The ‘IMF crisis’ as South Koreans call the ‘Asia crisis’ of 1997 is the worst event to have hit South Korea since the civil war of 1950-53. The focus on the IMF is because South Koreans, perhaps ungratefully, focus on the damage after the International Monetary Fund bailed out a country tormented by a currency-turned-banking crisis.
Even though South Korea’s economy rebounded quickly from IMF-imposed austerity, the crisis scarred South Koreans. One legacy was a consensus that Seoul must not let gross government debt exceed 40% of output.
No longer. The government of President Moon Jae-in in August vowed to use fiscal stimulus to counter the damage of the pandemic and, more broadly, fight poverty and inequality. Public debt is expected to reach 59% of GDP by 2025, from 36% of output when Moon took office in 2017.
And why not let government borrowing rip? Does anyone care that government debt-to-GDP ratios (however imperfectly measured) are higher than seemed possible because interest rates are so low? US government debt is now at 103% of GDP. Eurozone public debt is at a near-record 98.3% of output. While Australia’s federal debt is only headed to 50% of GDP by 2025, Japan’s public debt stands at 257% of GDP, while for advanced countries the figure is 124% of output. Public debt in emerging markets extends to a record 64% of output. The IMF estimates ‘general’ government debt now reaches a record 99% of global output, from 83% in 2016.
An overarching question is: At what level might public debt become disruptive? History is replete with examples of when excessive debt triggered a crisis, from an inflationary economic collapse to endless stagnation.
Governments have three standard options when it comes to tackling debt burdens. The first conventional cure is to raise taxes and reduce spending. The handbrake here is austerity is often politically fraught and undermines economies so much it backfires in that debt ratios rise.
A second, and the most appealing, option is to ensure economies flourish in a way that erodes real debt burdens over time – this is how the victors reduced their bills after World War II. The formula is to ensure nominal output (GDP unadjusted for inflation) grows at a higher rate than the average interest rate on public debt – a historic norm.
Over the pandemic, these formulas were met because interest rates were around record lows partly due to central-bank asset purchases. A repeat of the post-World War II drawdown will be hard because back then pent-up demand, low regulation, favourable demographics and free trade drove economies, advantages lacking now.
Still, within this option, governments can choose to allow some inflation and suppress interest rates. The benefit of this approach is that rising nominal GDP growth offers governments tax windfalls. But artificially low rates would only encourage companies and consumers to add to their record debt loads that come primed with risks too.
Permitting inflation is tricky. Officials might lose control of prices and interest rates would rise. To counter that, governments might be tempted to pressure central banks not to raise rates. But that would demolish central-bank independence to fight inflation, perhaps the economic policy most responsible for recent prosperity.
The other option is to default. While no defaults in advanced countries with their own currencies are imminent, their governments can’t boost debt forever. Pressure will mount for authorities to control debt ratios to stop ratings downgrades, perhaps even engage in accounting tricks.
Eurozone governments with high debt ratios are more vulnerable to default because they lack their own currencies. Yet any default could bring down the European Monetary System. More crises from the euro area are likely, especially if bond yields rise after the European Central Bank stops its asset buying.
Emerging countries, which are inherently less stable economically and politically, are most likely to default. The candidates are many – the IMF in December estimated that 60% of low-income countries are at “high risk or already in debt distress” compared with 30% in 2015. Emerging countries that have borrowed in foreign currency (a diminishing percentage) and ones that have borrowed from foreigners rather than locals are the most at risk.
For indebted advanced and emerging countries, a world of record government debt could soon enough be a realm of hard choices and one of sporadic crises. As the debt status quo appears unsustainable, any rise in US interest rates will signal trouble ahead.
To be clear, government debt proved its worth during the pandemic and there’s nothing risky with it per se, especially when governments borrow in local currency from locals. As Japan shows, debt-to-GDP ratios can climb far higher than thought possible without any obvious damage to an economy. It’s true too that few indebted governments are struggling to sell debt at low rates. But, at some point, rising debt would trigger steeper borrowing costs and puncture the complacency that public debts are manageable because interest rates are low.
History shows that public debt ushers in its nemesis; higher interest rates. That reckoning one indeterminant day likely means a harsher, poorer, perhaps crisis-prone future awaits.
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