While unfavourable structural factors may continue to hamper economic growth, if we befriend and control inflation, we might be able to recoup faster
By Ajit Pai & Utkarsh Katyaayun
Economic disruptions caused by the Covid-19 pandemic may take the global economy towards an economic depression in the coming decade due to a sudden increase in debt at the confluence of high and rising global debt to GDP, increasing geopolitical instability, and other weakening fundamentals for economic growth. Large OECD countries, with high debt relative to GDP and ageing populations, face the highest risk.
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Global debt as a percentage of global GDP is set to rise to more than 300% by the end of 2020, as major economies continue taking measures to finance spending on public health and economic stimulus packages amidst the Covid-19 pandemic and contracting global GDP. Debt rarely rises linearly; it goes through several leveraging (increasing debt to GDP) and deleveraging (falling debt to GDP) cycles, rising faster relative to income in a leveraging cycle, but not necessarily falling to pre-cycle levels in the deleveraging phase. Low interest rates encourage accumulation of debt over time. Large debt accumulated in a low interest rate environment, becomes unsustainable when interest rates rise materially. Thus, interest rates impact leveraging and deleveraging cycles. The accumulation of debt over several leveraging and deleveraging cycles most often leads to a precarious level of debt, which has historically culminated into or coincided with a revolution or a war or a regime change.
In the US, the world’s biggest economy, there are parallels in debt to GDP and interest rates between today and the 1930s. US federal debt to GDP started rising during World War I (1918) to the highs reached during the US Civil War (1860s) leading up to the Great Depression (1930s), a U-shaped pattern over 70 years.
Similarly, the US federal debt to GDP started rising in the 1980s and may now breach the highs reached during World War II (1945), a U-shaped pattern over 75 years. Like the 1930s and 1940s, interest rates have been close to zero since 2008. Today’s scenario of debt and interest rates rhymes with the 1930s.
Another similarity to the 1930s, is rising political tension among countries. Two noteworthy instances of the last decade are the political uncertainty in Europe during the European sovereign debt crisis and the more recent political tensions evident during the US-China trade war. Rising uncertainties due to political tensions negatively impact trade, which has been a material driver of global economic growth since World War II. Since the Global Financial Crisis (2008), global trade as a percentage of global GDP has plateaued, contributing to further limiting economic growth. Global GDP grew at only around 2% per year between 2011 and 2018, as compared to around 8% per year between 2001 and 2010. Historically, political tensions in a high debt environment have led to revolutions or regime changes. For instance, the Seven Years War (1756-1763), which was fought because of rising tensions between the Kingdom of Great Britain and France, further pressured France’s already high debt to GDP. It has been argued by many that to reduce the debt burden, the poor were taxed more, which increased income inequality in the society, caused social unrest, and lead to the French Revolution.
Another weakening driver of long term growth is demographics. The age dependency ratio started rising for Japan since 1993 and for the EU since 2003 (the ratio for Italy and Germany started rising around the 1990s). The ratio for China also started rising around 2010. This has been, and will continue creating headwinds for economic growth rates. What makes global growth prospects dimmer is that, amongst large economies, these countries have the highest debt levels relative to their GDP, possibly due to rising debt compensating for slowing population growth and slowing trade & productivity growth given that these economies were strong trade and productivity growth drivers early on.
High and rising debt levels are sustainable as long as they are accompanied by a similar pace of economic growth. Global economic growth was already weak when the Covid-pandemic struck. The recent lockdown, to slow down the virus spread, further weakened prospects of economic growth acceleration. It is highly unlikely that negative interest rates are sustainable for an indefinite period of time, and thus, a deleveraging may eventually occur in most large OECD economies. If this deleveraging is deflationary in its effect, it will increase the real value of debt burden, making debt servicing more difficult, and leading to bankruptcies, which may further increase the already rising unemployment, further hampering economic growth, and commencing a vicious cycle. This may lead to a global economic depression in the coming decade, if not in the coming years.
To prevent a depression, it is important to be able to service the high levels of debt despite low real economic growth. This can be achieved through controlled inflationary policies, which in the short run will afford some relief to challenged borrowers, and in the long run, will help in reducing the real value of debt. It is extremely important to minimise the number of bankruptcies over the coming few years to reduce the period of sluggish growth. While unfavourable structural factors may continue to hamper economic growth, in a high debt and low growth environment, if we befriend and control inflation, we might be able to recoup faster.
The authors are with the Economics and Finance Cell, NITI Aayog. Views are personal