Recently, I found a fascinating paper entitled "The future of public debt: prospects and implications" released in March 2010 by the Monetary and Economic Department of the Bank for International Settlements (BIS). The authors of the paper examine the prospect of rising debt among the world's industrialized nations, how fiscal policy will be impacted by rising spending on age-related issues and how this increased spending will impact debt-to-GDP ratios over the next few decades.
For those of you that aren't familiar with the BIS, it was established in 1930 and has its head office in Basel, Switzerland. The BIS functions as the banker for the world's central banks and does not accept deposits from or provide financial services to corporate banks or individuals. To better explain their purpose, I'll quote from their website:
"The mission of the Bank for International Settlements (BIS) is to serve central banks in their pursuit of monetary and financial stability, to foster international cooperation in those areas and to act as a bank for central banks."
Now, let's get to the paper.
The Great Contraction of 2008 was a watershed moment in the world of sovereign debt. Governments around the world were forced to recapitalize their failing banks, take over failing corporations and spend untold trillions on economic stimulus programs. This has led to a very rapid increase in the debt-to-GDP ratio for the entire world with the OECD estimating that the world's public debt-to-GDP ratio exceeded the 100 percent mark in 2011, something that has never happened in peacetime. While all of this is frightening enough, the future fiscal balance problems will be complicated by the world's aging population. The future costs of supporting an older population are very difficult to estimate and, unfortunately, are not being planned for by most governments around the world.
The authors note that high levels of sovereign debt are not terribly uncommon throughout history, particularly in the years after World War II when debts in excess of 100 percent of GDP were not uncommon as shown in this graph for the United States:
Unfortunately, things really ARE different now. What was tolerated in the past may not be tolerated in the future. Stock and bond traders have become notoriously short-sighted with their investment horizon no longer stretching to years or decades; rather, traders now buy and sell with daily or weekly time horizons. As we have seen recently, any perception of fiscal weakness leads to higher debt costs; one need look no further than the example of Italy to see how rapidly bond yields can rise as shown on this one year chart:
As well, this period of prolonged, generationally ultra-low interest rates has lulled many in both government and the investment community into thinking that this is the "new norm" and that governments can go on spending because the new debt that is accrued is accompanied by very little interest penalty. At some point in time, bond investors and traders will decide that enough debt is enough debt and that the risk of default has risen beyond their gag point. It is then that bond prices will drop as investors demand a greater reward for the risk that they are taking and medium and long term interest rates will rise no matter how much Mr. Bernanke and his gang of bankers protest or experiment with easing or twisting. This rise in the cost of debt will also complicate central banks attempts to rein in inflation.
Sovereign debt for most developed nations has grown rapidly since 2008, even among nations that were normally not considered overly indebted. Here is a chart showing how much debt growth has occurred and is projected to occur among some of the world's major economies over the most recent three year period:
Notice that the United States' debt-to-GDP is expected to rise from 62 percent to 100 percent in just three years, a 78 percent increase. The United Kingdom's debt-to-GDP is expected to rise from 47 percent to 94 percent, an increase of 100 percent. Rather surprisingly, some of the bad boys of debtor nations are seeing far smaller increases in debt; for example, Italy's debt is expected to increase by only 16 percent between 2009 and 2011 and Greece's debt will only increase by 25 percent.
Here is a graph showing the growth in developed nation public debt as a percentage of GDP since 1970 (red line) and the changes in fiscal balance which have been pretty much negative since 2002:
Much of the increase in indebtedness was related to increases in expenditures to provide stimulus and losses of tax revenue due to the Contraction. As you can see from the chart, this has led to an increase in debt-to-GDP by 20 to 30 percentage points over just a three year period. With only modest/lukewarm economic growth in 2011, this situation is not expected to improve. Not surprisingly, the BIS notes that most of the projected deficits are structural rather than cyclic in nature. This is particularly frightening since it means that no matter how much the economy may recover, the deficits will be persistent even during the best of times. On top of that, the economies of Ireland, Spain, the United States and the United Kingdom have seen their ratio of government revenue-to-GDP drop by 2 to 4 percentage points between 2007 and 2009; with stubbornly high unemployment in these countries, it is unlikely that governments will see stellar increases in growth. Historical experience with lagging growth and persistent negative fiscal balance suggest that government fiscal policy is likely to "remain highly expansionary" in the near term...that is, until governments are forced to cut their stimulus spending.
Now let's change gears for a moment and look at the longer term. Since 2008, governments have been forced to spend, spend, spend with no regard for the future. In the past 3 fiscal years alone, the United States has added $4 trillion to its debt, an increase of nearly 30 percent. Unfortunately, with the short election cycles in most democratic countries, politicians become extremely myopic and plan only for their next campaign with no regard for our distant or not-so-distant futures. The issue of the rising ratio of old-age population to working-age population is pretty much ignored. Not for long! Here's a graph showing the rising ratio of old-age citizens to younger, working-age citizens (ages 15 to 64) for three of the Eurozone's major debtor nations along with a graph that shows the increase in age-related government expenditure as a percentage of GDP out to 2050:
Despite the "solution" to Greece's debt problems, it certainly appears that their big spending days are far from over.
Cato Senior Fellow Jagadeesh Gokhale estimates that, without tax increases, 23 of the world's industrial nations will require an annual present value surplus of 8 to 10 percent of 2005 GDP to 2050 to finance future benefits required by aging populations. The Congressional Budget Office projects that the United States will require a permanent improvement in its budget balances of 2.6 percent of 2009 GDP in the next 50 years to stabilize the debt-to-GDP ratio at its 2009 level. United States health care spending is projected to double from about 5 percent of GDP in 2010 to 10 percent by 2035 and to 17 percent by 2080 making it extremely difficult for the government to meaningfully improve its balance.
The study concludes with projections of the growth in the gross debt-to-GDP ratios for the major nations in the study incorporating the impact of an aging population. The authors used the assumption that the real interest rates on the debt remain constant at the average from the years 1998 to 2007 and that real GDP growth potential is the post-Great Contraction average for OECD nations. If either of these factors is worse (i.e. higher interest rates and slower growth, the situation is worse and vice versa). Here are a series of graphs showing the BIS projections of debt-to-GDP for various industrialized nations from the 1970s to 2040:
Note that the red line shows the baseline scenario (i.e. the status quo), the green line shows the scenario where the primary balance improves by 1 percentage point of GDP in each year for five years starting in 2012 and the blue line shows the untenable situation where governments are forced to freeze age-related spending as a percentage of GDP at 2011 levels despite their aging populations.
If governments' spending and taxing remains as it is today, by 2020, Japan's debt-to-GDP will exceed 300 percent, the United Kingdom's will exceed 200 percent and Belgium, France, Ireland, Greece, Italy and the United States will exceed 150 percent. Notice that by the time we get out to 2040, Japan's debt-to-GDP is 600 percent and the United States' debt-to-GDP is in excess of 400 percent. The growth in debt will also have a marked impact on what governments must spend to service their debt interest payments. The conflict between rising costs related to an aging population, rising debt costs and a shrinking workforce (and tax pool) will make it exceedingly difficult for nations to even approach fiscal balance. My guess is that debt levels will never reach the stratospheric levels shown in this analysis; defaults will "clean the board" and there will be haircuts for all involved.
Fortunately, governments around the world are making last ditch attempts to curb their profligate spending ways, although, the looming possibility of Part II of the Great Contraction may curb their abilities to cut stimulus spending and increase taxes. Unfortunately, it is all of us who will pay, one way or another…and we are most likely to not like the medicine being offered.