The debt tree must stop growing

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“If something can't go on forever, it will stop.” This is known as Stein's Law, named after the late Herbert Stein, former chairman of Richard Nixon's Council of Economic Advisers. Stein published this in June 1989, referring to the US trade and budget deficits. They haven't stopped yet! But as an equally important German proverb says, “Trees do not grow to the sky.” At some point, the weight of the tree becomes unbearable. This also applies to financial debts. Limits on debt exist in every economy, even one as strong as the United States.

In a recent blog titled “Financial and Fiscal Risks of an Indebted, Slow-Growing World,” Tobias Adrian, Vitor Gaspard, and Pierre-Olivier Gorinchas explain the dynamics of today's global situation. Broadly speaking, they note that debt sustainability depends on four elements: initial balances, economic growth, real interest rates, and debt: “Higher initial balances—the excess of government revenues over expenditures, excluding interest payments—and growth help achieve debt sustainability.” , while higher primary balances—the excess of government revenues over expenditures, excluding interest payments—and growth help achieve debt sustainability, while debt sustainability depends on four elements: primary balances, economic growth, real interest rates, and debt. High interest rates and debt levels make it more difficult.

The global financial crisis that struck the world in 2007, the 2020 pandemic, and the subsequent pandemic caused huge jumps in public debt-to-GDP ratios in high-income and emerging economies. By 2028, this percentage is expected to reach 120 and 80 percent, respectively. In the first case, these percentages are the highest since World War II. In the latter case, this is the highest ever.

Debt dynamics have been very favorable for a long time, partly due to very low real interest rates. But now everything is more difficult. “Medium-term growth rates are expected to continue to decline on the back of modest productivity growth, weaker demographics, weak investment, and continuing scarring from the pandemic,” the authors say. Aging also directly increases public spending pressures. Moreover, even if short-term real interest rates—the so-called “natural interest rate”—fall to low levels again, as seems likely, long-term real interest rates may not, partly because of recent jumps in interest rates. interest rates. Risk perception. The “term risk premium” has recently risen significantly.

Thus long-term real interest rates may remain persistently high, partly because of perceptions of inflation risk, partly because of quantitative tightening, and partly because fiscal deficits in many countries are expected to remain large. All of this threatens to create a vicious cycle in which high perceptions of risk push interest rates above potential growth rates, thus making financial positions less sustainable and keeping risk premiums high. High financial debt also exacerbates the threat to the “bank-sovereign nexus,” as weak banks raise concerns about the ability of sovereigns to bail them out, and vice versa.

The situation in the United States is arguably the most important of all. In Budget and Economic Outlook: 2024 to 2034, the nonpartisan Congressional Budget Office notes that “the public's debt is rising every year relative to the size of the economy, reaching 116 percent of GDP in 2034 — an even greater amount.” Ever in the nation's history. From 2024 to 2034, increases in mandatory spending and interest costs will exceed declines in discretionary spending, revenue growth, and the economy, causing debt to rise. This trend continues, pushing the federal debt to 172 percent of GDP in 2054.

Only a brave economist could insist that this could go on forever. To be sure, at some point, Stein's Law will bite: investor resistance to further rises in debt will rise, and then monetization, inflation, financial repression, and global monetary chaos will ensue.

Here are three facts relevant to the United States: First, by 2034, mandatory federal spending is expected to reach 15.1% of GDP versus total federal revenues of just 17.9%; Second, federal revenues amounted to only 73% of expenditures in 2023; Third, the primary balance has been in persistent deficit since the early 2000s. All of this shows how extremely difficult it will be to control the overall deficit.

More importantly, politics is vehemently against it. Since Ronald Reagan, Republicans have become indifferent to balancing the budget. Their goal instead is to reduce taxes. Bill Clinton and Barack Obama have made serious attempts at fiscal prudence. But this allowed George W. Bush and Donald Trump to cut taxes. Now Democrats have decided that a scorched earth policy is a better strategy. So both parties will happily run huge deficits – and let the future take care of itself. How long will this last? Not forever. As the late Rüdiger Dornbusch warned: “In economics, things take longer than you think, and then they happen faster than you thought.”

Some economists seem to believe that the demand for sovereign money is infinite: as long as there is some slack in the economy, the government can keep printing. But escape from the king's money could easily happen before then. Others believe that if borrowing turns into a profitable investment, it will pay for itself. What borrowing is used does not matter. But the relationship between illiquid assets and the ability to service debt is imperfect.

Prudent sovereigns, even powerful ones able to borrow in their own currencies, cannot escape an explosive debt trajectory forever. “First and foremost, countries must begin to gradually and credibly rebuild their fiscal buffers, and ensure the long-term sustainability of their sovereign debt,” the IMF blog says. This is all wise. But the fiscal pressure will also require increased spending elsewhere, some of it abroad. The best approach is to start soon, adapt slowly, and coordinate at the global level. What are the chances of anything being too plausible? Close to zero, unfortunately.

martin.wolf@ft.com

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