This Policy Paper is an analytical assessment of 5 recommended policy positions on Global debt.
The motivation behind this policy discussion is to illuminate the radical increment in cutting edge economies’ public debt, which may hamper growth and development. Efforts to curb deflation through lower interest rates has not borne any fruits in the recent past. By driving down interest rates and empowering all the more lending, debts of different types keep heaping up with no reasonable method for paying off those obligations. This raises the concern of debt sustainability in advanced economies. The piling publics are bound to be passed on to the future generations. The future generations will, therefore, inherit debt burdens that they had nothing to do with. In fact, instead of reducing public debts, advanced economies are characterized by higher borrowing levels compared to their GDPs each year as compared to the previous years. Economists have over the years established key propositions upon which the conceptions of public debt should either be completely discarded or radically revised (Buchanan 17). The decision to radically revise or completely discard is based on whether the propositions are either true or false.
Inquisitive personalities dived into a captivating yet long McKinsey’s investigation of public debt and deleveraging after the great financial crisis(Dobbs, Lund and Woetzel 23). It is projected that the debt will continue to rise given the prevailing economic fundamentals. The current economic policies are not effective in ensuring that global economies pay these debts without recurring new debts. The rapid rise in public debts can be highly attributed to the catastrophic recession whereby global economies took too long to recover. Public debt reduction compels advanced economies to consider new approaches and restructuring programs such as asset sales, timely taxation and expansion of revenue collection and most importantly more efficient public debt restructuring plans.
In 2008, the global economy was hit by the most catastrophic financial crisis since the great depression. The crisis began mushrooming in 2006 in the United States where the rate of mortgage defaults started skyrocketing. Later that year, there was a downfall of housing prices. The most affected victims of the crisis in 2008 in the US were insurance companies, investment bankers, mortgage lending enterprises and commercial banks as well. The carnage spread overseas and not just in the financial sector but other industries as well. The crisis persisted for close to two years a period within which recovery seemed very unlikely. When the crisis is subdued, advanced economies cut down capital injections and interest rates a move that was welcomed by investors.
The crisis originated from the US, but its implications spilled over globally. The United Kingdom, for instance, experienced a 7.4% rate of decline, Germany recorded 14.4%, Japan at 15.3%, 8% in the EU, and 21.3% in Mexico. 1. By 2009, the Arab world experienced a $3 trillion loss due to global all due to the crisis. The US lost close to two million jobs giving rise to the unemployment rate that rose up to 7.2% in December from 4.4% in March the previous year. The only major difference between this crisis and the great depression is that whereas the great depression in the 1930s started in the manufacturing industry, the crisis in 2008 started in the financial sector. By the end of 2009, Arab countries had lost approximately three trillion dollars which was attributed to the fall in foreign investment in the Middle East as the demand for oil declined.
In 2012, IMF global stability report indicated a decline in global growth but there were no indications of a complete overhaul.
- 1. Debt restructuring
Debt restructuring processes that allow renegotiation and reduction of debt payment burden especially in times of financial turmoil. It involves the review of the conventional terms and agreements of a debt. In cases of public or private organizations, the new agreement is commonly referred to as trouble debt restructuring. In an unprecedented scenario where the debtor is in a financial turmoil, the creditor may decide to change the agreements as opposed to compelling the borrower into liquidation. The agreement changes include but are not limited to changes in debt interest payments or the principal amount. In 2007, what started off as mere financial problems progressed into a great depression after which an element of debt restructuring dubbed debt mediation was introduced.
Global debts restructuring is only applicable where the prevailing policies and market-based approaches are lacking(Brooks and Lombardi 28). Some economists, however, are of the opinion that the current policies are not lacking and that the problem lies in their execution. If that were the case, debt restructuring would not be as fruitful. Other opponents also argue that to maintain a smooth and efficient global debt market, the prevailing agreements such as sovereign bond terms or contracts should be left unchanged. A process should be duly established ensuring that the changes are in line with all parties involved.
Additionally, another opponent school of thought on debt restructuring disputes that changing borrowing terms ease the repayment burden that may ultimately attract imprudent global borrowing. Debt restructuring should be costly divergent from which they are bound to happen more frequently. Restructuring may limit the need for somberness that comes with global debt. It is also not easy to reach a consensus with all creditors not to mention the whole process is very costly. The primary goal of debt restructuring as a policy is to reduce the public debt and enhance its sustainability, but this may not always be the case as investors tend to shy away.
On the other hand, despite the flexibility and ease of debt burden advanced economies will be obliged to bear the burden to avoid high borrowing costs in future. These economies also strive to keep their position in the international markets. In his article “The Economics and Law of Sovereign Debt and Default”, Ugo Panizza asserts that the alarm of prohibition from future global is adequate to support global debt(Panizza, Sturzenegger and Zettelmeyer 672). This argument, however, is not sufficient, but its contribution cannot be overlooked.
Extensive studies and research plausibly conclude that debt restricting does not favor the prevailing finance ministers and politicians(Panizza, Sturzenegger and Zettelmeyer 685). Effective or not, debt restructuring is bound to stir political, economic and social effects be they positive or negative. Economic implications of restructuring include reduction of creditor moral hazard and deadweight losses. Consequently, the key political implication is sustainability, for instance, do the changes enhance the validity of crisis tenacity policies?
Inflation is the rate at which the general prices rise and the rate at which the value resultantly falls. Inflation as a policy public debt management involves the reduction of the real value of debt. The world war saw the United States accrue a debt of more than its GDP. The economy was, however, able to reduce the debt by half over a period of ten years thanks to a combination of growth and inflation approximately at 4%. Advanced economies are obliged to slow down the inflation process given the alarming public debt to GDP ratios in the economies.
Inflation reduces the value that creditors received in real terms and relatively less than the initial agreement but compared to debt restructuring; making it a more preferable policy. In this case, a creditor is not forced into new terms as stipulated in restructuring thus making this policy less disorganized. The primary goal of this policy is to aim at reasonable inflation that significantly ease the debt burden (McCauley, McGuire and Sushko 212).
This policy also faces a few challenges one being its viability. Adequate levels of inflation that would offset the global debt burden are likely to impact the economy negatively. Such economic implications are very costly and could cripple the economy as well. Despite the good intentions, inflation might end increasing the fiscal revenue in an economy and subsequently resulting in negative political issues, especially in democratic countries. It would, therefore, be challenging to reach a moderate inflation level and avoid the negative economic and political implications at the same time.
Low inflation rates have little or no effect in mitigating debt burden. The lack of clarity between inflation and debt burden limits its effectiveness. The ambiguity in the relationship between the two aspects may also pose as a hurdle. Opponents of this policy argue that inflation could result into a deeper problem instead of solving the current ailment that is global debt burden.
Comparison between the current economic situation and the past economic situations show traces of similarities between debt burden and inflation and substantial evidence of instances when the policy was successful(Aizenman and Marion 528). It is clear that the policy is only applicable when domestic creditors hold the majority of debt owed.
Although there is the question of fiscal sustainability, a combination of growth and inflation policies would be immensely valuable compared to debt restructuring. Inflation must, however, be introduced after inception and come as a surprise to the creditors otherwise the risk of inflation would be factored in the valuation of borrowing cost.
- Fiscal consolidation
Substantial empirical analysis over the recent past shows that decrease in debt burden is closely influenced by growth and effective fiscal consolidation measures. Fiscal consolidation fundamentally involves an increase in revenue collected in taxes or decrease in government spending. Decrease in government spending in advanced economies is more likely to lower the rate of growth in the short term as a result of a resultant decline in aggregate demand. It also entails control of the public wage bill, efficiency in the public sector and sealing of all leakages. Complementing the policy with a collective debt reductions approach such as augmentation of a tax base and tax policies is the key ingredient. Mitigation of the public debt burden by the use of fiscal consolidation keeps up trustworthiness of the governing body, which might frequently be politically troublesome in the long run.
Continued fiscal consolidation in advanced economies leads up to the economic implications of the policy. If the decrease in economic activities happens to be higher that the debt, the debt to GDP ratio is more likely to rise. Compared to inflation, fiscal consolidation is, therefore, more efficient, unlike inflation that lacks in fiscal sustainability.
Fiscal multipliers of the current fiscal policy are significantly above the regular level. The regular levels were however recorded before the financial crisis. The negative economic implication of fiscal consolidation is as a result of the loopholes and defects of the prevailing policies and current environment such as lack of effective monetary policies, low external demand, to name but a few. The fact that fiscal consolidation can increase the debt ratio in the short term unlike the inflation policy is good enough an incentive to boost the confidence of investors. The challenge, however, lays in the political aspects whereby it may be difficult to implement both the short run and in the long run.
- Fiscal Repression
Fiscal repression is measure utilized by governments to decrease debt burden and mostly incorporate the conscious endeavor to hold down interest rates beneath inflation, signifying an expense on savers and an exchange of advantages from lenders to borrowers. By so doing, the government influence buying or holding of government debt instruments by domestic investors at relatively low-interest rates. Consequently, investors receive returns at rates lower than the initial market rates(Renhart 12).
This policy is however faced with the challenge of effective utilization and implementation and defining the relationship between domestic saving and investment(Husain and Diwan 271). Effective investment is dependent on the respective interest rates elasticities. It would not be plausible to draw a conclusion that if the decrease in investment is always as a result of inefficient allocation. If it so happens that financial repression maintains domestic saving as at a level below the optimum level, there would need to worry by the policy makers. Increased borrowing may result in high economic costs thus hampering current and future growth as well. Reduction in domestic saving as a result of the economic offset ultimately causes capital flight.
Many countries have in the past successfully used various repressive policies in their domestic financial institutions a fact that signals the policy’s superiority and effectiveness in comparison with other policies. After the World War II, advanced economies were hit by huge public debt burdens(Riet 28). Truncation of the domestic financial system by these economies proved to be immensely valuable.
The heterogeneity between public debt and growth clearly manifested itself after the financial crisis that hit advanced economies after the recession in 2007. Growth policy involves lowering the size of the public debt about the size of the specific economy. These economies have been striving to fuel economic changes through subsidies; tax relieves among other fiscal strategies, but it may prove to be very difficult without an expansionary fiscal policy that also makes the growth policy highly uncertain in the long run.
Growth policy may be uncertain in the long run due to the traditional crowding out effects some of which are found in the fiscal repression policy, public expenditure as well as social welfare. It was also divergent from the fiscal consolidation policy illustrated above. Political implications are arising from this policy, include the ability of the governing bodies to formulate fiscal policies, such as regulatory control and also the rule of law. Political stability, therefore, stems from this policy.
The backdrop above clearly illustrates that there is not a single option, activity, or policy that will ease the debt burden in advanced economies. As policy makers, we are therefore tasked with formulating sustainable strategies that will genuinely decrease public debt and reduce the burden imposed on future generations. Economic growth should also not be accompanied by an expansion of public debts. No single policy is sufficient by itself; ideal situations, therefore, require a perfect mix of policies or aspects of these policies as was in the case of growth and inflation in the United States after World War II.
First, the creation of an integrated program such as the European Union would increase accountability. Greece was, for instance, accountable to the union in light of the recent economic crisis in the country. Such programs in advanced economies will not only promote accountability but also boost healthy competition and collective economic growth. Additionally, negative implications of policies such fiscal instability in the long would be greatly reduced. G20 is an international platform for the top 20 economies in the world. It is a platform that brings together leaders from these countries to discuss global policies key among them being global debt and transparency.
Second, it is also crucial to create standardized worldwide rules for reporting the full debt that can be regulated by the IMF, which will decrease the occurrence of Defaults. As a result, proper debt levels will be provided. Thus, the sufficient policies needed to promote economic growth and limit the expansion of debt will be enacted. All countries are in debt for similar but different reasons; therefore each country will need to pass different policies about each other, which can be effective through transparency.
Fiscal consolidation could be done selectively depending on whether funded programs are achieving desired results or not. Governments should stop the funded programs if not effective in making money, or achieving desired results. This would put a cap on debt before it gets out of hand, and gives priority to investments that promote economic growth. For this to be done there must be a regulatory service to check consistently on borrowers, to ensure that they are achieving promised/desired results.
Fiscal repression will be very effective to help promote economic growth without recurring new debt, or having to crowd out. The process to implement the policy should therefore commence immediately. As explained above, the process is not immediate but progressive as it fundamentally involves the use of government policy to force domestic investors to buy or hold government bonds at low-interest rates. This would then increase domestic investment, which promotes economic growth. Fiscal repression would be very effective if implemented with qualitative easing strategies to keep rates low on longer bonds. This would provide an incentive for domestic investors to buy bonds with a longer time to maturity. A combination of these two would work efficiently in a time of debt. Typically low real interest rates would normally reduce savings, move consumption from future years into the present, and generate stronger economic growth. The backdrop explains why fiscal repression policy is the most effective of the other alternatives.
Economic growth is at the heart of public debt elimination. An increase in public debt results in higher interests that lower the rate of investment that ultimately leads to low or stagnating economic growth. Government borrowing, on the other hand, may crowd out private investment, which leads to a further lowering of economic growth forecasts. As a result, the Canadian government would not be able to control costs anymore.
In addition to considering the level of public debt, it is also important to factor in the type of debts in determining debt sustainability in the future. Perfect examples are the current structural deficits, where even with full employment, government revenue will not cover government expenses. This case exists in most of the advanced economies.
The government extended fiscal support to troubled banks to stabilize the financial system, and enacted many large packages to boost output, demand, and employment. This is resulting in lower tax receipts and increased government spending on programs such as employment insurance. All of these factors combined contributed to the vast increase in government debt among advanced industrialized countries.
With either option selection, there should be a cost-benefits analysis by the government to determine whether the benefits of option outweigh costs for implementing the option. For each option, the total cost should be divided by its effectiveness, to complete a cost-effectiveness analysis. On the other hand, the cost benefits analysis includes an extra step by looking at the total benefits minus the total cost to show the net benefits of each option. Finally comparing all options to find the optimal option.
While governments take on debt, their ability to pay their existing debt becomes harder and increases the risk for the investor. As a result, investors will increase interest rates on borrowing to compensate for risk. Having a higher interest rate means a higher cost of borrowing for future. On the other hand, governments that have significant borrowing crowds out investment and decreases saving. This reduces private investment spending as a result of a supply of funds increase, with no change in demand for loanable funds, hence increasing interest rates.
There are many positive benefits to lower public debt for an economy that allow governments to borrow at lower interest rates, which means spending less on a budget of interest payments that allows for future growth and stability. If we continue with this consistent increase in debt levels, there will be negative impacts on investment and economic growth in future.
An increase in risk should be accompanied by a higher premium to compensate for that risk. Advanced economies are burdened with heavy public debts that hinder the governments’ ability to fund future programs and services while debt expenses increase. With high debt burden, governments may not be able to raise necessary funds to respond to a crisis since the increased debt levels hinder their flexibility. Borrowing today also shifts the burden of paying for current spending to future generations. Changing investor’s perception about countries economic stability and ability to repay loan also increases risk thus increases interest rates, and limits a nation’s access to credit markets.
Public debt, an underlying cause of most financial problems in advanced economies continues to be a menace and hampers economic growth. It has become almost impossible to repay the debts without incurring more debts a situation which if not effectively controlled will cripple the future generation. Implementation of the policies discussed above will mitigate the menace and ensure a debt free future.
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