Are we worrying too much about public debt?

We’re all worried about financial ruin right now. Or at least that’s the vibe I got from the bubble talk and symposiums on the “coming US financial crisis.” Of course, I think this is something to be admired. Forearmed is forearmed, and so on. At the same time, although experts warn about the financial crisis a few years too early, I tend to think that there is a tendency to give up or become complacent in time to fall into a crisis along with others.

There’s nothing wrong with worrying. However, it’s best to worry about the right things. Today’s Free Lunch will address some of the concerns we think are wrong.

Below is a graph released by the IMF a month before the IMF/World Bank annual meeting held in Washington last week. I think the idea is to strike fear into the hearts of the readers about how much debt has grown. There is no doubt that this is actually the most common reaction.

However, my reaction was the opposite. I was shocked to see how stable global debt was. In 2019, the combined debt of governments, households, and non-financial businesses amounted to approximately 230% of global GDP. Five years later (think about what has happened in the last five years), this ratio has increased to . . . Approximately 235%.

(It makes sense to exclude the financial enterprise sector from these figures; overall, the financial enterprise sector is an intermediary and has almost zero debt with the rest of the economy.)

The increase in public debt has slightly outpaced the overall increase, and the private debt ratio has actually fallen slightly over this tumultuous five years. It makes sense when governments shut down economies to prevent millions of deaths. The shocking thing here is not how big the numbers are, but how small the changes are.

That’s true even going back further than just a few years. If you look at the past quarter century as a whole, the debt situation hasn’t changed much. According to this IMF measure, total debt to GDP was about 200% in 2000, with about one-third public debt and about two-thirds private debt. Today, that total is a bit higher, with a slightly larger share (about four-tenths) exposed. In short, it’s a lot.

Yet people are angry about public debt (and China, for that matter) on both sides of the Atlantic. There are bad reasons for this and some not-so-bad reasons. The worst reason is monetary illusion. Real growth and inflation have more than quadrupled the nominal value of debt. But this means nothing in terms of the actual burden of that debt. Worrying about rising interest rates isn’t such a bad thing. But interest rates in the early 2000s were higher than they are now. Below are the US government’s 10-year borrowing costs, with other interest rates following a similar pattern.

So while it is true that debt refinancing has increased the funds needed to service it, this is relative to the windfall for borrowers during the nearly 15 years after the global financial crisis, when interest rates were exceptionally low. Actual debt burdens are returning to normal and are even moderate by historical standards. For the U.S. government, it now has to devote the same percentage of the economy to interest payments as it did in the late 1990s (just under 4%).

Go ahead, there’s nothing to see here, right? Well, not completely. I think there is too much haphazard fear-mongering every time new fiscal numbers are released. That doesn’t mean you don’t have to worry. But worry about the right things. There are three below.

Actual resource allocation. Even as debt service burdens return to historically normal levels, they still have to be borne. For example, the U.S. government needs to generate 1.5% more GDP than before the pandemic. Other governments face similar challenges. Added to this are increasing demands on defence, productivity, climate change and digital transition, and an aging population. However, funding the government budget is more of a political than a financial issue. As John Maynard Keynes said, all we can do is all we can afford. Getting there, however, could be a politically winding road. Also worry about what will happen to the real economy. When growth is lost, all financial problems become worse.

Transnational exposure. Fiscal crises are almost always accompanied by large and unsustainable cross-border exposures. Insofar as the debt burden includes lending and borrowing between people within the same country, the same applies to interest payments. And governments have many options for redefining the terms of public and private debt to their populations. Relying on the kindness of strangers makes things even more difficult. And things get even more difficult when lending between strangers becomes geopolitical.

So if you want your pessimism justified, look for large and increasing cross-border dependencies. But mostly good news here. Bank cross-border lending, as measured by the Bank for International Settlements, has reached a historic record of $34.7 trillion, surpassing its peak before the global financial crisis. But that’s only nominal. These exposures represent about 30% of global GDP and represent a much lower share of activity than at their peak in 2008, when they were around 50%.

Also pay attention to the current account deficit. The Eurozone debt crisis and the Asian financial crisis before it occurred in economies that were living far beyond their means, with external deficits (sometimes driven by the private sector rather than public borrowing) reaching double-digit percentages of GDP in extreme cases. Today, you would be hard-pressed to find a developed economy near that danger zone. The US and UK stand out, with external deficits accounting for 3-4% of GDP.

France’s public and private debt-to-GDP ratios have each increased by more than 50 percentage points since 20 years ago, according to the IMF’s global debt watchdog. But given how minuscule the country’s current account deficit has been over the years, these are overwhelmingly debts owed to fellow citizens. (When it comes to public debt, Eric Nielsen explains why, despite all the talk of the crisis, Paris is less exposed to debt servicing problems than other G7 governments.)

Even the United States, where fiscal policy is clearly not taken seriously at the moment, may not be as bad as it seems in terms of cross-border vulnerabilities. Much of the recent increase in external debt reflects the stock market boom, not borrowing. As for public debt, the share of the burden on foreigners has risen from the typical 10-15 percent in the 1990s, but has remained stable for almost two decades, at around 25 percent (see chart below).

When debt (and equity) is not what it seems. It is important to understand the basic structure of a financial meltdown. I posted it before, but

Financial crises occur when the value of the assets people think they have in the financial system does not equal the sum of all the claims they think they have on the financial system. This means that not all of those claims will be honored in full.

And that almost always happens when insurance benefits that are supposed to be serviced and paid out at a predetermined amount, no matter what, fund investments that may or may not produce a return. To illustrate, let’s consider excessive debt financing that backs up equity-like investments. This is clearly a risk, as excess tends to be actively hidden or unintentionally buried in complexity so it doesn’t stand out.

So the place to sniff out trouble is where debt and investments like equity meet, and these days, it seems most likely to be private equity and private credit, as some of my colleagues have written (be sure to read Katie Martin, Rob Armstrong, Chris Giles). Be especially careful if banks are involved. Banks’ lending to non-banks for further lending is now at a scale that is worrying the IMF. This should be especially scary if this is what finally brings fresh cash to the merry-go-round of complex financing schemes being developed between artificial intelligence developers and chip makers.

In this context, strain on government balance sheets should be fairly low on our priority list. Public finance is the least complex and most transparent of public finances. Of course, sometimes things don’t work out. But the other thing, the sectoral issue of funding investments that look less like debt than anyone realizes, is likely to go wrong first. This has happened before and will continue to happen. Whenever something happens, the burden ultimately falls on the government. But if it is this serious, you can be sure that interest rates will fall and that the internal problems of the public finances themselves will be somewhat ameliorated.

Predicting the nature and timing of the next financial crisis is a fool’s errand. But I’d wager that the fiscal crisis may be a consequence rather than a cause of meltdowns elsewhere, and part of the solution rather than part of the problem.

Other readable

● Europe is fighting with one hand tied behind its back in dealing with Russia’s frozen central bank reserves.

● Sign up for our new sister newsletter. ‘AI Shift’ by Sarah O’Connor and John Byrne-Murdoch on how artificial intelligence will shake up the labor market. John and Sarah are also hosting live Q&As here.

● But in reality, AI can migrate. I review two books that highlight the continued importance of land to economies and societies.

● After years in which the poorest Americans began to catch up with the richest, the fight against inflation has revived the two-speed economy and sent Americans back to the bottom of the wage growth league table.