Drowning in debt
The IMF recently warned of a “massive” increase in public debt as governments around the world pump unprecedented levels of stimulus into their economies.
Globally, net public debt will rise from 70 percent of national income last year to 85 percent in 2020. Meanwhile, New Zealand’s public debt is expected to more than double from under 20 percent to well above the 50 percent by the mid-2020s, a level not seen since the early 1990s.
By international standards, New Zealand’s public debt projections seem modest, but in the context of our already high levels of household debt are we relegating ourselves to a tepid, low-growth recovery?
How much debt is too much?
Expert opinion is divided about how much public debt is acceptable, and a lot depends on a country’s capacity and willingness to repay. Countries with chequered histories of servicing their debts may struggle to find sources of lending or to sustain high debt levels. However, unlike many of its trading partners, New Zealand’s government debt leading into the pandemic was relatively low.
Treasury’s advice in 2019, given our small size and high levels of personal debt, was that public debt should not exceed 50 to 60 percent of GDP with a “prudent” level of 30 percent to give a buffer against future shocks. Therefore by mid-2020 if current forecasts hold, we will have reached the top of the range.
Public Debt as % GDP New Zealand
Even at this level, public debt will be low by global standards. For instance, the IMF’s framework for Debt Sustainability Analysis suggests that advanced economies should not go above 85 percent debt to GDP to avoid the risk that debt will be unsustainable. There is a lot of debate about whether there is an “upper limit” on the amount of sustainable public debt for advanced countries particularly when interest rates remain below growth rates.
Negative impact on growth?
One of the common concerns about high levels of public debt is that it will constrain a country’s ability to grow which can be particularly painful after a recession. However, whether this is true, and what level of debt will strangle growth is widely contested. IMF research suggests that there is no simple threshold over which debt leads to lower growth, although it may lead to more volatile growth.
While countries with very high levels of debt tend to grow slowly, it seems there are no conclusive studies that show a direct causal link between high public debt and growth.
To pay it off or not?
Attempting to bring debt levels under control by reducing spending or raising taxes can itself be a drag on economic growth.
Using taxation as a way to raise money is falling out of favour with policymakers because of its negative impact on corporate investment and consumer spending which in turn dampens long-term economic growth. The IMF even advised in 2015 that for countries not likely to enter a fiscal crisis “raising distortive taxes merely to bring the debt down is a treatment cure that is worse than the disease.” They suggest the best solution is to learn to live with the debt as long as it is sustainable.
This is the approach the U.S. used to bring down its government debt from the 1945 peak of 112 percent of GDP. In the following decades, the U.S. government didn’t try to pay down its debts but rather relied on economic growth, moderate inflation, and low interest rates to reduce the debt. As a result, by the mid-1970s, public debt to GDP had dropped to around 20 percent.
Worryingly high household debt
Unlike government debt, New Zealand had some of the highest levels of household debt in the OECD, even before the pandemic struck. Most of this is mortgage debt due to the high cost of housing. Household debt to GDP reached an all-time high of 94 percent in 2019 compared to a low of 28 percent in 1990 (when government debt was similar levels now being forecast). This makes households particularly vulnerable in a downturn, as evidenced by the number of households who are already slipping behind on mortgage payments.
Household Debt as % GDP New Zealand
Economists Atif Mian and Emil Verner of Princeton University and Amir Sufi of the University of Chicago suggest high levels of household debt are a predictor of economic instability and lower economic growth. Ultimately, this can make the economy more susceptible to further recessions in the future. According to the Bank of Economic Settlements, household debt starts to impact on GDP growth when the ratio to GDP exceeds 80 percent, a point which New Zealand passed over a decade ago.
The net effect is the government will need to spend more and for longer to prop up the economy. As Ezra Kein wrote in the Washington Post “indebted households can’t spend, which means businesses can’t spend, which means that unless government steps into the breach in a massive way or until households work through their debt burden, we can’t recover.”
Expect to see more jobs programmes, sustained low-interest rates and even tax cuts, to support employment and give households a chance to pay down their debts over time.
Some have even called for household debt to be partially written-off or refinanced by the government on the basis that this is a relatively inexpensive way to avoid the drag on economic growth. Despite the potential moral hazard of this approach the argument is that cancelling personal debt and resetting the household balance sheet would be a better outcome — not only for individuals stuck in a debt trap, but for economy as a whole.