The economic statistics published in the last few weeks show that economic activity in the leading industrialised countries is starting to slow down again. A slowdown that is hardly surprising: I’ve written on numerous occasions about the artificiality of the economic upturn of the last twelve months since it was induced by public spending. The fundamentals for a sustainable recovery were not in place given a debt-laden private sector and the fragility of the banking sector. What was surprising in the last 12 months was not the strength of the economic recovery but its weakness, when we consider the resources deployed – interest rates at historic lows and budgetary deficits at record levels for peacetime.

The renewed economic slowdown comes at a particularly delicate time. To combat the banking crisis and counter the negative impact on growth resulting from the deleveraging underway in the private sector (especially Anglo-Saxon households and banks), the authorities have accepted an unprecedented increase in their own debt, witness the massive increase in the public debt-to-GDP ratio in all countries and the explosion of the balance sheets of the central banks which have been forced to increase the monetary base to buy up dubious-quality notes held by the banks. The objective was that once the economic recovery was sustainably on track and the situation “back to normal”, governments would start to reduce their budgetary deficit and the central banks would start to unwind the exceptional measures they had put in place during the crisis.

A new slowdown in the economic situation, or even a recession, would put this objective in danger. The United States would have to take action just when unemployment rates are hovering around 10%, short-term interest rates are close to zero and the budgetary deficit is more than 10% of GDP. Before the publication of the recent very bad statistics on unemployment and the real estate market, a debate had already started between those calling for a rapid return to budgetary rigour and those coming down on the side of not rushing into any such return for fear of risking a headlong dive back into recession. The latter have been vindicated by the latest economic figures and are calling for further budgetary stimulus measures.

However, a government cannot go on racking up debt endlessly. In their book “This time is different” (1), the American professors Reinhart and Rogoff show that it is nevertheless impossible to determine a precise level of debt (in absolute value or as a percentage of GDP) that would trigger a crisis or payment default. The Russian crisis in the 1990s came at a time when the country’s debt-to-GDP ratio was only 12%, while Japan’s public debt is currently over 200% of GDP without a crisis. It all depends on investors’ confidence in the country, the presence of domestic investors, the percentage of public debt denominated in foreign currencies, the reasons at the source of the public sector debt (productive investments that increase the country’s growth potential – and therefore its capacity to honour its debt – or cash for clunkers?), and the capacity of the political authorities to impose public spending cuts or a tax hike.

That said, there are several elements that make the current situation particularly dangerous. The deterioration of public finances is now a widespread phenomenon in the industrialised countries. The examples often cited of heavily-indebted countries that have succeeded in re-establishing their budgetary situation and reducing their debt, such as Canada, Finland or Sweden in the 1990s, are a bit deceptive since at the time, these countries were the exception and not the rule and they were able to profit from robust world growth and the depreciation of their currency to enhance their fiscal receipts. Secondly, countries now have to bear the burden of a welfare state that is becoming ever more onerous with the ageing population and increased life expectancy. Current debt-to-GDP ratios, high as they are, do not take into account a number of commitments made by governments to their citizens, especially as regards pensions and health insurance. And lastly, notwithstanding historically low interest rates, debt servicing is starting to swallow up a growing proportion of government receipts. Without enormous political courage and substantial sacrifices by the population not to mortgage the future for generations to come, it will therefore be extremely difficult to reduce public spending in any meaningful way. The worry must thus be that a potential return to budgetary rigour will entail an increase in taxes despite numerous academic studies that show the negative multiplier of a tax rise on the economy. In other words, a tax rise reduces the potential for medium and long-term growth. The multiplier of a tax hike is often estimated at between -1 and -3, meaning that a 1 billion tax rise will have a contractionary impact on GDP of 1 to 3 billion over 10 years. However, to reduce the public debt-to-GDP ratio, it is vital not to ignore the ratio’s denominator, i.e. the growth aspect. To avoid a catastrophic scenario, the growth rate of GDP must exceed the interest paid on the debt. A return to budgetary rigour should then be achieved by measures that will not penalize the long-term growth potential of an economy. In their book, Reinhart and Rogoff show that cuts in public spending are preferable to higher taxes when it is a question of re-establishing the economic health of a country after a financial crisis. This is particularly the case for Europe where public expenditure already represents a significant proportion of GDP, to the detriment of the private sector. 

Highest Marginal Income Tax Rate in the United States between 1925 and 1940

Source: Gluskin Sheff

So what are the consequences for the financial markets?
First of all, we are in an exceptional situation and investors should stop basing their investment strategy on what has traditionally happened in a classic cycle. Second, interest rates will remain low, partly because of structural elements weighing on growth and the risk of deflation, and partly because the authorities will do their utmost to prevent a rise in interest rates given the disastrous effect that such a rise would have on debt servicing. Hence the recent emergence of the term “financial oppression” – forcing creditors to accept a real return that is artificially low, or even negative (by, for example, encouraging the banks to massively buy government bonds). But the low level of interest rates is not a good enough reason to buy risk assets with unrealistic return expectations. As the Financial Times said recently: “The only thing worse than a low-yielding world is denying that it exists.” Unlike the bond market, so far the equity market has not factored in the new economic reality of lower growth. And lastly, as regards government borrowing, we are bound to conclude that some countries are now in a situation where the only logical outcome is debt restructuring. In general, these are countries that do not have control over their currency, where the low level of interest rates has led to over-consumption and speculative bubbles, and where a significant portion of their debt is held by foreigners. For other countries, creating inflation to reduce the real cost of debt could be tempting but we haven’t quite got to that point yet. Especially as a significant proportion of public expenditure is now indexed to inflation.

(1) Carmen Reinhart, Kenneth Rogoff: This time is different - Eight Centuries of Financial Folly, Princeton University Press.