The world is swimming (perhaps drowning) in debt because, well, who doesn’t like debt? Borrowing allows us to spend money we do not have — yet. According to the International Monetary Fund (IMF), global debt-to-GDP hit a high of 256% at end-2020, post-Covid 19 pandemic, up from 195% in 2007, on the eve of the global financial crisis (GFC) (see Chart 1). In absolute terms, debts totalled a record US$226 trillion, up from US$116 trillion over the same period, with government borrowings (public debt) rising at nearly double the pace of private debt.
This massive surge in borrowings was enabled primarily by falling interest rates. Interest rate is the price of money and falling rates mean debt becomes more affordable. In the US, yields on the benchmark 10-year Treasury fell from more than 4% in 2008 to barely above zero in 2020. The same trend was observed across the globe as central banks eased monetary policies in response to the two major crises (the pandemic and GFC).
Ultra-cheap money increased the affordability, and attractiveness, of debt. Over the past decades, each downcycle has been better managed, through the use of both fiscal and monetary policies. As a result, the world saw a sustained long cycle of economic growth and benign inflation. Profits expanded and stock markets rallied strongly, driven by massive liquidity and cheap money. The US market enjoyed its longest-ever bull market rally. Business failures became rarer and unemployment rates consistently trended lower, in the aftermath of the GFC. The confluence of all these factors generated optimism that led to increasing complacency — and people were more willing to take on greater risks, including the use of leverage, to amplify low yields and boost returns.
Debt serves a crucial economic function. Make no mistake, without it, our quality of life would be far poorer. For instance, what if there were no mortgages? Most of us would have to save for decades before we could afford to buy a home that would provide a safe and comfortable shelter, and for parents to raise their children. Similarly, loans allow entrepreneurs to fund their start-ups and businesses to invest, innovate and expand capacities, to seize opportunities as they arise — again, without having to wait years for sufficient savings or existing operations to be self-financing. Governments borrow to build infrastructure today, provide education and healthcare for the population, and create an environment attractive for investments.
As with everything in life, however, there is also a cost to rising debt. Consumption funded with borrowings is, in effect, a pulled-forward spending — that is, spending more than current incomes based on the expectation that they will rise in the future. Today’s investments in productive assets will enhance tomorrow’s productivity and economic growth, which will drive future income-revenue increases for households (wages), businesses (profits) and governments (taxes). Investments in non-productive assets, on the other hand, will sap growth potential, as increasing debt-servicing costs eat into savings/profits that would fund future investments.
Debt becomes a problem when it becomes an addiction, when we borrow and spend way beyond our means — more than what we could realistically expect to pay back with future incomes. History is filled with instances in which excessive debts led to financial crises, which are usually accompanied by painful economic recession, the last of which was the GFC in 2008. This is why the rapid accumulation of debts over the past decade is very worrying. It leaves households, businesses and governments more vulnerable to shocks/disruptions, raising both financial and economic risks.
Private debt growth has been relatively more constrained
Naturally, we all want to upgrade our lifestyles and enjoy the better things in life. It takes fiscal discipline — for some, more than others — to keep debts in check. Positively, there is a checking mechanism for household debt and, to a lesser extent, corporate debts. Financial institutions (banks) are generally vigilant in giving out loans, in assessing the creditworthiness of borrowers, especially since the GFC. Anecdotal evidence also shows some behavioural changes that are due to scarring effects — businesses and households themselves are more prudent about their ability to repay and are less inclined to take on excessive debt.
See also: Education was, is and always will be the great equaliser
Case in point: US households have largely repaired their balance sheets since the GFC by tightening spending, and many opted to pay down borrowings with their pandemic handouts. S&P 500 companies have, on average, maintained more cash buffers — reflected in their higher cash ratios — since the GFC, and even higher in 2020, as managements remain wary of future shocks. Excessively leveraged businesses lead to bankruptcies, which is neither advantageous to shareholders nor top management.
According to the IMF, global private sector debt increased by 75% between 2007 and 2020, or equivalent to a “modest” compound annual growth rate of 4.4%. That said, the current environment of rapidly rising interest rates is still worrying. It will raise debt-servicing costs, at a time of record-high debt, compound cost of living inflation and eat into savings/reserves.
Mortgage accounts for the biggest chunk of household debt
For households, mortgages typically account for the biggest chunk of their debts. For instance, mortgages make up more than 70% of total household debt in the US. As we showed last week, globally, property prices have risen rapidly over the past 20 years, outpacing income growth (see “The golden decades of broad-based wealth creation [accumulation] are over”, The Edge Singapore, Issue 1056, Oct 10). The situation is worse for countries such as Canada and Australia, which have seen a huge influx of overseas monies into their property markets, leading to rapid home price appreciation (see Chart 2).
To us, the ability to own a home is a basic human right — not just an economic right — but higher and higher property prices mean ownership will become more concentrated. Left unaddressed, soon, only the rich will be able to afford to buy a home — worsening inequality. And it will surely continue to drive the rise in household debt — meaning, less savings, including for investments. Because homes are growing more expensive, many people are now able to buy one only later in life and/or stretching out the tenures of mortgages. While our parents are typically able to leave us their properties fully paid off, there are rising risks that future generations may, increasingly, have to inherit our debts as well.
Worse, while essential to our well-being, housing investments are non-productive assets — they do not improve economic productivity. Excessive housing construction and price appreciation — driven by speculation — is unhealthy and a drag on the country’s future growth potential. It is why countries such as Australia and Canada try to rein in speculation, especially by non-residents. And it is one of the biggest obstacles for China today — over-investments and excessive leverage in the property sector.
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Measures by the Chinese government to clamp down on speculation and unsustainable developer debts in 2020 triggered a property market slump. The fallout is spreading. Rising developer debt defaults are now affecting revenue for local governments, heavily dependent on land sales and highly leveraged themselves (including through local government financing vehicles used to undertake massive infrastructure projects) — and may be creating potential systemic risks. Abandoned projects and falling prices are also deeply hurting home buyers/owners and consumer confidence. While the government measures, no doubt, came too late, there is no option but to contain such excessive speculation.
Last week, we explained how rising property prices would contribute to the end of the golden decades of widespread wealth creation — as households are priced out of the property market (homes become increasingly unaffordable). Historically, property — along with its steady price appreciation (home equity) over time, at a low borrowing cost of mortgage — has been one of the biggest drivers of mass wealth creation, owing to its comparatively wide ownership. As this trend reverses, what is the wealth effect, if any, on future consumption and growth? We hope to share more of our thoughts on falling housing affordability and rising household debt in a few weeks’ time. Are we looking at household indebtedness correctly? Is it a real problem and, if so, to what extent? What are the possible ways to address the growing home ownership problem? For now, the rest of this article will focus on ballooning government debt (see Chart 3).
Governments’ worsening debt addiction — public debt rose 142% from 2007 to 2020 (13 years)
As we said in the first paragraph, public debt has risen at nearly double the pace of private debt since the GFC, by 142%, or 7% a year, over the 13 years to 2020. Government debt now accounts for nearly 40% of total global debt, the highest since the mid1960s. The increase in government borrowings was especially elevated for advanced economies, including in the US and Europe during the pandemic, thanks to massive stimulus spending. We bet it will be significantly harder to wean governments off their debt addiction. Why?
For one, governments may think they can always print more money. While true, this ability is not unlimited, and certainly not without consequences. Emerging countries, through painful lessons in the past, understand this very well. The latest financial market turmoil afflicting the UK has shown us that even major advanced economies are not exempt from at least some degree of fiscal discipline. The UK may be able to issue debt in its own currency, but the country still needs to convince investors. Investors can always dump government debt, force yields sharply higher and collapse currencies. Rating agencies Standard & Poor’s and Fitch lowered their outlook for the UK’s sovereign debt after the government’s fiscal stimulus debacle.
As we mentioned, there were notable behavioural changes for households and corporates after the GFC — many became more prudent because they had suffered the consequences. The situation is very different for public debt — the people, who would ultimately have to pay for it, do not get to directly decide how much borrowing is too much. Only the few in positions of power do — and they will not be held personally accountable for these debts in the future. Quite the opposite, in fact. They get to enjoy all the benefits of racking up debts today and face none of the downside if and when things turn bad further down the road. This is dangerous and often leads to excesses.
Excessive debt will rob the potentials of our future generation
Democratically elected governments rule by popular support. There is little upside for politicians to make tough decisions — even if they are the right — that are unpopular or inflict pain on the people. Election cycles are short, typically four to five years, which means most politicians are focused on short-termism — perhaps far more so than many corporate leaders. In other words, governments of the day will always choose populist measures, even if it means taking on more debt — and even if it is to the detriment of future generations.
Make no mistake, eventually, someone has to pay. And that will be our children and our children’s children. As more of future government income goes towards servicing current high levels of debt, in absolute terms, it necessarily means less for investments and development — effectively robbing the potentials of our next generation. And lest we forget, there will be other domino effects from excessive debt on the value of currencies and high interest rates (after adjusting for inflation). We wonder what future generations will have to say to the fiscal irresponsibility of today’s leaders. Do we not have the responsibility to safeguard their future?
Raising taxes and/or cutting expenses unpalatable to most populist governments
Mathematically, rising debts can be managed as long as nominal GDP growth outpaces nominal interest rates (or real GDP growth > real interest rates, adjusting for inflation). This was the case for the past decade — when interest rates were below inflation and economic growth, countries could take on more debt and grow faster than interest payments. More on this a bit later.
Governments can also reduce public debt ratios through direct fiscal measures, typically a combination of:
• Higher taxes, such as personal-corporate income tax and consumption-based goods and services tax (GST); and
• Lower operating expenditures, for example, pulling back on subsidies and cutting salaries and emoluments for civil servants.
Both options will be hard to implement for any populist government, even in the best of times, and near impossible today, given the sharp inflation in living costs. In fact, by most accounts, governments are increasing subsidies, to keep voters happy and maintain socio-political stability. For example, governments across Europe are giving out huge energy subsidies to shield households/businesses from soaring prices, largely the result of Western sanctions on Russia.
Subsidy bills are also surging in emerging markets, hit by higher energy and food prices, made worse by the strong US dollar. According to the IMF, 60% of low-income countries may be in, or at risk of, debt distress. Countries such as Sri Lanka, Ghana, Egypt and Pakistan have already asked the IMF for aid.
Raising taxes too is hugely unpopular. Case in point: GST was one of the main issues in Malaysia, heading into the last general election (GE14). In addition, higher corporate tax rates will make the country less competitive and disincentivise investments, which will weaken productivity growth, hurt innovations and result in fewer new companies and job creation. Higher personal taxes will discourage people from work. Both will ultimately lead to slower economic growth — and, thus, lower future tax revenue.
In short, there are real-world limitations to the use of fiscal measures to address high debt issue — just as there are when it comes to monetary policies. Central banks, led by the US Federal Reserve, may be hiking interest rates aggressively right now. Make no mistake, though. Once they regain control over inflation, interest rates will fall. Given the massive global debt load and the potential fallout from higher debt-servicing costs on financial stability, central banks will be less and less inclined to raise interest rates over time. What then?
How, then, do we grow out of our debts?
Back to our earlier comment — rising debts can be managed as long as nominal GDP growth outpaces nominal interest rates. In other words, we grow out of our debts, though we have little clarity on how we achieve this. As we explained last week, the golden decades for robust global GDP growth are over. In the near term, growth will slow — the global economy is heading into recession. We have explained why this is so in a previous article (see “Central banks cannot address supply disruptions, the cause of global inflation”, in The Edge Singapore, Issue 1054, Sept 26). And it will have cascading repercussions on medium- to longer-term growth for emerging economies. They may take years to recover from the setback, depending on the severity of the recession. This will be compounded by several secular trends that will weigh on future growth prospects — possibly leading to yet another period of sluggish economic recovery.
One, the ageing population. This is a major challenge for most developed countries, the US, Europe and parts of Asia, including Japan and China. Economic growth, and wealth, is a function of the size of the population (workforce) and productivity. Low and falling population growth will make it extremely difficult to sustain GDP growth — and why productivity-enhancing innovations from the fourth industrial revolution is so critical (for a more detailed explanation, please read our article “IT and biotech are the battlegrounds to determine future global dominance”, The Edge Singapore, Issue 1055, Oct 3).
With an ageing population, pensions and healthcare costs will continue to rise, while tax collection declines — adding to government budget deficits. Ageing plus low population growth means the larger debt burden will be, increasingly, shouldered by a shrinking number of people.
We foresee that interest rates too will eventually start declining again as growth slows. They have to, given the mountain of debt to be serviced and repaid. A debt-laden global economy cannot survive sustained high interest rates. Low interest rate penalises savers, hurting incomes for retirees as well as pension funds’ ability to generate sufficient returns for expected future payouts. Just this month, we saw the consequences of sudden market volatility on UK pension funds, which had turned to leverage and complicated derivative products to boost returns as bond yields fell over the past decade (yes, financial innovations can be dangerous, often masking the true extent of liabilities and the risks. Case in point: the US subprime crisis that triggered the Great Recession). The Bank of England had to mount a bond market rescue to prevent a catastrophic collapse for these pension funds.
We also discussed the repercussions of tech disruptions as more and more jobs will be taken over by artificial intelligence and robots. This is likely to lead to rising unemployment, not just among low-skill workers but, increasingly, across the economy. As we said, no job will be absolutely safe in the future digital world. This would necessarily mean more government spending on social safety nets and unemployment benefits — and, again, more burden on public finances.
How are countries going to pay for all these growing obligations amid sluggish economic recovery or, worse, prolonged recession? Can governments continue to take on more and more debt? The most obvious answer is that the world needs to boost economic growth, through productivity gains — from investments in science and technology, particularly, in IT and biotech. The question is, how?
Time for out-of-the-box solution — a new social contract
Countries have, in the past, mostly relied on pro-growth policies — such as tax cuts (notably for corporates and high earners), deregulation and myriad tax-investment incentives — to stimulate investments and productivity, and create jobs for the people. This should, in theory, lead to a win-win situation for all — higher income for the people, profits for businesses and tax revenue for governments.
These supply-side economic policies were embraced by then US president Ronald Reagan and UK prime minister Margaret Thatcher in the 1980s. China’s economic reforms, starting in the late 1970s, were very successful in attracting massive foreign investments, propelling its economic transformation, which in more than 40 short years has given rise to the single-largest uplift of the middle class in history. Asean thrived on the investment-driven, export-oriented economic development model.
But while free-market capitalism did create enormous wealth, its lopsided distribution led to widening income-wealth inequality in the world today, even in socialist China, albeit to a lesser extent. Globalisation benefited capital owners at the expense of the working class. We discussed this in detail last week in our article entitled “The golden decades of broad-based wealth creation (accumulation) are over” (The Edge Singapore, Issue 1056, Oct 10).
As the rich grow richer, the poor are being left further and further behind while middle-class households are being suffocated, between years of cumulative lagging wages growth and rise in cost of living. The effects will, eventually, be detrimental to the global economy. As we know, the biggest driver of consumption and growth is not the rich but the middle class, and the aspiring middle-income households. Human feelings of success, satisfaction and happiness are based on relatives, not absolutes. Thus, even the perception of constantly being measured down will, over time, be demotivational, leading to discontent and destabilising social unrest, which will not be conducive to future investments and productivity gains.
Look no further than new UK Prime Minister Liz Truss’ disastrous attempt to replicate her predecessor’s trickle-down economics — her massive tax cuts/fiscal spending (incidentally, to be funded by more debt) plan was almost universally panned. Yes, the timing for more stimulus was truly awful, given the prevailing high inflation. But even more so, although the proposed tax cuts for high-income households were just a small percentage of the overall spending, it created an uproar, which eventually forced an embarrassing U-turn. Optics very much matter for populist governments.
How, then, should governments address both economic growth and inequality issues? Perhaps it is time for an out-of-the-box solution and new social contract with the people.
To be continued …
The Global Portfolio fell 3.5% for the week ended Oct 12, less than the MSCI World Net Return Index’s 5.3% loss. All five stocks in our portfolio fell, led by Yihai International Holding (-14.3%), Alibaba Group Holding (-11.7%) and Guangzhou Automobile Group Co (-5.7%). Last week’s losses pared total portfolio returns since inception to 11.9%, trailing the benchmark index’s 22.2% returns over the same period.
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