Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 385

Beware of burning down the barn to bury the debt

As this country knows all too well, fires usually end up being much harder to put out than they are to start.

In the decade since the global financial crisis, there’s been a large build-up in sovereign debt by almost all Western nations. As with so many things this year, the COVID-19 pandemic has accelerated the trend. At some point, policymakers will have to turn their attention to the task of deleveraging, to somehow work off these large debt burdens.

Fire versus ice policy moves

They face a difficult set of choices. Do they go down the path of deleveraging via fire (inflation) or ice (deflation)?

If we take history as our starting point, there are four pertinent examples.

1. Japan has been attempting to deleverage through deflation since the late 1980s. The good news is that economic conditions have muddled through; the bad news is that Japan’s sovereign debt position is now well more than 200% of GDP. The result is a chilled-down economy, but with little success at debt reduction.

2. Another example of deleveraging with deflation is the 1930s Great Depression in the US. Here, the reduction in debt was very successful – but this came with an enormous hit to the economy and widespread destruction of wealth. So, deleveraging was achieved by freezing the economy almost to death.

3. During the same period, Germany also underwent a debt reduction. The Weimar Republic reduced its ruinous load of reparations debt, although the vast monetary expansion that enabled this led to hyperinflation and widespread destruction of wealth. So this was deleveraging by raging conflagration, at the cost of burning the whole economy to the ground.

4. However, there is one historical example of a successful deleveraging process that did not entail widespread wealth destruction. In fact, it occurred during a period of prosperity and it was brought about with the nice warm glow of moderate inflation. How was this happy outcome achieved?

After peaking at 116% in 1945, US sovereign debt-to-GDP more than halved over the next 15 years. This was achieved by limiting the interest rate payable on US Treasury bonds, limiting the ability to sell these bonds, and a demand set-up to fuel a decent level of inflation.

Financial repression

This resulted in low nominal returns to bonds, and negative real returns. In other words, holders of US debt lost their purchasing power year after year for 15 years, but with no damage to the broader economy.

They effectively locked bondholders in the barn and then burnt down the barn.

This policy manoeuvre has become known as 'financial repression'. As Carmen Reinhart observed in an IMF working paper in 2015, this 'financial repression tax' is a transfer from creditors to borrowers.

Three ticks in the policy boxes

So could we see policymakers following the same playbook today? We are already seeing evidence of this around the world, and even here in Australia.

1. Limits on the rates payable on government bonds? Tick. In March, the RBA announced a target for Australian three-year debt of 0.25%, with the potential to extend this into longer durations. This is also known as yield curve control (it's now 0.1%).

2. Limits on the ability to sell bonds? Tick. Prudential regulations imposed on banks have gradually increased their requirement to own government debt. The budget’s recent measure to scrutinise superannuation funds’ performance could also result in funds owning more government debt to be more in line with bond indices.

3. Set up for inflation? Tick. The RBA’s stance is to "maintain highly accommodative policy settings" until inflation is within the 2-3% target band.

This playbook is unlikely to play out in the next year or so, since – hand sanitiser and face masks aside – the effects of the pandemic are broadly deflationary. But, in time, the extreme fiscal stimulus being deployed in Australia and elsewhere is likely to have a tightening effect on prices.

 

Kate Howitt is a Portfolio Manager for the Fidelity Australian Opportunities Fund. Fidelity International is a sponsor of Firstlinks.

This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL 409340 (‘Fidelity Australia’), a member of the FIL Limited group of companies commonly known as Fidelity International. This document is intended as general information only. You should consider the relevant Product Disclosure Statement available on our website www.fidelity.com.au.

For more articles and papers from Fidelity, please click here.

© 2019 FIL Responsible Entity (Australia) Limited. Fidelity, Fidelity International and the Fidelity International logo and F symbol are trademarks of FIL Limited. FD18634.

 

  •   24 November 2020
  •      
  •   

 

Leave a Comment:

RELATED ARTICLES

The three main factors when the next storm hits

Investors face their own Breaking Bad moment

When do fundamentals matter?

banner

Most viewed in recent weeks

It’s time for LICs to die

A high-profile dividend cut and a prominent fund manager’s apology have reignited a long-running debate. If investors can access similar exposures more cheaply and efficiently elsewhere, what exactly is keeping LICs alive?

Testamentary trusts survived the trust tax. The drafting battle has just begun.

The fight over testamentary trusts looked settled. Then the draft legislation arrived. Hidden in a technical detail is a question that could force many families to rethink wills they thought were already future-proof.

The new capital gains tax trap for your portfolio

Investors have long accepted one portfolio rule without much question. A major tax shift could change that calculation entirely, forcing difficult trade-offs between risk, discipline and an overlooked cost lurking beneath.

The retirement scorecard: how many of these questions can you answer?

From the maths of retirement, estimating spending and picking the right asset allocation to survive a poor decade, here are the questions every retiree – current or future – should be able to answer for themselves.

How the typical Australian Family could save $844,350 in taxes

The value of a testamentary trust is not determined by wealth alone. Depending on circumstances, it can reduce the tax burden on inherited income, create efficiencies and help build intergenerational wealth.

The housing slide could become a crash

House prices are sliding across Australia, yet the most dangerous ingredient for a housing crash is still missing. If job losses surge amid growing economic risks, today's correction could become a historic property downturn.

Latest Updates

Testamentary trusts: Treasury has picked the wrong reading

A decades-old estate planning tool has survived one tax crackdown only to be caught by another. The surprise isn't who the reform is targeting, but who could end up paying the price for drafting choices made years ago.

Latest from Morningstar

Does an American retirement rule work for Australians?

The 4% rule has survived decades of scrutiny, but Australia's retirement system changes the equation in ways most overlook. Before accepting or rejecting this rule of thumb, it pays to understand what really drives retirement outcomes.

Shares

Glencore lands on the ASX. Should BHP and Rio shareholders switch?

A coal-heavy miner with governance concerns isn't the obvious choice for investors. Yet, Glencore's ASX listing may offer something BHP and Rio can't. The challenge is working out whether the opportunity outweighs the risks.

Why does the system treat capital gains and losses differently?

Investors are often told not to let tax policy drive their investment decisions. Yet, under the new CGT rules, portfolio construction, volatility and even how assets are owned may have an outsized impact on their final outcome.

Economy

Three common sense reforms that Australia needs

What do frozen bank accounts, mortgage traps and pension penalties have in common? They're all symptoms of a system that makes life much harder. Yet the obvious solutions seem to have escaped the attention of Canberra.

Shares

The hidden cost of government debt for investors

Some of the important effects of rising public debt never make the headlines. Research shows the immediate effects may already be unfolding, influencing corporate behaviour in ways that many investors would never suspect.

Investment strategies

When do fundamentals matter?

Is fundamental investing losing its grip on markets? Investors continue to search for valuation-based explanations for every price move, but the dominant force behind short-term returns may be something else altogether.

Sponsors

Alliances

  • ASA-Logo-RGB-ActiveGreen-web.png

© 2026 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.