The dangerous “safe” debt level

The current financial crisis in Europe has, to a large degree, been caused by high level of sovereign debt. In simple terms the way it works is that countries collect money (mainly through taxes) to fund public spending. Any shortfall in the revenue collected (also known as budget deficit) can be covered by issuing bonds, selling assets or printing more money. Bonds are typically purchased by central banks of other countries or managed funds. Assets will usually go to managed funds or private investors. The money printed to cover budget deficit will just float in the economy and can cause inflation. There are some exceptions (for example the Japanese citizens own most of their country’s bonds) but I believe that the above is a reasonable description of how governments fund their spending. The level of sovereign debt is usually quoted as a percentage of gross domestic product (GDP). So if, for example, the US public debt is 100% of GDP it is worth about as much as the country produces in one year.

Debt attracts interest. The interest payments add to the public expenditure, without creating any positive spin-offs for the economy. This increases budget deficit and leads to the need for more borrowing. At some level of borrowing the lenders get jittery and are reluctant to invest in country’s bonds. This means the bond yield (interest offered) has to go up to attract the investors. So, in essence, when old bonds mature the money to repay them comes from new bonds, with a higher interest rate tag. This hits the balance sheet even more, increases budget deficit and leads to more borrowing. The process is cyclic and at some point countries are not able to service their debt and default on bond repayments. It is generally accepted by the economists that sovereign debt under 60% of GDP is “safe” – meaning acceptable and manageable. The highest manageable bond yield is deemed to be around 6%.

I believe that, in the political context of democracy, both assumptions are fallacious.

To explain why I will start by looking at what happens when a commercial entity like a personal borrower or a company get into financial trouble. If a person has too much debt they will be expected to adjust. This will typically involve working longer hours, curbing the spending, trading their Lexus for a Corolla etc. With the right motivation changes can be made almost instantly and will affect the balance sheet. In the corporate world an under performing company will do some soul searching, fire the CEO (or the whole board) and appoint someone new at the helm. The new management will go through the company structure selling off unprofitable branches and letting people off to slash the spending. Again, the impact on the balance sheet should be prompt and substantial. Commercial entities are quite responsive and, generally, will adjust. When the odd one does not it will go under and the bank’s loss will be recovered through interest collected on other, performing loans.

But what will happen to a democratic country with say 30% of GDP worth of sovereign debt and bonds yielding 3%? A political party (typically of conservative persuasion) will announce that budget cuts must be made to get on top of the debt. They will propose increasing fees for various public services, reductions to benefits, lifting the superannuation age etc. Other parties will disagree – the debt level is well below the “safe” limit, there is no need for “heartless” changes, reducing the spending will “stifle” the economy, push so-and-so many people below “poverty line” etc. We have all heard this line of argument before, have we not? Electorate will vote for the spenders and more borrowing will follow. So, a few years down the track, the debt level hits 60% of GDP, bonds yield 6% and something has to be done. A company would sell off unprofitable branches – is a country prepared to cull the beneficiaries? Of course not. So what are the options?

Both the debt and interest rate on bonds have increased by 100%. This means the ongoing cost of servicing the sovereign debt is up by a factor of 2×2=4.  Now, is the electorate which flopped out at the 30% of GDP debt level going to change their mind, at four times the cost? I doubt it. As long as there are parties selling the mirage of “growth through spending” there will be people willing to vote for them. At the tipping point (roughly where Greece are at this moment) they will be replaced by “it is all the lenders’ fault” parties and the process will continue to self-destruction.

So, to sum up, I believe that there is a “safe” level of sovereign debt. It is 0% (zero percent) of GDP. Anything above that, in a democratic environment, is bound to spiral out of control and eventually lead to default.

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