The Bank for International Settlements announced last week that global debt markets grew to $100-trillion at the end of 2013, up 40 per cent since 2007. Governments accounted for two-thirds of this increase as policymakers borrowed to spend their way back to growth.
Fiscal stimulus was the right response to the Great Recession, but this mountain of debt is not going to be repaid. The last five decades have been marked by progressively more complicated and expensive financial meltdowns. J.P. Morgan CEO Jamie Dimon infamously cautioned in 2010 that we should expect crises “every five to seven years.” He’s right: more sovereign debt distress lies ahead. We need to get ready for them.
Although government bond markets in the European periphery have rallied since the beginning of 2014 and the U.S. recovery has gained momentum, the global economy remains fragile.
As the U.S. Federal Reserve has tapered its purchases of debt securities, the “wall of money” that moved into emerging markets a few years ago has receded back to advanced economies. No emerging country has been insulated from this financial riptide. In fact, some of the best governed and most liquid markets have borne the brunt of this retreat because exiting them is relatively easy.
Unlike past episodes of sovereign debt distress, however, both emerging and developed markets are vulnerable.
The International Monetary Fund has warned that lower-than-expected inflation in the euro zone implies higher real interest rates and greater real debt burdens, which could dent demand, lower growth and push Europe into deflation – making its debt load even more onerous. Japan’s experience remains a cautionary tale: since it slipped into deflation in the mid-1990s, its public debt has ballooned from 80 per cent of GDP to nearly 230 per cent.
The ratio of debt to GDP across industrialized countries has increased by 30 percentage points since the onset of the crisis and now approaches 110 per cent of GDP – well into the danger zone where governments typically encounter problems servicing their debt. This kind of increase happened twice during the 20th century. On both occasions the spike in debt was unwound quickly by subsequent growth spurts. That’s unlikely to happen now.
While exceptional monetary and fiscal stimulus is withdrawn, interest rates will trend higher than GDP growth rates. Reducing public debt ratios will then require more aggressive fiscal consolidation, which could further hurt growth. Ageing populations will push up spending and narrow tax bases, making the fiscal situation worse. In our forecasts, by the 2020s, gross public debt could, under reasonable assumptions, easily rise to 150 per cent of GDP across advanced economies.
Yet, despite a history of sovereign defaults spanning 24 centuries from ancient Athens to the present, we still don’t have an effective and efficient system for dealing with governments in financial distress. As Petros Christodoulou, former head of Greece’s public debt office recently noted, “the system needs to be fixed. We should have a predictable framework for restructurings that ensures that other countries do not have to go through what Greece did.” Even after two restructurings and years of austerity, Greece’s debt is still not sustainable despite concerted support from the IMF and European institutions.
More than a decade ago, the IMF undertook a massive effort to build a Sovereign Debt Restructuring Mechanism (SDRM) into its operations. In 2003, the SDRM was rejected as several countries were unwilling to cede the sovereignty necessary to make the SDRM function. Work in this critical area was put on ice.
Recent experience shows, however, that the status quo is both inadequate for our current challenges and woefully under-gunned for the crises that lie ahead. The system has always been tipped toward cleaning up messes rather than preventing them.
After 24 centuries of business as usual, it’s time to do things differently.
In a 2013 policy paper, the IMF diagnosed the problem that needs to be solved: troubled governments wait too long to deal with their debt problems, which deepens their pain and limits their options when crises occur. When they finally bite the bullet and approach their creditors for assistance, sovereigns tend to agree to debt restructurings that are too modest in an effort to quickly regain access to financial markets.
While there’s no appetite for another big-bang reform like the SDRM, some modest changes could significantly improve the lot of distressed sovereigns.
Most importantly, we need to reduce the impediments to governments and their creditors proactively dealing with incipient crises. To do this, we’ve proposed the creation of a Sovereign Debt Forum (SDF) to provide a structured venue for early collaboration to prevent sovereign liquidity problems from developing into fully-blown defaults and to do ongoing research on future policy reforms.
We should also discuss ways to provide sovereigns with some breathing room to consider their options when crises develop. As Bank of Canada economists have advocated, governments should consider issuing bonds that automatically provide a hiatus from debt-service obligations when economic conditions sour – when, for instance, growth slows or export prices plummet.
Finally, we should consider ways to refine bond contracts so that the terms of a debt rescheduling can be made to stick once they have been agreed.
None of these initiatives would require negotiation of binding treaties, the creation of new multilateral organizations or onerous reforms to our existing bodies. They simply require a few governments to begin taking action.
Canada has a rare opportunity to lead change that’s been 24 centuries in the making.
Richard Gitlin and Brett House are Senior Fellows at the Centre for International Governance Innovation (CIGI); House tweets at @BrettEHouse.