The debt burden of nations has been growing in recent years. As a result of the coronavirus crisis, sovereign debt has reached a substantially higher level. Currently, the government debt of the euro area countries stands at 101.7 per cent of GDP. Concerned citizens may take some comfort in the fact that the corresponding figure for Japan is approaching 270 per cent.
For the time being, the high level of debt has not caused problems during the course of the pandemic, quite the contrary. After all, there was a problem and governments had to respond by borrowing. Of the two evils, countries made the necessary choice of increasing public debt to support the economy.
Sovereign debt not a problem at the moment
Recently, we have been hearing comments arguing that the indebtedness of countries would not pose any problems. References have also been made to the ‘modern monetary theory’, which many do not even consider a theory to begin with. The argument goes that a country borrowing money in its own currency could go on borrowing practically without a ceiling. A limit, if any, would be imposed by the resources of the economy. If the resources threaten to be exhausted and inflation appears to run amok, taxes could be increased to curb economic growth.
Growing government debt is a development that the markets have permitted. In fact, increased state borrowing is enjoying widespread support. It is understood that only governments are capable of taking the necessary action to promote economic growth when the private sector is struggling due to the virus and restrictions.
Low interest level
Interest rates are record-low. Asset purchases by central banks have kept the interest rates down. The markets have not punished countries with a high debt burden. It is commonly believed that COVID-19 is a crisis that can be overcome quickly with the aid of vaccines. Asset purchases by the central banks have been well suited for the coronavirus crisis and have kept short and long-term yields at low levels. This has allowed large scale borrowings by the governments without market turmoil.
Sovereign debt may be a problem
Two economists, Carmen Reinhart and Kenneth Rogoff, have drawn upon extensive data to demonstrate that public debt problems are both common and recurring. They stem from a number of circumstances. One is the high level of debt. They argue that when public debt increases too much, economic growth may slow down and make the economy susceptible to financial crises.
A high level of debt also poses a potential problem if countries are dependent on external borrowing at the same time as the debt burden is substantial. This seems to be the case in most developed countries. A crisis may be triggered by some external impulse or a political credibility problem at home.
Political decision making
A high level of public debt is closely related to the capability for decision making. If the political system fails to deliver the necessary decisions, it may create concerns in the financial markets. At times, decision-makers need to be able to take unpopular measures when they are called for.
Buffers needed
Everyone should have buffers for a rainy day, including governments. History and the even more recent past show that crises are bound to erupt from time to time. They may arise from unforeseen circumstances and cost dearly. A double crisis may arise if sufficient buffers are not available to avert it. The additional borrowing resulting from the initial crisis may itself turn into a new problem that may prove too much for the markets.
Last word
So far, the market forces have treated growing national debt with kid gloves showing an abundance of understanding. The measures taken in response to COVID-19 have been widely accepted. No other options have been available, unfortunately. However, this should not be taken to mean that the market forces could not respond differently.
Asset purchases by central banks have succeeded in keeping the interest rates on public debt in check. However, there are voices cautioning that we have entered uncharted waters and that unconventional monetary policy tools have never been tested to this extent previously. The ultimate acid test would be experienced if the interest rates started increasing for some reason and the central banks’ efforts to keep the rates down failed. After all, the market forces may decide to re-price the loans at a higher level of interest.
In conclusion
Sovereign debt is not a problem at the moment. However, it may turn into one. The line between these two statements is blurred and mercurial. Nobody knows where the line should be drawn at any given time until it becomes obvious and then it is, of course, too late.
The writer is VER's CEO Timo Löyttyniemi.
