Government debt is surging across the world, is it sustainable, and will it sink the global economic recovery and stop a recovery in equities?
Beyond Covid: will government debt stop global economy recovery & sink equities?
I had thought that the latest news on inflation would tell us a lot. If post-Covid, we see significantly rising inflation, then central banks will struggle to maintain low-interest rates. If interest rates go up, so will the cost to governments of servicing debt.
Then there is the option of printing money. If all else fails, some governments have the option to resort to the printing press and monetise their debt. The big risk with money printing is that it can lead to inflation. So what inflation does now, tells us a lot about whether resorting to the money printing press is a possible solution.
Before I go any further, let me rewind a little. The fear that I keep seeing expressed is that post-Covid, the scale of government debt will be such that we will see both higher taxes and severe austerity. This combination will hold back economic recovery, and it will be years before the economy is back to pre-Covid levels. This will, in turn, be disastrous for equities.
There are a couple of points here. If governments can continue to borrow at super-low interest rates, then the surge in government debt may not create too onerous a legacy.
Once this crisis is over, providing economic growth is greater than budget deficits as a proportion of GDP, then total debt to GDP could fall without austerity.
So interest rates matter a good deal. And that means inflation matters.
Which will see the biggest hit, demand or supply?
Across the economy, the Covid-crisis has hit demand and supply. Whether we get inflation or deflation post-Covid depends on which sees the slowest recovery. If consumption rises faster than output, we will get inflation. If output rises faster than consumption, we will get deflation.
That’s one of the big differences (economically speaking) with the 2008 crash which was largely about a crash in demand— this is why inflation fell so low and central banks were able to get away with ultra-low interest rates and quantitative easing.
What’s happening now
The latest data on UK inflation showed a sharp fall in the key index. UK CPI rate of inflation fell from 1.5 % in March to 0.8% in April. That was a massive fall. A superficial glance would suggest that inflation is on a downward trend, leaving plenty of scope for central banks.
But a second look shows that the majority of the fall was down to one-offs.
However, strip out these one-offs (such as energy, food and tobacco) and focus on core inflation and it dropped from 1.6% in March to 1.4%. If that single set of data proves typical, then inflation seems likely to stay low.
Borrowing at negative interest rates
The UK government has now joined a growing list of governments that can borrow at negative interest rates. As I write, the yield of five year UK Treasuries is minus 0.2%. On 30 year bonds, the yield is 0.58%.
In the UK, tax revenue is roughly a third of GDP. So a rough back of the envelope calculation would suggest that with those bonds yields, the government could borrow an amount equating to 100% of GDP, pay 0.58% interest over 30-years, equating to an annual interest bill of 1.74% of GDP, which could be funded by a 5% increase in taxes.
Of course, UK government borrowing won’t increase by anywhere near that level. Latest projections suggest government debt will increase by £300bn this year, which is around a seventh of GDP. (Although it will be more than a seventh after taking into account likely contraction of the economy).
There is no doubt that government debt will increase at an unprecedented rate this year, but interest rates are so low, inflation so unthreatening, that interest rates are likely to stay low. It seems to me that the increase in debt is eminently affordable.
Looking beyond UK
Last week saw another first. The average yield on treasuries from across the world fell to 0.48 %, the lowest level ever. What I just said about the UK seems to apply globally.
There will be regions where things will be tricky. The Eurozone is a case in point
Capital Economics reckons that government debt in Germany will rise from 60% of its GDP to 70% this year. It thinks that the debt will increase in Italy from 135% to 180% of GDP. It predicts that in Greece government debt will exceed 200% of GDP. German government debt does not seem to pose any long-term threat. In Italy and Greece, it threatens to squash any hope of economic recovery.
The Eurozone seems to have been on the brink of collapse for ten years — yet somehow it avoids that fate. But it has never experienced a crisis like this one. Can the single currency survive? In its current form, this seems unlikely. The implications of a collapse in the Eurozone are not pretty.
As for equities, there are lots of reasons to be fearful — reversal in globalisation, collapse in Eurozone, a rise in authoritarian governments, amongst them. But I don’t believe that government debt will be amongst these problems — not in most cases.
These views are those of the author alone and do not necessarily reflect the view of The Share Centre as a whole.