Après the debt crisis, le deluge?

Greek debt was back in the news last week. The news that Eurozone finance ministers had overcome an impasse with the IMF and will disburse €10.3bn to enable Greece to meet its immediate commitments to the IMF and the European Central Bank (ECB) of about €4bn. This still leaves Greece with close to €300bn of debt to be repaid over the next 30 years. A surely impossible task of fiscal adjustment – despite debt relief to date that has amounted to close to €200bn. One can only wonder all over again how Greece managed to run up such debt and why it has so little in the form of productive infrastructure and additional human capital to show for it.

The graphic below, from the Wall Street Journal, reveals Greece’s obligations over the next 40 years:

But this particular odyssey has moved on beyond the Aegean Seas.The Euro debt crisis seems to have faded into the background. Eurobond yields for the most vulnerable of the Euro borrowers are now well below pre-crisis levels, as we show below.

The relief for the bond markets came partly in the form of some modest fiscal austerity but largely, and more importantly, came from the ECB doing “whatever it took” to rescue the bond market with its quantitative easing programme – buying bonds in the market place in exchange for deposits placed by banks with their central banks. It was following the example of the US Fed, the Bank of Japan and the Bank of England in providing extraordinary supplies of central bank money to their banking systems via purchases of government and other debt instruments in the debt markets.As a result, central banks have become major sources of demand for government bonds and as such, have not only relieved the banks of any lack of liquidity but have also, through their actions in the bond markets, have directly led interest rates lower. We rely on the Bank of International Settlements (BIS) for the operational details and balance sheet outcomes shown below.

These central banks are all government agencies and so their assets and liabilities should be consolidated with those of their respective government treasuries. In effect, the net debt of the government (net of central bank holdings) has been to an ever greater degree funded with deposits (cash reserves) issued by their central banks. In the case of the ECB and the BOJ, but not the US Fed, these deposits are penalised with a negative rate of interest. In other words, with cash that is an interest bearing liability of the government. So far, most of the extra cash issued by central banks has been held by the banks rather than used to supply bank credit. Hence aggregate spending by households and firms has remained highly subdued.Deflation rather than inflation has become the feature of the developed world, despite the unprecedented increase in the supply of central bank money. Deflation and, more important, the expectation that inflation will remain highly subdued for the next 30 years at least, has meant persistently low interest rates. In parts of the developed world like Japan and Switzerland, nominal interest rates offered by governments for 10 year loans have turned negative. In other words, lenders are now paying governments to take their savings for an extended period, rather than receiving interest income from them. Another way of explaining such circumstances is that issuing long-dated debt at negative interest rates is even more helpful to governments and their taxpayers than issuing zero interest bearing notes or deposits at the central bank, unless bank deposits held at the central bank also attract a negative interest rate (as they may well do).

Accordingly while government debt has grown – though much less so for debt held outside central banks – interest rates have receded and government’s debt service costs have declined rather than increased. The debt burden for taxpayers has become less rather than more oppressive. Moreover, the global economy continues to operate well below what may be regarded as its growth potential. These conditions make for an obvious political response. They make the case for more government spending, funded by issuing very cheap debt rather than higher tax rates or tax revenues. A call, that is, for government stimulus rather than austerity now that the debt crisis has been dealt with.

The major central banks, other than the Fed, are still doing as much as they can to add to the money stock and to reduce interest rates across the yield curve. But the lack of demand for, as well as reluctance to supply, bank credit has meant persistently weak demand. The temptation for governments to popularly spend more and raise more debt would seem to be irresistible.

The Japanese government, with a gross debt to GDP ratio of as much as 400% (though with much of the debt held by the Bank of Japan and the Post Office Bank) is not resisting. It is postponing an intended increase in sales tax that had been mooted before to close the large fiscal deficit. Where Japan, with its negative costs of borrowing leads, other governments will be encouraged to follow. Will inflation be expected to remain as low as it now does?

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