Econosights: Will fiscal stimulus lead to a global debt problem?

Introduction

High global debt (both private and government) is often identified as a major vulnerability to future economic growth. Concern around unsustainable debt growth will be exacerbated by the Covid-19 pandemic. It is inevitable that global debt, especially in the public sector, will skyrocket from government’s increasing fiscal stimulus. The chart below shows the value of direct fiscal stimulus and loan programs across the world, with many countries implementing large stimulus packages as a share of the economy.

We look at the impact recently announced fiscal programs will have on global public debt and the economy in this Econosights.

Fiscal stimulus
Total direct fiscal spending is worth nearly 5% of global GDP including stimulus still expected to be announced (see chart below). Lending programs are not technically direct fiscal spending (and therefore not included in the chart) but may end up in government debt if they end up being unpaid and they are worth another 4% of GDP. All up, this is well above fiscal stimulus undertaken during the Global Financial Crisis and more akin to spending taken during periods of war.

This fiscal stimulus will result in a surge in global public debt.

Budget deficits and ballooning public debt
Government budgets are simply the difference between revenue (mainly tax collection) and all government expenditures. Government revenue will take a hit from the collapse in economic activity (via lower taxes paid). Stimulus spending and the increase in automatic stabilisers (higher unemployment benefits) will lift government expenditures and cause a deterioration in budget balances. Accumulating budget deficits add to government debt.

In the US, the budget deficit was already increasing before Covid-19 and is now set to reach 18 % of GDP (see the next chart) with public debt rising towards 120% of GDP outpacing the World War II record of 106% of GDP.

In Australia, the budget deficit is expected to peak at 8.5% of GDP and with gross debt rising to nearly 60% of GDP (from ~40% before Covid-19). While this is a large increase and the highest level of public debt (as a share of GDP) since the 1950’s, Australia’s public debt position still looks more favourable than its peers (the US, Germany, Canada and the UK are all set to have far higher debt to GDP ratios after Covid-19). In this sense, because Australia’s net debt position will be more favourable compared to its peers the AAA credit rating is probably secure.

The chart below looks at global debt levels through time. We expect total debt (including private and public) to increase to around 250% of GDP, from 230% before Covid-19.  

The impact on private debt is mixed. Businesses drawing on loan facilities to help with get them through the pandemic will increase private debt levels. However, a rise in business defaults will probably more than offset this rise.

Are there limitations to how much further government debt can increase? It depends. Some countries face limitations around debt levels. The US has a “debt ceiling” limit but it can be increased if Congress agree to it. While debt ceiling debates often result in arguments and stand-offs in US politics, if there was a need to increase the US debt ceiling to get another economic assistance package passed, it would eventually happen. European Union countries also have limitations around debt holdings (government debt should not be above 60% of GDP although many EU countries exceed this amount) although this limit was suspended for now.

While debt-to-GDP ratios are one useful guide to debt level, they don’t tell you much about the serviceability of debt. Serviceability is the more important indicator of the sustainability of running high government deficits. Government bond yields indicate the borrowing cost for governments. If GDP growth exceeds the cost of borrowing (determined by the government bond yield), debt serviceability should be manageable. This is generally the case in the large advanced economies. For example, the US 10-year bond yield is at 0.65% but potential US GDP growth is 2.5%. In Australia, the 10-year bond yield is at 0.85% and nominal GDP growth is much higher at 4.5%. As well, interest payments on government debt remain low (as a share of GDP) and have been stable for years (see chart below) in Australia and the US.

Of course GDP growth and inflation will take a short-term hit from the Covid-19 disruption, but both metrics should be back to positive from 2021.

Impacts of high public debt on the economy
The main problems with rising government debt are around the impact on government bonds yields, inflation and future economic growth. Increasing public debt could be taken as a sign of increasing default risk and if government bond yields rise it would increase interest costs. Inflation would become more of a risk if government debt was being directly financed by the central bank creating (or printing) new money. This hasn’t happened yet (despite talk of it occurring although the Bank of England is probably close to it). Central banks remain independent of government although their policies have become much more coordinated with central banks large buyers of government bonds (in the secondary market). In the US, the Federal Reserve has also used Treasury funds to leverage lending programs to businesses.

High debt is often seen as an economic burden because it can crowd out private investment which is negative for productivity growth and living standards. Another problem is how current debt is perceived by the public. If consumers expect higher taxation down the track, then consumer spending will be lower than otherwise.

Implications for investors

The surge in public debt now occurring could create an unfavourable situation of high inflation and lower economic growth (or stagflation) down the track. However, it is currently more important for policymakers to use fiscal stimulus to keep the economy from going into a lengthy depression (which is harder to recover from). The level of economic activity is likely to take years to recover back to its pre-coronavirus levels. This excess capacity will keep inflation and interest rates low for now.