“CNBC – Global debt is at historic highs and governments should start cutting levels now, the IMF says”
*Sigh*
So, there’s been a lot of debt chatter coming out of the IMF recently. Just yesterday, we had them offer their unsolicited analysis on how the U.S. debt/GDP ratio will be worse than, gasp, Italy’s by 2023. Today, we have Christine Lagarde, former French finance minister and current head of the IMF, imploring governments around the world to reduce their debt loads now while the getting is good. Don’t get me wrong, if you have the ability to reduce your debt burden in a responsible manner, do it. That said, just telling people debt is too high and that it’s a risk shows either a misunderstanding of the global financial system or an unwillingness to actually explain to people how it works and why we’ve racked up $164T in obligations.
The IMF piece focuses mainly on public sector debt as that has increased the most in the last decade, but we should touch on private debt first. Private, non-financial debt accounts for most of the debt globally, about 63% of it. In the last decade of low rates, households have borrowed to purchase houses, and corporations to fund domestic operations while leaving cash overseas and away from the tax man. In the case of the former, a house is a huge asset that can appreciate in value, be sold or be collateralized. In the case of the latter, the newly raised cash shows as an asset on the balance sheet while the bond appears as a liability, largely canceling each other out minus some interest expense. To the extent the cash is used for capex, that too will appear as an asset on a balance sheet as new equipment, property, investments, etc. In the end, the macro impact of private borrowing is a relative wash (barring credit cards and other consumer lending products, those are poor financial choices).
Let’s jump into public debt though, because that seems to be what’s worrying the IMF the most. They claim that debt/GDP ratios for advanced economies have only been this high once before: WWII. This is very true, but also very misleading. It’s helpful to understand the role government debt plays in a modern, credit-based economy before losing our minds.
Modern economies all have a (i) Government, (ii) Central Bank and (iii) Banking System. There are slight nuances here and there (especially in the Eurozone), but their functionalities are generally the same. Since all three of my readers are here in the U.S., we’ll use our system as a proxy for all developed economies. The Federal Reserve is the arbiter of the dollar. It controls the base money supply, credit availability / expansion, the cost to borrow in dollars, etc. It does this through what is called Open Market Operations (“OMOs”). This means that when the Fed wants to increase the money supply, they create some dollars and use them to buy shorter dated U.S. Government bonds. This pumps dollars into the banking system and reduces short term interest rates with the intent of stimulating the economy, and vice versa when the Fed wants to do the opposite. In a nutshell, the Fed uses the credit of the U.S. Government to conduct monetary policy. It’s no coincidence people say the dollar is backed by the “full faith and credit of the U.S. Government”, it’s a fact. Because of this relationship between the dollar and U.S. Government bonds, the two are more or less accepted universally as collateral in financial transactions (this is true for most other developed nations as well). At this moment, there are trillions upon trillions of dollars worth of government bonds posted as collateral all around the world, reinforcing trust in counterparties to transactions and keeping the system humming along. So while governments would be doing right by their taxpaying citizens to reduce or eliminate fiscal imbalances, a global, coordinated effort to actually pay down outstanding debt would wreak havoc on the financial system as bonds posted for collateral would cease to exist. Not only would there be a need to source new collateral to conduct transactions, the need would be great enough the materially impact interest rates and dollar reserves around the world. There’d be funding shortages, leading to soaring overnight and repo rates. It would be a mess (not cataclysmic, but messy regardless).
What’s also grinding IMF gears is not just the amount of public debt/GDP, but the pace at which it has accelerated over the last decade or so. The concern is understandable, but also a bit misguided. Since the financial crisis, central banks in the developed world have pumped trillions of dollars of liquidity into the financial system through Quantitative Easing (“QE”). This is a monetary policy tool in addition to the standard OMOs we discussed up top, and is used when conventional methods of stimulating the economy aren’t sufficient. The main difference between OMOs and QE is that the latter is more broad in its bond purchases, targeting government agency (Fannie, Freddie, et al.) and longer dated bonds. During and after the crisis, governments around the world, in tandem with their central banks, undertook an effort to recapitalize the global banking system through QE. For example, the U.S. Government would issue bonds directly to banks, who would turn around and sell the bonds to The Fed. At the end of the process, the U.S. Government has more debt, the banks have newly created cash and The Fed owns the bonds. This is where a lot of the incremental debt came from – a decade long effort to recap and stimulate the global economy through QE is directly responsible for the sharp uptick in public sector borrowing.
And that’s not a necessarily a bad thing. The Fed is what’s considered a quasi-government entity, but for all intents and purposes, it functions as part of the U.S. Government. If you think about it along those lines, you have bond issuance showing up as a liability on the U.S. Government’s balance sheet, but as an asset on the Fed’s. What’s more, the U.S. Government is paying interest to The Fed on the bonds, and The Fed turns around and writes a check each year to the Treasury to return the proceeds (minus operating costs). Lastly, The Fed reserves the right to buy and sell those bonds to conduct OMOs in the future, but it can also hold the bonds through maturity if need be, at which point the U.S. Government will either pay the principal to The Fed who will give it back at year end, or simply refinance the bonds in an endless cycle: wash, rinse, repeat. So yes, governments have been borrowing hand over first since the crisis, but when you combine central bank participation alongside how much government debt is owned by public and private retirement vehicles, much of it is actually owed to ourselves.
And that’s my problem with pieces like these. They’re all show and no substance. People read this stuff with the IMF stamp on it and then think they’re making informed decisions on how to invest, vote or spend – but they’re not. The only way modern capitalism works is the expansion of credit, not the contraction of it. Take a lap, Lagarde.