Are we worrying too much about public debt?

We are all worried about a financial meltdown now. Or at least that’s the mood I’m taking from bubble talk and symposia about “the coming US financial crisis”. I think this is laudable, of course — forewarned is forearmed and so on. At the same time, I tend to think that experts have a habit of warning about financial crises a few years too early, but then giving up or even joining in the complacency in time to be brought down with everyone else.

There is nothing wrong with worrying. However, it’s best to worry about the right things. In today’s Free Lunch, I look at some of the worries I think we get wrong.

Below is a chart the IMF published a month before the IMF-World Bank annual meetings that took place in Washington last week. I think the intention is to strike horror in the hearts of readers over how high debt has become. I have no doubt that this is indeed the most common reaction.

My reaction, however, was the opposite: I was shocked to see how stable global debt has been. In 2019, the global sum of government, household and non-financial corporate debt amounted to about 230 per cent of world GDP. Five years later (think about all that went on in those five years), the ratio had risen to . . . about 235 per cent.

(It makes sense to exclude the financial corporate sector from these numbers: in the aggregate, it’s an intermediary, whose debt to and from the rest of the economy largely nets out to zero.)

The rise in public debt was a bit greater than the overall rise, and the private debt ratio actually declined a little in those turbulent five years. That’s as it should be when governments shut down economies to prevent millions of deaths. If there is anything shocking here, it’s not how big the numbers are but how small the changes.

That remains true if you go further back than just a few years. If you look at the entire last quarter-century, the debt picture simply hasn’t changed a lot. Total debt-to-GDP, on this IMF measure, was about 200 per cent in the year 2000, about one-third public and two-thirds private. Today, the aggregate is a little higher, and a slightly larger share (about four-tenths) is public. In short, much of a muchness.

And yet people are up in arms about public debt, on both sides of the Atlantic (and about China, too, for that matter). There are bad reasons and less bad reasons for this. The worst reason is money illusion: real growth and inflation mean the nominal value of debt has more than quadrupled. But this means nothing in terms of the real burden of that debt. Slightly less bad is to worry about the rise in interest rates. But rates were higher at the start of the millennium than they are now — below is the US government’s 10-year borrowing cost, and other rates have followed similar patterns.

So while it’s true that the resources needed to service debt are going up as debt is being refinanced, that is relative to the windfall for borrowers in the roughly 15-year window after the global financial crisis, when rates were exceptionally low. The real burden of debt is just returning to normal, and is even moderate by historical standards. Take the US government: it now needs to devote the same share of the economy to interest payments as it did in the late 1990s — just under 4 per cent.

Move on, nothing to see here, then? Well, not quite. I do think there is far too much knee-jerk fear-mongering whenever new public finance numbers come out. That does not mean one shouldn’t worry. But please worry about the right things. Here are three:

Real resource allocation. Even if debt service burdens are just returning to historically normal levels, the burden still has to be shouldered. The US government, for example, must find 1.5 per cent of GDP more than before the pandemic. Other governments face similar challenges. On top of that come increasing demands for defence, productivity, climate and digital transitions and ageing populations. But funding the government budget is more of a political challenge than a financial one. As John Maynard Keynes said, what we can do, we can afford — although it can be politically tortuous to get there. Worry, too, about how the real economy fares — when growth disappears, all financial problems get worse.

Cross-border exposures. When fiscal crises occur, they almost invariably involve large and unsustainable cross-border exposures. So long as debt burdens involve lending between people within the same country, so do interest payments. And governments have a lot of options to redefine public and private debt terms for their own residents. Things are much harder when you rely on the kindness of strangers. And when lending between strangers becomes geopolitical, things get harder still.

So if you want your pessimism validated, look for large and rising cross-border dependencies. But here the news is mostly good. The Bank for International Settlements measures cross-border lending by banks, which has just hit a historic record of $34.7tn, only now surpassing the pre-global financial crisis peak. But that’s in nominal terms. At about 30 per cent of global GDP, these exposures represent a much lower share of activity than at the 2008 peak of around 50 per cent.

Look, too, at current account deficits. The Eurozone debt crisis, and the Asian financial crisis before it, happened to economies that were living well beyond their means, with external deficits (sometimes driven by the private sector, not public borrowing) reaching double-digit percentages of GDP in extreme cases. Today, you would be hard-pressed to find an advanced economy anywhere near that danger zone. The two standouts are the US and the UK, with external deficits of 3 to 4 per cent of their GDPs.

Contrast this with France, where public and private debt-to-GDP ratios have each increased more than 50 percentage points since 20 years ago, according to the IMF’s global debt monitor. But these are overwhelmingly debts owed to compatriots, given how negligible the country’s current account deficit has been over the years. (As for the public debt, despite all the crisis talk, Erik Nielsen explains why Paris is less exposed to debt servicing problems than several other G7 governments.)

Even the US, where fiscal policy is clearly not being taken seriously at the moment, may not be as bad as it looks in terms of cross-border vulnerability. Much of the recent increase in liabilities to the rest of the world reflects the huge stock market boom, not borrowing. As for public debt, the share owed to foreigners has risen from the 10 to 15 per cent typical of the 1990s, but only to 25 per cent, where it has been stable for almost 20 years (see chart below).

When debt (and equity) isn’t what it seems. It’s important to understand the basic anatomy of financial meltdowns. As I have put it before,

Financial crises happen when the value of assets people think the financial system holds does not add up to the sum of all the claims they think they have on it, meaning that not all those claims will be honoured in full.

And that almost invariably happens when claims that are supposed to be serviced and paid in a pre-determined amount, no matter what, have financed investments that may or may not give a return. For simplicity, think of too much debt financing backing equity-like investments. Because this is obviously risky, excesses will tend to be obscured, either actively hidden or unintentionally lost in complexity.

So the place to sniff out trouble is where debt meets equity-like investment, which these days seems most likely to be private equity and private credit, as several of my colleagues have been writing about (always read Katie Martin, Rob Armstrong and Chris Giles). Be particularly alert when banks are involved. Bank lending to non-banks for further lending is now sufficiently big to worry the IMF. If this is what ultimately brings fresh cash into the merry-go-round of complex financing schemes being developed between artificial intelligence creators and chip manufacturers, be especially afraid.

Amid all this, creaking government balance sheets should be well down our list of priorities. Public finances are the least complex and most transparent bit of finance. Things can go wrong, of course. But other things — sectoral problems where more debt than anyone knows is funding investments that are less like debt than people realise — are likely to go wrong first. That has happened before and will happen again, and whenever anything goes down, the buck ultimately stops with the government. When it’s as serious as that, however, we can also be quite confident that interest rates will fall, somewhat remedying any problems inside the public finances themselves.

It’s a fool’s errand to predict the nature or timing of the next financial crisis. But I would be willing to bet that a fiscal crisis will be the consequence, not the cause, of a meltdown elsewhere, and may well be more part of the solution than part of the problem.

Other readables

● In dealing with frozen Russian central bank reserves, Europe is fighting with one hand tied behind its back.

● Sign up for our new sister newsletter: Sarah O’Connor and John Burn-Murdoch’s The AI Shift, on how artificial intelligence is shaking up the labour market. John and Sarah are also hosting a live Q&A here.

● Actually, however, AI can move over: I review two books that reveal the continuing importance of land to our economies and societies.

● After several years when the poorest Americans were catching up with the richest, the fight against inflation has led to the return of a two-speed economy that has sent them back to the bottom of the wage growth league table.