The chart shows that those OECD countries with the greatest
burden of debt servicing a decade ago have subsequently had the lowest growth
in government spending. It isn’t hard to understand how that might happen when we
think about the consequences of accumulating debt in our personal lives. If we
go heavily into debt, a higher proportion of our income must be devoted to
servicing debt and less is available for other spending. Our creditors are
likely to be reluctant to extend further credit if they become concerned about
our ability to service existing debt.
At a national level, there are additional complications
including the potential for governments to inflate away the real value of debt denominated
in local currency and possible ‘bailouts’ by the IMF and ECU. Nevertheless, governments
that become poor credit risks must pay a higher risk premium than is normal for
government bonds, in order to obtain access to additional credit.
There is evidence that rising government debt to GDP ratios
are associated with lower economic growth, which in turn, leads to lower growth
in government revenue. That obviously has potential to further squeeze non-interest
government spending. The results of a recent study published by the Dallas Fed (‘Rising
Public Debt to GDP Can Harm Economic Growth’, by Alexander Chudik, Kamiar
Mohaddes, M. Hashem Pesaran and Mehdi Raissi) suggest that over the longer term
persistent accumulation in debt as a percentage of GDP at an annual rate of 3
percent is eventually associated with annual GDP growth outcomes that are 0.2
to 0.3 percentage points lower on average. To put that in perspective, the
average growth rate of OECD countries has been about 1.5 percent per annum over
the last decade. Causality could run both ways. Lower GDP growth can lead to higher
debt levels, which, in turn, can lead to lower economic growth.
You might be wondering why I think the chart shown
above has much relevance for western democracies other than Greece, Italy and
Portugal, which had high government debt servicing burdens a decade ago. The
relevance stems partly from the continued increase in government debt as a
percentage of GDP in most OECD countries over the last decade. On average, net
financial liabilities of those countries have risen by around 23 percentage
points of GDP over the last decade to around 67% of GDP in 2018.
Those looking for reasons to be complacent can obtain
some reassurance from low world interest rates. With interest rates paid by
governments lower than the rate of economic growth in most OECD countries, debt
servicing is not yet a widespread problem. At current interest rates, it would
be possible for the debt to GDP ratio to decline in most OECD countries, even
if governments pay interest on their debts by borrowing additional funds.
How likely is it that world interest rates will
remain at low levels over the next few decades? In their recent OECD paper, The Long View: Scenarios for the World
Economy to 2060, Yvan Guillemette and David Turner suggest that relatively
low growth in investment is likely to keep downward pressure on world interest
rates, even though population ageing is likely to reduce savings rates.
Nevertheless, they note evidence that reversals of the relationship between
world interest rates and economic growth rates have been “fairly common” in the
past. They warn that a sustained rise in interest rates relative to growth
“could eventually make large debt stocks costly to service and unsustainable”. Their projections suggest that some decline in
economic growth rates is likely to occur in most parts of the world over the
next 40 years.
My concerns about the potential for debt stocks to
become costly to service in many more OECD countries are related to the
implications for government spending of the ongoing increase in the proportion
of elderly people in the populations of these countries. The implications of
demographic change have been much talked about over the last few years, but the
magnitude of the likely impact on government spending doesn’t yet seem to be widely
appreciated. The study by Guillemette and Turner projects an increase in annual
public health and pension spending of about 5 percentage points of GDP for the
median OECD country between 2018 and 2060. The bulk of that increase is for
public health spending, which is projected to continue to be pushed up by
technological change and government health policies, as well as demographic
factors.
The methodology used by Guillemette and Turner
produces estimates of the increase in the revenue to GDP ratio needed to pay
for projected government spending increases without any further increase in
debt to GDP ratios. An increase in revenue as a percentage of GDP of 6.5
percentage points of GDP is projected to be required for the median OECD
country over the period to 2060. A much larger increase is projected to be
required in some countries. For example, the required increase in revenue for
the U.S. is projected to be 10 percentage points of GDP.
I think the baseline scenario presented by Guillemette
and Turner is too optimistic because their modelling takes no account of the
disincentive effects of higher taxation on GDP growth. The possible magnitude
of this excess burden of taxation is discussed in an Australian context in an
article posted on this blog a few years ago.
Leaving that aside, it seems to me that ongoing
increases in debt to GDP ratios - and hence substantial increases in government
interest payments as a percentage of GDP - are a much more likely outcome in
most OECD countries than tax increases in the years ahead. In those countries where
debt servicing isn’t yet a problem, there seems likely to be much less political
opposition to further increases in public debt than to tax increases. That
suggests to me that over the next few decades most OECD countries are likely to
increase their debt to GDP ratios until debt servicing does become a more
widespread problem.
Guillemette and Turner present scenarios that would
require smaller increases in government revenues than in the baseline
(no-change) policy scenario, but those scenarios involve health policy and
labour market reforms that have been difficult to achieve in the past. I don’t
think we can expect voters to be any more supportive of reforms that could
damage their short-term interests than they have been in the past. The best we
can hope for is that when they see the writing on the wall, a sufficient
proportion of voters in most countries will be supportive of political parties
proposing economic reforms, rather than waiting until they are imposed by creditors
(or institutions such as the ECB and IMF). In 2013 I wrote something here
contrasting the responses of Sweden and Greece to fiscal crises, that
illustrates the choices available.
The transition may be traumatic, but it seems likely that technological advances will provide options
superior to government provision of many services in coming decades. What I
have in mind particularly is the potential for blockchain to enhance
opportunities to seek mutual benefit in voluntary cooperative enterprises, as previously discussed on this blog. That may create potential for functions to
be transferred from the public sector to cooperative enterprises that can
perform the functions more efficiently.
During the next few decades most of the western
democracies seem likely to experience ongoing difficulty in coping with the additional
government spending required to meet the health needs of the elderly. The most likely outcome seems to me to be an
increase in debt to GDP ratios that will result in more widespread debt
servicing problems. It seems inevitable that debt servicing problems will lead
to a lower rate of growth in government spending in many OECD countries, possibly
accompanied by the transfer of some functions to voluntary cooperative
enterprises.
That leaves the difficult question of identifying which
of the western democracies are more likely to be able to implement those
reforms through normal democratic processes in order to avoid having austerity
imposed upon them by creditors and international agencies.