Deutsche Bank research paper tackles the history and future of debt
by Ben Poole
The global head of Thematic Research & Credit Research at Deutsche Bank Research, Jim Reid, has just published his annual Long-Term Asset Return Study. This year's focus is on the History and Future of Debt. The report also includes all the usual long-term returns data for dozens of countries across different asset classes tracked back over more than a century for many series.
Common wisdom suggests that the prudent upper threshold for government debt/GDP is in the range of 70-90% for high-income countries, 50-70% for euro area countries and 30-50% for the EM complex. Evidence has suggested that growth slows past these thresholds and thus risks creating an unsustainable and negative debt/GDP cycle.
Today many countries are above these levels, with the globe seeing the highest peacetime debt in history, and yet until recently hardly a week went by without fresh record lows in bond yields. The other unusual part of this cycle is that although aggregate government debt/GDP has soared since the GFC, if you assume that the post-GFC accumulated central bank holdings never get repaid, then most governments have actually de-levered over the past decade. The report questions whether we have to rethink our view on debt sustainability or whether this is a big bubble.
Much depends on the future interaction between governments and central banks. In a world of stubbornly low growth and low inflation, and with populist governments increasingly looking at reversing prior fiscal consolidation and austerity, eventually the temptation to use negative or ultra-low rates to borrow to spend will prove too tempting, the report surmises. At current yields, Germany could move from a surplus of c1.5-2% to a deficit of roughly the same magnitude and still keep debt/GDP constant over the next several years. This won't be easy in reality.
The multi-trillion dollar question is whether governments can successfully and consistently issue the holy grail of funding - zero-coupon perpetual bonds. If they can do that, spend the money, and central banks buy the bonds, then that is pure helicopter money. The research suggests that we're actually not a million miles away from this, describing how it feels like central banks have given governments the keys to the helicopter in helping yields fall to current levels, but governments have yet to fully embrace the spending power that this may offer them. It may take the next recession to encourage the move.
Ironically, the biggest risk to a plan to borrow at low/negative rates to facilitate fiscal spending might be that it is actually successful. If inflation is generated (as it should be with such policies), then the bonds that are still 'free float' may be much more vulnerable than they are today, when markets don't believe inflation is possible and total returns are still being made by buying negative-yielding bonds. At this point, if such polices are to be maintained, even more central bank buying of government bonds may be required to keep yields down.
The research notes that the key to a sustainable debt environment over the next decade(s) will be about keeping nominal yields well below nominal GDP. As such, financial repression and aggressive central bank purchases might still be in the early stages. The big difference - relative to the past decade - will likely be that governments start spending the 'free' money that central banks have served up. Infrastructure, led by technology, and green investment may give even the most prudent of countries the political cover to spend. The report concludes by painting a picture of higher debt, higher inflation, higher nominal GDP, higher yields, and higher central bank balance sheets.
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