Government debt-to-GDP ratios in many advanced countries are approaching post-World War II highs, leaving them increasingly vulnerable to a worsening in economic conditions and demographic forces, argues Stewart Robertson, senior economist for the UK & Europe at Aviva Investors.

Surprisingly little attention has been paid to the threat of sovereign default

One consequence of the global financial crisis has been rapid growth in public debt in most advanced economies. This is the result of governments being too complacent about their fiscal position before the crisis; and the cost of bailing out financial institutions, lower revenues, higher welfare spending, and slower economic growth ever since.

While a widespread deterioration in government finances would ordinarily be cause for concern, bond yields remain extremely low by historical standards almost everywhere thanks to the unprecedented actions of central banks. This has sparked a fierce debate among economists as to whether the size of deficits matters any more.

Classical economic theory contends that running large and persistent deficits is not sustainable over the long run. The functioning of markets will be impaired as higher interest rates begin to ‘crowd out’ private-sector investment, depressing economic growth. By creating a burden of indebtedness that is difficult for taxpayers to bear, deficits compromise the living standards of current and future generations. Left unchecked, the cost of debt servicing may spiral out of control, leading to a government’s solvency being called into question.

However, others see less need for governments to get deficits under control given the world is continuing to shake off the effects of the financial crisis. Some Keynesian economists, such as Robert Skidelsky, have downplayed concerns over high debt levels,1 while others, including Paul Krugman, have called on various governments to abandon ‘austerity’ policies.2

The apparent success of central banks in helping to keep bond yields under control in the face of large fiscal deficits has led some to conclude the theory needs to be re-written. For now, financial markets – seemingly fixated on the power of central banks to keep bond yields low – appear largely unfazed by the worsening fiscal position facing many countries.

Yet debts and deficits do still matter. With the world economy enjoying its best period of economic growth since the crisis, governments with high debt loads would be well advised to get deficits under control since low rates of interest won’t last for ever. In the majority of cases, worsening demographics underscore the need for action.

Global debt hits record

Surprisingly little attention has been paid to the threat of sovereign default in debates over policy, except in countries that lost market access at various points in the past decade, such as Greece. However, the International Monetary Fund on April 18 sounded the alarm when it argued a prolonged period of record-low interest rates had left the world more heavily indebted than before the financial crisis. It said countries needed to take “immediate action” to improve their finances before the next downturn.³

The fund pointed out that by the end of 2016 the world was sitting on a $164 trillion mountain of debt, equivalent to 225 per cent of Gross Domestic Product (GDP), 12 points above the previous high in 2009. While China was responsible for much of that build-up of debt, the Washington-based institution also singled out the US for criticism. It warned President Donald Trump’s package of tax cuts and spending increases was going to lead to a bigger budget deficit at a time when it should be on the way down.

Just days earlier, the US’s own budget watchdog had warned of “serious negative consequences” from rising debt.4 The Congressional Budget Office said with the country heading for trillion-dollar annual budget deficits from 2020, US Federal Debt owned by the public is set to rise to more than 96 per cent of GDP by 2028 – its highest level since World War II – from 76.5 per cent currently.5 That the Trump administration should be embarking on a huge fiscal stimulus when the US economy is in danger of overheating is highly unusual, flying in the face of economic doctrine. It is arguably reckless, too.

The mathematics of deficits

To assess whether public debt is on a sustainable path, it is possible to carry out simple simulations using the following equation:

Essentially, the equation states that the change in a country’s debt-to-GDP ratio between one year and the next depends on three variables: the real rate of interest, the real rate of GDP growth, and the primary budget balance (the government’s fiscal position excluding interest payments). In simple terms, if a country’s real economic growth rate does not exceed the inflation-adjusted cost of servicing its debt, it must run a primary budget surplus to keep its debt-to-GDP ratio stable.

By plugging in assumptions for interest rates and economic growth, we can use this equation to assess the fiscal positions facing eight countries. In the first simulation we assume real interest rates will remain close to zero and real economic growth will persist at what we estimate to be long-run trend rates.6

Figure 1 shows the change in the primary budget balance (as a percentage of GDP) required by each country to keep its debt-to-GDP ratio stable. Positive figures imply tighter fiscal policy is required, while a negative number means there is scope for looser policy. As can be seen, on the basis of the above assumptions the majority of these eight countries actually have scope to loosen fiscal policy. Only in Japan is there a need for substantial tightening.

However, if we assume real interest rates rise to 2.5 per cent for each country – the historical average for G7 countries between 1965 and 20177 – the situation gets appreciably worse, as figure 2 shows. Suddenly the majority of countries would have to tighten policy, in some cases substantially.

Furthermore, the second simulation is based on an assumption economic growth will continue at a relatively healthy clip. Should it disappoint, the required tightening could be greater. The recent loosening of fiscal policy in the US, which is not accounted for in the above simulation, makes the country’s debt position even more precarious. The CBO reckons the annual deficit will average 4.8 per cent over the next decade, even with another 10 years of uninterrupted economic expansion.

Recessions can have a devastating impact on government finances as tax receipts drop and welfare payments rise. Figure 3 shows the extent to which some of these countries are still struggling to get debt under control, 10 years on from the global financial crisis, with Germany alone in avoiding a big increase.

Deteriorating demographics

While the financial crisis wreaked havoc on many countries’ finances, the deterioration has actually been going on for longer. Take the case of France, where last year the net public debt-to-GDP ratio hit 80 per cent. In 1985, the country carried net debt equal to just eight per cent of GDP; by 2007, it had reached 32 per cent.8 While some of the rise in the two decades to 2007 was down to general fiscal profligacy, much was also down to a worsening demographic backdrop, the consequences of which the French government, like others around the world, has been slow to tackle.

Figure 4 shows the old-age dependency ratio (people aged 65+ per 100 people aged 15-64) in ‘high-income’ countries more than doubled from 12.3 per cent in 1950 to 25.7 per cent in 2015. Assuming unchanged fertility and mortality rates, the United Nations expects it to rise further, reaching a peak of 40.3 per cent in 2060.9

Perhaps more worrying in terms of its potential impact on government finances, the OECD in 2011 forecast that by 2050 the share of those aged 80 years and over in OECD countries will more than double to 9.4 per cent from 4.0 per cent in 2010.10

This will put further pressure on developed countries’ finances for three reasons. Firstly, it is likely to hurt economic growth. Whereas between 1960 and 2000 the population of working age in the G7 rose by an average of one per cent a year, between 2018 and 2050 it is forecast to fall by 0.15 per cent a year.11 This comes straight off growth. In other words, other things being equal, the trend rate of annual growth will be 1.15 per cent lower in the second of these periods than in the first.

Secondly, the cost of healthcare – used disproportionately by the elderly – has risen rapidly. In the US, the Centers for Medicare and Medicaid Services reckons national health spending – which includes spending by federal and state governments, the private sector and individuals – rose from just five per cent of GDP in 1960 to 17.9 per cent in 2016. With health spending projected to grow one percentage point faster than GDP per year over the subsequent decade, it could rise to 19.7 per cent by 2026.12

Thirdly, many of these countries have covenanted to pay what now seem like overly generous state pensions. When national social security systems were established, their funding was calculated based on much shorter life spans. Despite most of these schemes being structured on a pay-as-you-go basis – in other words, funded from current taxation – pensioners have come to view their pensions as rights based on the contributions they made during their own working life. That has made these entitlements virtually immune to political attack.

In a report published in March 2016, Citigroup analysts said an increase in the retirement-age population, accompanied by a decrease in the working-age population, was starting to put a strain on pay-as-you-go government pension schemes.13

They estimated the total value of unfunded or underfunded government pension liabilities for 20 OECD countries had reached $78 trillion, close to double the $44 trillion published national debt number.

Longer life expectancies suggest either taxes will have to rise, in some countries’ cases quite sharply, to pay for the pensions and healthcare costs of retirees, or those entitlements will need to be renegotiated. While most industrial nations recognise the need to address these issues, few have tackled the problem comprehensively. Most have engaged in piecemeal policymaking to mitigate the most pressing deficit problems. Although these measures provide some relief, more drastic action may soon be needed.

However, according to Gabriel Sterne, head of global macro research at economic forecasting group Oxford Economics, while it may be true that worsening demographics cause deficits to rise, it is unclear this will trigger as big a rise in real interest rates as some suggest. He points to Japan as evidence to support this view.

“Demographic changes have played a crucial role in pushing savings rates up and real rates down in the advanced economies. Despite some voices to the contrary, we think such forces will remain in place for many years to come.”

Surprisingly little attention has been paid to the threat of sovereign default

Growth in a Time of Debt

In the immediate aftermath of the financial crisis, governments on both sides of the Atlantic pursued Keynesian stimulus programmes in an effort to stave off a repeat of the Great Depression. But it wasn’t long before a number of economists and policymakers began to question whether these expansionary policies, which involved high levels of borrowing to finance additional government spending and tax cuts, should be continued or wound down to balance the budget.

While most industrial nations recognise the need to tackle these issues, few have done so

Some, including UK Chancellor of the Exchequer George Osborne and Speaker of the US House of Representatives Paul Ryan, cited a 2010 paper entitled Growth in a Time of Debt, written by Carmen Reinhart and Kenneth Rogoff, as they looked to promote austerity policies. The US economists claimed rising government debt could seriously hurt growth. They found evidence economic growth was likely to turn negative when government debt rises above 90 per cent of GDP.14

Although Reinhart and Rogoff’s findings were called into question in 2013 when a student at the University of Massachusetts discovered some flaws in their methodology,15 the debate as to whether or not large deficits impede economic growth continues.

Three competing theories

From a theoretical perspective, economists fall into three camps; two of which contend deficits don’t matter and the third that they do. Arguably all three views can hold over different time horizons and at different moments in time, depending on the stage of the economic cycle.

The Ricardian equivalence proposition is an economic theory proposed by Harvard professor Robert Barro in 1974, building on the work of David Ricardo in the 19th century, as a means of refuting a key strand of Keynesian economic theory. It hypothesises financing government expenditures through taxes or debts is equivalent, since debt financing must be repaid with interest, and households, anticipating higher future taxation, would boost savings to leave total output unchanged. However, it seems highly unlikely people act in such a hyper-rational way in anything other than the extremely long run.

Ironically, the second camp to argue deficits do not matter comes from the opposite end of the ideological spectrum. A fundamental law of economic theory states savings must equal investment. But John Maynard Keynes said in some instances households’ desire to save could exceed companies’ wish to invest, even at a zero rate of interest. In other words, if interest rates cannot fall enough to ‘clear the market’, income must fall instead. That is why disciples such as Krugman and Joseph Stiglitz are unconcerned by deficits, and for much of the past decade have instead called for governments to take up the slack by borrowing to pay for consumption. For them, the process can easily be reversed when economic activity recovers.

The third argument contends deficits do matter and will be viewed with concern by financial markets, at least in a ‘normal’ world that exists most of the time. In such a world, rising government deficits will not only lead to higher rates of interest, crowding out private-sector investment, but by misallocating scarce resources could also potentially lead to much higher inflation.

This is the world Reinhart and Rogoff based their research on. Unfortunately for them, the financial crisis struck just as they were producing their conclusions. Keynesians were able to argue against austerity by saying the ‘normal’ economic conditions they had based their conclusions on no longer applied. The world was saving so much that even real interest rates falling to zero were insufficient to prevent downward pressure on economic growth. The real interest rate that would have cleared the market was probably closer to minus three per cent.

Are we in a normal world yet?

Even if there were some errors in their work, Reinhart and Rogoff’s fundamental conclusion – if the world is normal, and inflation is responding to interest-rate movements, then deficits matter – probably remains valid. Which begs the question: are we in a normal world yet, and if not, how close might we be to one?

At this juncture, the jury is still out. On the one hand, there is growing evidence inflation is returning and the world economy is moving out of the deflationary regime that has prevailed for the past 10 years. Should the removal of quantitative easing by central banks cause real interest rates to exceed real growth rates, the mathematics behind Equation 1 suggests many governments will need to tighten fiscal policy.

On the other hand, Germany, Japan and China are still producing a glut of savings; suppressing both real and nominal rates of interest around the world. If that situation were to persist, real interest rates may not rise very far and countries with high deficits could potentially rely on the  same arithmetic to reduce their debt-to-GDP ratios by generating modest economic growth.

After all, this was what the UK did after World War II. Having stood at 259 per cent in 1947, by 1991 the country’s debt-to-GDP ratio had fallen to 22 per cent.16 Very little of the reduction was the result of a fiscal squeeze. Instead, for most of the period, economic growth exceeded interest rates.

While most industrial nations recognise the need to tackle these issues, few have done so

No room for complacency

Of course, the danger in relying on such a strategy is the world goes back into recession. The US is on the verge of completing its ninth year of uninterrupted growth, a record bettered only twice – in the 1960s and 1990s – and close to double the 58 months average duration of the other 11 economic expansions since the Second World War.17 While it may be true recessions happen for a reason and not because they are overdue, the current expansion will end eventually. Were the world to go back into recession, it could have bleak implications for governments’ balance sheets. The threat is compounded by the concern central banks will have limited scope to ameliorate the path of any downturn, since interest rates might well be lower than they have ever been at the start of a downturn.

Recessions happen for a reason, not because they are overdue – but the current expansion will end eventually

Some commentators have suggested central banks could always print money to cancel their holdings of government debt. However, it is questionable how effective such a policy would be, which probably helps explain why the Bank of Japan (BoJ) has opted not to go down this route. If a central bank were to ‘monetize’ its debt in order to safeguard the government from default, the fear is this could lead to runaway asset price inflation and maybe even sharply higher goods and services inflation, with potentially disastrous consequences, as the currency was debased.

For now, even the BoJ appears to think the best way of getting the deficit down is by keeping r less than g. But in Japan’s case, the process could take a century or more. Even then it is far from guaranteed to succeed given the country’s demographic position.

While other advanced countries are in less-dire straits than Japan, there is no room for complacency. True, the UK’s experience in the post-war years showed it is possible to bring very high deficits back under control eventually. But the post-war years were characterised by high levels of productivity growth, which in turn fuelled strong rates of economic expansion. The poor productivity records of many advanced economies in recent years suggest a repeat may be hard to achieve.

Sovereign debt is generally regarded as the safest form of investment thanks to what is usually seen as a minimal risk of default. While investors do not appear to be calling Japan’s solvency into question, it is unclear the country will ever be able to pay them back. Governments in other advanced countries with rising levels of debt and a worsening demographic backdrop would be advised to bear the Asian nation’s recent history in mind.


1 ’The scarecrow of national debt,‘ by Robert Skidelsky. Project Syndicate, August 2016

2 ’ The Austerity Delusion,‘ by Paul Krugman, The Guardian, April 2015

3 IMF Fiscal Monitor: Capitalizing on Good Times, April 2018

4 Congressional Budget Office, The Budget and Economic Outlook: 2018 to 2028, April 2018

5 US Department of the Treasury. Note that total US debt, as measured by outstanding Treasury securities, stood at 105.4 per cent of GDP at the end of 2017. Subtracting intragovernmental debt, such as bonds held by the Social Security Trust Fund, gives debt held by the public.

6 Assumed trend annual economic growth rates are: Italy, France and Japan one per cent; UK 1.5 per cent; Germany, Spain and US two per cent; Ireland four per cent.



9 United Nations World Population Prospects, June 2017. Note high-income countries are based on the World Bank’s classification.



12 US Centers for Medicare & Medicaid Services, National Health Expenditure Projections 2017-2026

13 ’The coming pensions crisis‘, Citigroup, March 2016

14 ’Growth in a time of debt,‘ by Carmen Reinhart and Kenneth Rogoff, Working Paper No. 15639, The National Bureau of Economic Research.

15 ’Does high public debt consistently stifle economic growth? A critique of Reinhart and Rogoff, ‘by Thomas Herndon, Michael Ash, and Robert Pollin, University of Massachusetts, April 2013

16 UK House of Commons Briefing Paper No. 05745, April 2018

17 The National Bureau of Economic Research

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