Sovereign debt is casting an ominous shadow over global markets. In January, Japan’s debt was downgraded. Two weeks ago, the sovereign-debt crisis already engulfing Greece, Ireland and Portugal seemed to spread to the bigger economies of Spain and Italy. Last Friday, Moody’s Investor Services put Spain under review for a possible downgrade. And on Tuesday, US lawmakers narrowly averted default on their country’s debt. What is going on?
What is sovereign debt?
Sovereign debt, also referred to as a nation’s government debt, is the total amount of money a country owes to its creditors. This debt comes in many forms but the most common is government bonds. If you or I need money to buy a house, for example, we will probably approach a bank for a mortgage bond. In exchange for cash up front, we promise to repay the bank the amount we borrow (the principal) plus interest. If a government needs money it does the same thing, only on a much larger scale. Instead of approaching one creditor for a loan, it approaches millions.
Rather than taking out a loan, a government issues bonds. These bonds are sold to domestic and foreign investors and basically work like a loan. In exchange for a certain amount of cash up front (the face value of the bond), investors receive a promise of regular interest payments plus their money back at the bond’s maturity date. Along with a government’s other financial obligations, these millions of loans collectively comprise a country’s sovereign debt. If a country breaks its promise to repay bondholders, it is said to have “defaulted” on its debt. Just like you or I might default on a loan.
How is sovereign debt measured?
Sovereign debt can be measured in multiple ways, but it is almost exclusively reported in the press as either a raw number (e.g. $14.3-trillion) or, to provide context, as a percentage of gross domestic product (GDP).
For measurement to be meaningful to us, it has to be relative. Saying that I owe the bank R1-million over the next 10 years, for example, doesn’t tell you very much. To put my debt into context you need to know something about my ability to repay, my salary for example. If I earn R1-million a year, I can probably repay my debt without too much trouble. If I earn R100 000 a year, however, repaying my debt may be a problem. The same holds true for governments.
To put government debt into context, we need to know something about the country’s ability to repay it. To do this, most analysts use GDP. GDP measures the total size of a country’s economy in a given year.
Let’s use Germany and Greece as real-world examples. The International Monetary Fund (IMF) estimates that Germany’s sovereign debt was €2-trillion in 2010, more than six times the size of Greece’s €327-billion debt. But Germany’s GDP was €2.5-trillion in 2010, nearly 11 times larger than Greece’s €230-billion economy. Greece’s debt as a percentage of GDP was therefore 142% of GDP while Germany’s was only 79%.
Which countries have higher sovereign debt?
Government debt in emerging economies, as a group, is much lower than in the so-called “advanced” economies of Western Europe, Japan, and America. Japan’s debt, for example was a whopping 225% of GDP in 2010 while South Africa’s was a mere 34%.
Government debt levels have been rising in the US, Europe and Japan for quite some time. The average debt level of the G7 economies (Canada, France, Germany, Italy, Japan, the UK and the US) stood at 84% of GDP in 2006. But the proverbial straw that broke many a camel’s back was the Great Recession of 2008 and 2009.
In an effort to stave off an even worse economic catastrophe than the one that occurred, governments across the globe shifted huge debts from the private to the public sector, enacted tax cuts, incurred further deficit spending and undertook a series of policies that ballooned public debt. So much so that, coupled with declining revenues in the wake of the recession, the average debt level of the G7 economies rose to 112% of GDP in 2010. To put this into perspective, that is the highest level since World War II. Many economists, investors, and credit rating agencies are concerned that debt levels will continue to increase in these countries as their aging populations drain even more money from government coffers.
Are high levels of debt a problem?
Potentially, yes. One problem with high debt levels is that, the higher they get, the more they cost. As debt levels rise, so do the interest payments associated with them. Rather than spending money on social services or infrastructure investments, governments are forced to divert more and more of the revenues they collect toward interest payments. In short, high debt levels limit a government’s policy options. For example, high debt can limit a government’s ability to undertake “fiscal stimulus”, spending increases and/or tax decreases, in times of economic distress.
A second potential problem with high debt levels is that they can also raise interest rates, making the cost of borrowing more expensive for the private sector. If borrowing is more expensive, companies and consumers tend to borrow less. This can cause private sector investment to decrease and economic growth to slow. The extent to which this occurs depends, in part, on why government borrows. If government borrows to invest in growth, for example infrastructure expansion, it may not have a detrimental impact on growth.
A final problem with high debt levels is that investors are currently concerned with them. Just as favourable investor sentiment can drive perceived values (and therefore real values) up, unfavourable sentiment can drive values down. As Yale University economist Robert Shiller points out, “something started to cause investors to fear that Greek debt had a slightly higher risk of eventual default. Lower demand for Greek debt caused its price to fall, meaning that its yield in terms of market interest rates rose. The higher rates made it more costly for Greece to refinance its debt, creating a fiscal crisis that has forced the government to impose severe austerity measures, leading to public unrest and an economic collapse that has fuelled even greater investor scepticism about Greece’s ability to service its debt.”
Can governments lower debt levels?
Yes, governments can reduce public debt levels in a number of ways. But as debt levels become higher, and crisis more imminent, the available choices become fewer.
Perhaps the most painless option for reducing high debt is to try to grow your way out of it. By pursuing policies that promote economic growth, governments can reduce their overall debt relative to the size of their economy. This approach takes time, but can eventually lower debt.
Another option available to governments is to cut spending, raise taxes or do some combination of the two to reduce borrowing. This is called “fiscal consolidation” or, when more significant in magnitude, “fiscal austerity”. The Americans and British, for example, are pursuing a strategy of fiscal consolidation to reduce their long term debt levels. Ireland and Greece have adopted fiscal austerity regimes as a condition of receiving assistance from other European nations.
In the face of an imminent crisis, governments may also try to negotiate their way out of trouble. They can do this by “restructuring” their debt, for example by lowering the interest rate on their bonds, extending the repayment period, or asking some investors to forego some of their principal. Restructuring is tricky. It involves getting bondholders and other creditors to agree to lose money. This strategy sometimes works with other governments, but often meets with fierce private sector resistance. In all likelihood, restructuring will result in a downgrade of a country’s credit rating.
Finally, governments can get rough. They can either force domestic investors to buy government bonds at artificially low rates — this is called “fiscal repression” — or they can simply stop paying investors — this is called “default”. They can also induce inflation to reduce the face value of their debt in terms of buying power. This is a strategy some have suggested the US may eventually use to “devalue” the dollar, thereby reducing its massive debt.
So what’s the problem?
Getting the policy options and their timing exactly right is extremely difficult, economically and politically. The latest economic data suggests that the current economic recovery, particularly in the US and Europe, is still precarious. Governments have been propping up the economy with massive stimulus. Some economists worry that if governments cut debt too much, too soon, the recovery may falter. Another recession is possible.
The cautionary tale, some say, is a lesson from the Great Depression which began in 1929. By 1932, the American economy bottomed out. GDP fell by a staggering 13%. The following year, however, things began to improve and by 1934 growth had risen to 11%. The economy continued to expand in 1935 and in 1936.
Concerned about record US deficits, the government cut spending and raised taxes to lower the country’s deficit. At the same time, the US Federal Reserve tightened its monetary policy stance, resulting in less bank lending. The result: by 1938, the US had significantly reduced its budget deficit. It had also thrown itself back into recession. GDP fell by 3.4% and the unemployment rate rose to 12.5%.
Sound familiar? It should. Circumstances are not exactly the same this time around, but there are some striking similarities. This is exactly the “damned if you do, damned if you don’t” dilemma currently confronting policymakers in Washington, Brussels and beyond. Let’s hope for all our sakes that, this time, they get it right.
- Matt Quigley is a former divisional director at the US Treasury’s office of the comptroller of the currency and fiscal policy analyst at the Federal Reserve Bank of Boston