Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 358

The uncertainties of using debt in a time of crisis

Even before COVID-19, there were few topics as polarising in politics and economics as the size and rectitude of government debt levels around the world. Fighting to avert economic depression and keep the financial system operating in the face of a ‘once in a lifetime’ global financial crisis (GFC), governments ran up towering fiscal deficits that, in most cases, are still with us today. Now, little more than a decade on, instead of being the once-in-a-lifetime event it was touted as, the GFC is looking like a mere entrée to the main Covid-19 borrowing event.

Cheque, please?

According to the IMF, gross government debt will rise by a staggering US$6 trillion in 2020, a greater increase than was seen in any of the years of the GFC. Moreover, it is a rare optimist that thinks 2020 will see the end of this pandemic, or its economic damage.

Figure 1: General gross government debt to GDP – G7 countries and Australia

Source: IMF, Fiscal Monitor – April 2020

The post-GFC debt burdens were highly divisive. In academia, a significant split emerged: Are higher levels of national debt dangerous, or do they represent prudent policy at a time of low interest rates? In 2010, two Harvard economists, Carmen Reinhard and Kenneth Rogoff, published a paper which argued that increased levels of government debt lowered a country’s rate of economic growth. Importantly, their work identified a number of key tipping points, the most alarming being when a country’s public debt to GDP ratio exceeded 90%, its economic growth should be expected to halve. With many countries’ debt levels then precariously close to this level, their analysis became a rallying cry for those that believed in fiscal prudence and austerity.

Embarrassingly, critics later uncovered a series of errors within Reinhard and Rogoff’s analysis. And while subsequent papers by the authors, and independent work by the IMF, also found that rising levels of debt do reduce economic growth rates, the relationship was weaker than previously thought, and there was little evidence to support the 90% debt-to-GDP tipping point. However, by then, the schism within the field of economics was already entrenched.

The most favoured and least painful solution to all debt problems is to grow your way out of them. When viewed in this way, increasing levels of government debt can be thought of like a factory that takes out a loan to expand. So long as the investment increases earnings by more than the interest on the loan, over time, the higher earnings pay back the debt.

What matters less than the size of debt, then, is its cost and whether it will be put to productive use. Across the rich world, government borrowing costs have fallen to almost zero, in some countries they are even negative. Faced with the prospect of ‘free’ money, who wouldn’t want to invest to expand the factory? When considering genuine long-term investment into an economy’s future capacity, this logic is hard to fault. When the Australian government can lock in ten-year debt today at less than 1% per annum, how could there not be a better time to be building the hospitals, airports and roads of the future.

Have cheque book, will spend

Taken to its furthest, the debt is ‘costless’ argument forms the foundation of some of the more extreme economic ideas that have arisen since the GFC, such as Modern Monetary Theory (MMT). In essence, the key insight of MMT is that government borrowing is manifestly different from the borrowings of households or businesses. Why? Because if governments can issue their own money, their supply of currency is endless.

If you need to stimulate the economy, or want to embark on some Gosplan-like spending initiative (in the US, some proponents of MMT see it as a way to pay for things like a ‘Green New Deal’), all you need to do is increase the deficit. If interest rates go up in the future, and debt is no longer so cheap, you just borrow to meet those costs too.

In their defence, the more reasoned MMT campaigners do not claim that large government deficits have no consequences at all. Rather, they claim there is significantly more capacity to use government debt than we have historically believed. Japan is typically held up as an example, having successfully managed debt to GDP ratios of >200% for many years. Perhaps undermining this, however, Japanese growth rates have collapsed in tandem with the country’s ever-increasing debt load.

Ideology is like your breath: you never smell your own

The truth is, we still have an incomplete understanding of the long-term consequences of large national debts, and there exists enough intellectual cover for those on both the left and the right to advocate their existing ideological positions. In politics, the media and around the dinner-party table, most people’s views on the virtues of government debt were firmly established before the pandemic struck. What is unfortunate about this is that it is going to make a reasoned debate about the challenges to come almost impossible.

Given all of this, perhaps it is best to acknowledge that, regardless of its impact on growth, increasing levels of debt indisputably escalate overall risk, and tie our hands in the future.

Today, countries that have treated national indebtedness as a scarce resource outside of times of crisis are the ones that find themselves with the greatest capacity to protect their economies. For years, Germany was criticised for pursuing its schwarze Null (black zero) policy—a commitment to run government surpluses. Vindicated today, and uniquely in Europe, Germany has had the ammunition to launch a substantial stimulus plan. Luckily, Australia also finds itself in this camp and has launched the second largest economic stimulus package in the world. Like Germany, it retains plenty of scope to add to this if needed.

We all hope that the ‘second wave’ proves to be manageable and that ultimately a COVID-19 vaccine is found. Hope, however, won’t keep the lights on if this doesn’t prove to be the case.

 

Miles Staude of Staude Capital Limited in London is the Portfolio Manager at the Global Value Fund (ASX:GVF). This article is the opinion of the writer and does not consider the circumstances of any individual.

 

RELATED ARTICLES

What should you look for when investing in private debt?

Six ratios show the market is off the charts

Retirement dreams face virus setback

banner

Most viewed in recent weeks

After 30 years of investing, I prefer to skip this party

Eventually, prices become so extreme they bear no relationship to reality, and a bubble forms. I believe we are there today, not for all stocks but for many in the technology space.

Australian house prices: Part 2, the bigger picture

There is good reason to believe the negatives will continue to outweigh the positives over the next 12 to 18 months. There is more concern about house prices than the short-term indicators suggest.

How to handle the riskiest company results in history

It is better to miss a results bounce and buy after the company has delivered than it is to step on a landmine. With such uncertainty, avoid FOMO by following these result season investing tips.

Australian house prices: Part 1, how worried should we be?

Three key indicators are useful for predicting the short-term outlook for house prices, although tighter lockdowns make the outlook gloomier. There is enough doubt to create cause for concern.

Welcome to Firstlinks Edition 367

There is a similarity between the current health crisis and economic crises of the past. For COVID-19, record amounts of biotech funding from government agencies and private companies are looking for a vaccine. Likewise, central banks once struggled treating recessions but the 'vaccine' now is record amounts of financial stimulus to ensure liquidity. While the world awaits a COVID treatment, markets are purring along, at least until side effects hit.

  • 22 July 2020

Welcome to Firstlinks Edition 369

Imagine you had perfect foresight about COVID-19 at the start of the year. You correctly foresaw that the global pandemic would kill over 700,000 among 20 million infections by August. In Australia, borders would close, cities would be locked down, most mortgagors would be on income support and companies would be allowed to trade while insolvent. You then had to guess how much the stock market would fall. Would you say about 10%?

  • 6 August 2020

Latest Updates

Shares

How to handle the riskiest company results in history

It is better to miss a results bounce and buy after the company has delivered than it is to step on a landmine. With such uncertainty, avoid FOMO by following these result season investing tips.

Shares

The rise of Afterpay and emergence of a new business model

Sometimes the simplest ideas are the best. The founders of Afterpay stumbled on the attraction for consumers of paying by instalments, and now retailers must offer the facility or lose business.

Property

WFH and its impact on Australian offices and tenants

Although most office workers are currently WFH, an energy and a buzz comes from working in the same physical space. Other benefits include team building, relationships, talent mentoring and creative collaboration.

Fixed interest

Why 2020 has been the year of the bond market

Going back to June 2019, investors would have questioned the logic of diversifying away from outperforming growth assets. But when markets feel at their best, it is paramount to keep a perspective on long-term goals.

Investment strategies

Is 5G all hype or real investable opportunity?

While its impact will take time to unfold, 5G will meaningfully change the world. Once adoption takes hold, there is huge potential for its application across a wide range of industries.

Property

Australian house prices: Part 1, how worried should we be?

Three key indicators are useful for predicting the short-term outlook for house prices, although tighter lockdowns make the outlook gloomier. There is enough doubt to create cause for concern.

Property

Australian house prices: Part 2, the bigger picture

There is good reason to believe the negatives will continue to outweigh the positives over the next 12 to 18 months. There is more concern about house prices than the short-term indicators suggest.

Sponsors

Alliances

© 2020 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.
Any general advice or class service prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, has been prepared by without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG) for more information. 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.