Satyajit Das: The impossible puzzle: how to reduce debt without growth

Economic Outlook: Greece may be only the first carriage of the Sovereign Debt Express to go off the tracks
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The Independent Online

In 2012, governments around the world will need to refinance around $7.6 trillion in debt (see table); $8 trillion if interest is included. A central part of the debate is how much government debt is too much. The unsustainability of sovereign debt levels above 60 per cent – 90 per cent of a country's gross domestic product proposed by economists Carmen Reinhart and Kenneth Rogoff, is accepted wisdom.

In practice, the level of sovereign debt acceptable to investors is more complex, depending on a combination of factors. One factor is the currency of that debt. The US, Japan and the UK have all benefited from the fact that its sovereign debt is denominated in its own currency.

Where it borrows in its own currency, a sovereign's capacity to borrow is only constrained by the willingness of investors to purchase its securities and the cost of that borrowing.

Where the borrowing currency is a major reserve currency, used in global trade or favoured as an investment by central banks, the scope for borrowing is higher. The ability to print money to service debt theoretically ensures repayment if not the purchasing power of the debt.

Substantial domestic savings, like in Japan, enhances the ability of the government to finance its expenditure. A nation can mandate domestic investors to purchase its debt through specific regulations. A country reliant on foreign investors for its funding is far more restricted.

A significant portion of government debt of weaker European states is held by foreign investors – Greece (91 per cent), Ireland (61 per cent), Portugal (53 per cent) and Italy (51 per cent). For some stronger nations, the level of foreign ownership is also high – Belgium (58 per cent), France (50 per cent) and Germany (41per cent).

In contrast, only 28 per cent of Spanish debt is held by foreign investors. Most of this debt is held within the Eurozone as the average holding of government debt outside the area is 25 per cent. The portion of government debt of other large economies held by foreign investors is lower – US (30 per cent), UK (19 per cent) and Japan (15 per cent).

The level of interest rates also determines the level of acceptable debt. Higher interest rates and the resultant larger claims on public revenues to service the borrowing limit the level of debt.

Extremely low interest rates, such as those in many developed economies including the US, Japan and the UK, allow higher levels of borrowing. However, a significant level of debt also increases exposure to interest rate increases.

A further consideration is the maturity structure of the debt. Short-term debt increases vulnerability to market disruptions, limiting the level of borrowing. Conversely, longer maturities and low concentration of maturing debt in an individual period can increase debt capacity.

Sustainable debt levels also depend on the size and structure of the country. A large, varied economy with a substantial potential tax base can sustain far more debt than a narrowly based and tax revenue poor country.

But the most important determinant of the appropriate level of debt is current and expected economic growth. An economy capable of high levels of growth, with the attendant ability to generate additional tax revenues and attract investment, can maintain a higher level of debt than one with lower growth prospects.

The sustainable level of debt depends upon the existing level of public debt (as per cent of gross domestic product, the current budget position (per cent of gross domestic product, interest rates and growth rates as follows: Changes in government debt = budget deficit + [(Interest Rate – GDP growth) times debt]

Italy illustrates the relationship between debt levels and growth. Assuming average borrowing costs of 4 per cent and a debt to GDP ratio of 120 per cent, Italy needs to grow at 4.8 per cent just to avoid increasing its debt burden where its budget is balanced.

At current market borrowing costs of 6 per cent, Italy has to grow at a 7.2 per cent just to avoid increases in its debt levels. With a projected growth rate of only of 1 per cent to 2 per cent at best, Italy must reduce its debt levels significantly to avoid the risk of insolvency.

Assuming interest costs of 4 per cent and growth of 2 per cent, Italy would have to run a budget surplus of 5 per cent per annum for 10 years to reduce its debt to 90 per cent of GDP.

The UK's current net debt, ignoring measures to support the financial sector, is around £1,000bn (around 63 per cent of GDP). Interest costs are around £49bn, equivalent to 5 per cent per annum (around 3 per cent of GDP and 10 per cent of tax revenue). Assuming government revenues equal expenditures, Britain must grow at 3 per cent per annum just to ensure its debt levels do not rise.

In the UK, significant cuts in government spending and higher taxes to bring the budget into balance have contributed to slower growth, in turn increasing the budget deficit driving higher government borrowing requirements and overall debt levels.

The link between growth and debt levels highlights the vulnerability of any indebted economy.

Economies with debt are forced to run a budget surplus (through spending cuts and tax increases), grow at very high rates, decrease borrowing costs or combination of these to merely stabilise debt levels. Where growth slows, indebted governments can become trapped in a self-defeating cycle of ever greater cycle of austerity which compound rather than solve the problem of debt or public finances.

As Europe illustrates, budget deficits, low growth rates and increased borrowing costs can rapidly trigger a debt crisis, as investor become concerned about a nation's creditworthiness.

The ultimate challenge is to restore growth. Without growth, the problem of debt is difficult to resolve. But without debt, growth is difficult to generate. This is the impossible puzzle that governments everywhere, including the UK, are trying to solve.

In a world of low growth, Greece and the other debt burdened European countries may only be the first carriages of the Sovereign Debt Express that go off the tracks.

Satyajit Das is author of "Extreme Money: The Masters of the Universe and the Cult of Risk" (2011)