plan helped stabilize Germany, though arguably it tied the nation more closely to the fortunes of America, as the 1929 crash loomed on the horizon.
My forecast, and proposal, is that by 2024 the world will have had another recession, with high debt levels in China and corporate America as the kindling for this economic bonfire. Low productivity, political unrest, and exhausted government budgets will be some important factors that will make the escape velocity from the recession very slow. Central banks may try wave after wave of quantitative easing, but they will have little effect, save to heighten currency volatility. For some time, the developed world will blame the recession on China and then on the fat cats of corporate America. Soon, the realization will dawn that, with the third debt crisis in twelve years (after America in 2007 and Europe in 2011) upon the world, a massive and thorough debt restructuring is necessary.
In the event of a deep economic crisis, international governments and central banks may decide that an international debt conference is in order. It is hard to think that many governments would take part in such a conference voluntarily; such a conference would only come after rounds of unsuccessful quantitative easing, wild currency volatility, and market stress and with the world facing the prospect of a long global recession. Once conceived, an international conference on debt and economic risk taking may be part of the laying down of the initial rules of the game for a multipolar world, and, not unlike the system put in place in the Peace of Westphalia of 1648 that followed the Thirty Years’ War, the new system may be one where nation-states begin to bear greater responsibility, in this case for their financial health.
Such a conference, though not unprecedented in recent history (think of the 1924 and 1953 debt conferences that allowed Germany debt relief), would be highly unusual, marking a debt restructuring of global proportions and bringing together the governments of the major economies. Ordinarily a body like the IMF would have a role here, but given the trend away from globalization and toward a multipolar world, I am going to speculate later in the book that some of the twentieth-century economic policy institutions we take for granted—the IMF, the World Bank, and WTO—may not exist by 2024. An international debt conference would mark an end of the road to the debt cycles spawned from the globalization process and would also mark an attempt to establish some of the financial rules of the new, multipolar world order.
I can see the conference taking place in Raffles Hotel in Singapore: the hotel’s old-world charm might chime with 1924, and it is luxurious enough for bankers, ministers, and advisers to spend weeks there. Conveniently, it is located in a well-run country that is yet within reach of China. The debt conference would have an overriding aim of encouraging risk bearing rather than risk sharing of debt, in much the same way that the Peace of Westphalia encouraged individual states and statelets to bear political and identity risk. The conference would have two parts: an international debt-reduction agreement and a risk treaty that would encompass central banks and financial markets.
The debt agreement would have several components: to curb the debt issuance of eurozone countries; to provide a framework for the apportionment of regional, financial, and corporate debt in China; and to insulate the international financial system from the consequences of a debt implosion in Japan. Other issues will arise, such as the high burden of corporate debt in the United States, though one would expect that market forces would resolve this.
In other countries, the unwinding of debt is complicated by other factors. Consider Japan, where there is an intricate system of cross-holdings: trying to resolve the ultimate ownership of assets and liabilities is not at all clear. In China one of the great obstacles to a debt restructuring is the cultural need for the Chinese not to lose face. What this means is that, given the way the European Union and IMF treated the likes of Ireland, Greece, and Portugal, a debt restructuring may be construed as humiliating China, and as others drawing moral lessons from China’s debt taking. If this were the case, it would greatly reduce the potential success of such a restructuring. Given these various complexities, such a debt conference would probably be a long one, and the bar at Raffles would probably be a busy place.
Solving Italy
The conveners of the debt conference will have a complex task, to put it lightly. This much is clear if we consider Italy and China as case studies. Let’s start with Italy. It has one of the biggest bond markets in the world, and a Greek-style debt crisis in Italy would easily destabilize debt markets in the United States. With government debt in the United States rising to record levels, Italy is a cautionary tale.
Typically, in Europe when an economic crisis loomed, someone raised a hand to repeat the dictum by Jean Monnet (one of the founding fathers of the European Union) that “Europe needs a crisis to move forward.” It is, however, worth noting a different point of view, from Monnet’s father, a merchant from Cognac. This wily Charentais (Cognac is in the Charente department in France) is on record as saying, “Every new idea is a bad idea.” Both Monnets might like the old idea of a debt restructuring conference, though applied in a new way.
With Cognac in mind, let’s stay in Europe and look more closely at its southern members: Spain, Greece, Portugal, and Italy. This group of countries is unique among OECD member states in that their economies did not grow at all in the decade from 2007 to 2017. Considering them on their own, bond markets would avoid thei
r debt, but the reassuring presence of the ECB—and its bond buying—means that investors are happier to buy Spanish debt today at lower yields (and therefore a lower premium for the risk that Spain presents) than at any other point in history, even the time of the Armada. The same is true for Italy. With over 130 percent debt to GDP and structurally low growth, Italy’s long-term interest rates should probably be closer to 5 or 6 percent to reflect higher default risk (more like emerging-market than developed-world debt: household debt in Italy is relatively low but regional and local debt is high and underperforming).
The European Union has rules in place to warn, scold, and fine countries when they breach the so-called Stability and Growth Pact criteria. Weak leadership means these warnings have failed before (in the cases of Greece and France) and continue to fail. The best way of ensuring that countries stick to the rules is to introduce a form of market discipline and to place the burden of excess debt accumulation on individual states rather than on the eurozone itself. The aim should be to ensure that countries take responsibility for excesses in policy.
The task of paring down existing debt levels for the large eurozone countries will be complicated and politically vexatious.30 It is likely to be made more difficult by the fact that by 2024 a lot of eurozone government debt will still be held by the ECB. Restructuring debt held by the ECB will be politically difficult, as it means that there will be a fractious debate as to who owns the losses associated with that restructuring. One hopes that by 2024 the European Union and the ECB will have put in place a formal mechanism by which a eurozone member country can exit the euro system (or be thrown out) and that this will not be costless, which might invite countries to default and leave. This might help to make the restructuring process more clear.
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