Market Perspectives March 2024
Amid hot equity markets and receding hopes of early rate cuts, find out our latest views on global themes, trends and events influencing investors.
Debt sustainability
01 March 2024
Lukas Gehrig, Quantitative Strategist, Zurich, Switzerland
Please note: This article is more technical in nature than our typical articles, and may require some background knowledge and experience in investing to understand the themes that we explore below.
Please note: All data referenced in this article are sourced from Bloomberg unless otherwise stated, and is accurate at the time of publishing.
Government debt ratios are now close to those seen at the heights of world-war financing, after trending higher over the last three decades (see chart). Yet politicians around the world are passing gargantuan bills to fund the coming green economy.
This article explores how deep the seemingly inexhaustible fiscal wells are. Is there a debt limit for governments? And at which point should investors care?
Public debt financing exploded between the global financial crisis and the COVID-19 pandemic, perhaps giving the impression that debt ratios can only go up. However, massive funding needs are soon followed by austerity and – in some cases – debt cuts, if history is a guide.
Historic gross-debt-to-nominal-gross domestic product ratios in the US, Japan, the UK and Italy suggest that wars and pandemics have been the most explosive and notable events
The big surges in debt ratios have often been about protecting an economy, whether by expanding the military budget or keeping it afloat during a pandemic. But the green economy bills, like the European Green Deal or the UK’s Net Zero Strategy: Build Back Greener, are planned expenses aimed at growing the economy in the future.
Research on the effectiveness of debt suggests that an economy’s productivity (and therefore attractiveness for investors) reacts well to debt increases – up to a certain point. Investments like digging tunnels or building hospitals and schools can have net-positive effects on government finances by increasing economic efficiency and tax returns. But at some point, fiscal policy may run out of good ideas for stimulative infrastructure projects. Academics call this effect “fiscal fatigue”.
Pinpointing when infrastructure projects become more about political goals rather than economic ones depends not only on efficiency gains but also on the cost of servicing the debt. Our research suggests that debt issuance could still raise productivity up to around 170-180% of gross domestic product1.
Beyond this point, the costs of additional debt issuance seem to offset the benefits. However, by no means does this mean that a government should aim for this debt ratio, as it would be left ill-equipped to address urgent crises.
But fiscal fatigue is only the tipping point at which drawing water from the well becomes more of a cost than a benefit – it is not the point at which the well runs dry. Finding the limit on debt is even more difficult than fiscal fatigue. In theory, it is related to two factors:
Given our estimates for fiscal fatigue and today’s g-r difference, the US could afford debt of eight times as large as gross domestic product (GDP) without it becoming unsustainable. Meanwhile, Greek and Italian debt already appears to be untenable.
However, while making some headlines, Italian government finances are currently not the financial world’s main worry. If this was the case, the cost of debt servicing could soar quickly, even hitting growth: a perfect storm that could trigger another European debt crisis. As such, investors should note that g-r is dynamic and today’s estimate does not seem to be at crisis levels.
Undoubtedly, g-r is a very important metric when assessing government debt. The US administration operated with g-r at around 2.5% in 2023. This means that only primary deficits larger than 2.5% would increase the debt ratio. But why is the US metric so large compared to countries like the UK (see chart)?
The difference between an economy’s ten-year average growth rate and the cost of servicing public debt (g-r) reflects a country’s fiscal strength
The answer lies more in low “r” than in high “g”. It is because creditors receive more than just the monetary interest paid. Some debt certificates – first and foremost the US ones – provide a very liquid store of value.
Most government debt acts as a counterbalance to equities: they appreciate in recessions as central banks cut rates, yields fall and existing government bond prices rise. These additional benefits, which can be strengthened by central bank credibility, put markets at ease and lower the cost of servicing the debt.
The potential future paths for r and g are what investors should focus on when deciding their asset allocation. Not all government debt is equally safe and none is always “risk free”.
Despite US debt accumulation being above g-r, the country’s bonds remain a desirable investment, for now. However, European government debt harbours many structural weaknesses that could prompt investors to “probe the depth of the well”. When this point will be reached is uncertain, but probable dates will likely be linked to the years when much debt matures.
Amid hot equity markets and receding hopes of early rate cuts, find out our latest views on global themes, trends and events influencing investors.
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Following the methodology used by Ghul et al (2013) we estimated fiscal reaction functions for 23 advanced economies using data from 1980 to 2022.Return to reference