- The tailwind that the western world long enjoyed has turned into a headwind. We will have to deal with reality.
- For many years, Western nations have borrowed from future wealth to fund today’s consumption.
- The West has reduced the potential for future economic growth for the next generation.
- We need a true assessment of where the West stands and which options are left to deal with the situation – now.
- Three steps need to be taken: Acknowledge the facts, deal with reality – and build for the future.
- In the 1960s, a dollar of new credit led to 59 cents in new GDP, in the early 2000s just 18 cents.
- The current debt overhang is $11 trillion for the United States and $10 trillion for the eurozone.
- Companies cannot invest in training, innovation or their capital stock, which causes lower future growth.
- Given the welfare burden, the public debt levels of governments are between four and eight times GDP!
This is part one of a three-part series on the longterm fiscal crisis facing the world’s advanced economies.
Five years into the financial crisis, politicians and central bankers continue to “kick the can down the road” on fiscal concerns. They pursue policies designed to postpone the day of reckoning and avoid telling the public the truth. A sizeable part of the promises they have made will not be fulfilled.
We have gone on talking quite nonchalantly for many years about borrowing significantly from future wealth to fund the consumption of today. Soon, that bill will hit home. This will have a direct impact on the promises made regarding future payments for pensions and for health care that no one will be able to fund.
In the process, we have reduced the potential for future economic growth. That makes it even more difficult for the next generation to deal with our legacy.
It is time to stop pretending everything is on a solid track and that we can continue as we did in the past decades. We need a true assessment of where we stand and which options are left to deal with the situation. And we need to deal with these challenges now. Every day longer that we wait increases the damage for all of us.
As in all crisis situations, three steps need to be taken:
- Acknowledge the facts
- Deal with reality
- Build for the future
The first step is to acknowledge the facts
Since 1980, the combined debt of governments, private households and non-financial companies in North America, Europe, Australia and Japan rose from 160% of GDP to 350%. In real terms, non-financial corporations have accumulated more than three times the debt they had in 1980, governments more than four times – and private households more than six times.
The vast majority of that debt has not been used to increase future income but to consume, to speculate in stocks and real estate, as well as to pay the interest on previous debt. During the 1960s, each additional dollar of new credit led to 59 cents in new GDP. By the first decade of the new century, that same dollar of credit was producing just 18 cents in new GDP.
Politicians and central banks in our “advanced” countries encouraged the credit boom. Facing increasing competitive pressure from cheaper labor in Asia and Eastern Europe, they looked for an easy way to keep up the welfare of their nations.
The better way would have been to invest in education, innovation and capital stock to remain competitive and to justify higher wages. Instead of pursuing this path, politicians supported the dream of ever-rising asset prices to allow for a credit-financed consumption boom in the United States and increased welfare spending, again on credit, in Europe.
Threshold for a sustainable debt level
Assuming a nominal interest rate of 5% and economic growth of 3%, the threshold for a sustainable debt level is roughly 60% of GDP. In this case, the government could take on new credit to pay the interest on its outstanding debt and the debt/GDP ratio would remain constant, as both debt and GDP grow at the same rate (paying 5% interest on 60% debt = 3% on 100% of GDP).
Applying that threshold to non-financial corporate debt and private-household debt as well establishes an overall “sustainable debt-to-GDP ratio” for an economy of 180%. Once an economy is above this threshold, it gets difficult to slow the growth of debt relative to GDP, as this requires using true savings. Being forced to do so affects the growth of an economy, as can be seen in Greece (or Italy, Portugal, Spain).
Under those assumptions, the current debt overhang – the debt which will not be served in an orderly way – is approximately $11 trillion (67% of GDP) for the United States and $10 trillion (78% of GDP) for the eurozone.
Only the economies of Italy and the United States have started the process of de-leveraging. In the case of the United States, this de-leveraging is mainly the result of defaults, not of actually paying back loans. Other highly indebted economies such the UK, Spain and France are still piling up additional debt.
Central banks have done “whatever is necessary” to stop the credit bubble from imploding. Record low interest rates, combined with the promise of keeping them low forever, and extensive purchases of financial assets have helped stabilize the existing debt load and it has helped the debtors deal with their obligations.
Akin to Japan in the 1990s, this approach leads to the creation of “zombie” banks and corporations.
While that strategy seems to delay the pain, it imposes some very real costs. These companies cannot invest in training, innovation or their capital stock, which leads to lower growth in the future, making the broader economy less competitive.
Factors amplifying the debt load
The problem of the debt load of the real economy is amplified by the financial sector. The real economy debt serves as collateral for further speculation, which leads to a credit pyramid on very shaky foundations.
The problem of too much debt is greatly exacerbated by the hidden liabilities of governments and companies, especially when it comes to age- or health-care-related spending. Over the last century, life expectancy has doubled and fertility rates have more than halved in the developed world.
In many ways, this is to be welcomed. In 1880, the median fertility rate among women in today’s G7 countries of Canada, France, Germany, Italy, Japan, the UK, and the U.S. was 4.6. Today, it is at or below the rate of natural reproduction (2.1) with Germany, Italy and Japan as low as 1.4.
But we have not done the relevant mathematical adjustments that these shifts necessitate. Instead, the retirement age has been lowered significantly – which would presume either a much higher fertility rate or lower longevity.
In Germany, for example, the old-age-dependency ratio (that is, the number of persons aged 65 or more per 100 persons of working age) was 14% in 1950. It is 31% today. And it will increase to 57% by 2050. In other words, every retiree will need to be supported by fewer than two fully employed people.
In Japan, the dependency ratio was only 8% in 1950. It is 35% today and will climb to 70% by 2050. By the end of this century, there will be at least a 50% dependency ratio in most developed countries.
Financial implications of the welfare burden
The financial implications of this growing welfare burden are dramatic. Even in the benign scenario of reducing current deficits to pre-crisis levels and freezing age-related spending at current levels of GDP, public debt is expected to continue growing at a significant rate. The implicit debt levels of governments are between four and eight times GDP!
In some countries, public and private institutions are putting money aside to save for future benefit payments. But even in these cases, a significant underfunding has to be acknowledged. In the United States, for example, the public pension schemes at state-level are underfunded by up to $4 trillion. States like Illinois have to contend with an underfunding of 70% on their liabilities.
Private companies providing fixed-benefit pensions are also confronting significant underfunding of their pension promises.
In 2011, the S&P 500 companies had combined unfunded liabilities of more than $500 billion and European Stoxx 600 companies had more than €300 billion. For some companies, the amount of unfunded liabilities is equivalent to more than 50% of their market capitalization.
Private households have relied too long on rising asset prices and the promises of politicians and corporate managers, instead of putting aside dedicated funds for retirement. In some countries, private households need to de-leverage precisely at a time when they should be building up assets for their future.
What’s more, the aggressive monetary policies of the leading central banks, designed to stimulate economic growth, have the perverse side effect of reducing interest income and expected future returns as asset values become inflated, forcing households to increase their savings even more.
Fewer working people, lower GDP
Fewer people in the workforce generate less GDP – and therefore less income to pay down existing debts.
Between 2012 and 2050, the working age population between ages 15 and 64 will shrink by about 13% (or 15.8 million people) in Western Europe. In Japan, it will drop by 30% (or 23.8 million people). The U.S. working age population will grow slightly at 0.4 percent per year, but that is slower than the annual growth rate of 1.1 percent during the past 20 years.
As important as the number of available people in an economy’s workforce is the productivity of that workforce. Robert Gordon of Northwestern University makes a compelling case that growth in GDP per capita has been slowing since the mid-20th century. He argues “the rapid progress made over the last 250 years could well turn out to be a unique episode in human history.”
In his view, the space for truly fundamental innovations that result in step-change improvements in living standards is getting smaller. The IT revolution of the past decades had a smaller impact on productivity growth than earlier waves of innovation.
Other factors supporting doubts concerning future productivity growth rates include the oversized public sectors (notably in Europe); the deteriorating quality of the education system in most advanced economies; the systematic underinvestment in public and private capital stock, increased global competition and rising inequality.
As much as the world ardently hopes to be able to grow out of the problem, that will unfortunately not work. The tailwind that the western world enjoyed from innovation, a growing workforce, cheap resources and ever more debt has turned into a headwind. We will have to deal with reality.
Continue to part II.