Governments’ Risky Debt Games

Reuters columnist Jamie McGeever recently raised an alarm that the chances of governments anywhere finding fiscal discipline in today’s world lie somewhere between slim and none.

Although economic growth ​has been resilient in recent years, the fiscal picture has deteriorated. Public debt in the U.S. and many developed economies is the highest in decades as a share of gross domestic product, excluding the pandemic distortions of 2020, in some cases the ‌highest since World War Two. The International Monetary Fund beat a ‌familiar drum at its spring meetings this month, calling on governments to reduce their deficits and debt. The window for an “orderly” adjustment is closing fast, and the fiscal buffers needed to stabilize debt-to-GDP ratios have all but disappeared. “Credible, well-sequenced fiscal adjustment ⁠is urgently needed across all ⁠country groups,” the IMF said. Good luck with that. In a balkanized world where countries are scrambling for tech, energy, defense, resource ​and supply chain security, this debt binge is unlikely to slow, never mind reverse.

None of this is really news. Countries have been scrambling for all these things and more for years. The politicians and bureaucrats who run governments in every country of the world know it and the potential consequences of it getting out of hand. Not only do they know all this, but they also keep doing it.

These public officials do it because they have an inherent incentive problem. The benefits they get from their bad fiscal policies mean more to them than just about everything else. In no small part because they believe such bad policies are vital to their staying in power.

The real question is, why are these fiscally unhealthy governments able to keep borrowing? The institutions that lend big money to spendthrift governments have to know all this stuff, too. What’s in it for them if there’s a rising risk they won’t be repaid on their loans to the debt-laden governments with worsening fiscal outlooks?

McGeever finds a depressing answer to that question:

Is this debt-laden outlook reflected in today’s market prices? Not if you ask BNP Paribas strategists, who recently referred to fiscal risks as “highly underpriced.” Or, perhaps investors do recognize the risks but are simply willing to take the gamble because they assume the benefits of loose fiscal policy—like a potential boost to a range of industries, sectors and assets – offset the risk of any wide-scale debt crisis. What’s more, fiscal taps may need to remain open if the global economy is going to be robust enough to meet aging ⁠societies’ needs. As fund manager Jeroen Blokland put it, “You buy GDP growth with debt,” and debt sustainability “hinges on low interest rates and high inflation.”

In other words, as ⁠long as the real rate of economic growth is higher than inflation-adjusted interest rates, today’s debt and deficit dynamics need not prove unsustainable. The debt will be inflated away at the margins, and, in theory, the price of risk assets should continue rising.

Let’s give this risky scheme a name and call it what it is: “financial repression.”

When politicians start playing the financial repression game, it goes well enough at first. They get a boost of GDP growth, which sets up the next round. It seems so easy.

Like drug addicts, they soon find their next boost doesn’t live up to the first when they try to repeat it. The next time they borrow to “buy GDP growth”, they get less bank for their borrowed buck.

Their only option is to jack up borrowing to fund their excessive spending habit. But even that has diminishing returns. That’s because repeating the game progressively chokes off productive investments in the private sector. That makes it increasingly difficult for the economy to grow as the borrow-and-spend game repeats.

As they say, “play stupid games, win stupid prizes.” It’s what politicians and bureaucrats do, all the way up to when the fiscal reckoning can no longer be put off and the crisis arrives.