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Against the tide: Sovereign discredit!

Burgeoning sovereign debt is a threat to economic recovery, not a way to achieve it. It will crowd out borrowing for more productive purposes and will inevitably foster inflation and possibly defaults.

I have argued before that the use of excessive sovereign debt to replace private-sector borrowing is like trying to cure a drug addict of his addiction with more dope. It will not lead to a sustainable economic recovery. And it will create more asset bubbles that will also collapse. The result will be a sovereign debt crisis.

It’s the theme of a new book, Sovereign DisCredit, co-authored with my colleague, Bob McKee (Sovereign DisCredit! by David Roche and Bob McKee, published by The cost of capital will rise and OECD economies will expand more slowly as booming sovereign debt crowds out the private sector from the available savings it needs for the economy to grow. There could be a series of sovereign debt defaults in several OECD countries, which would risk plunging the world back into a recession.

Big government and rising sovereign debt and deficits are a misallocation of resources that will generate inflation

Politicians and the authorities (treasury departments and central banks) were motivated to use leverage to fight over-leverage because, for more than 25 years, credit bubbles have been the fuel that drove global growth. Every time growth stalled, or there was an economic crisis, policymakers initiated another bubble. The debt burdens of deficit-ridden governments are now growing fast. Levels of sovereign debt in most OECD countries will reach 70% to 120% of GDP by 2011, up by 50% to 150% from before the crisis.

The need for funding government budget deficits now zaps a quarter of available world savings. It would take astronomical fiscal tightening to reduce this mountain of public debt to a level where it does not impinge on the ability of an economy to invest and grow at an optimal rate.

There’s a critical sovereign debt threshold beyond which increased state leverage and deficit spending is counterproductive and causes the economy to shrink. In nearly all the economies suffering the credit crisis that threshold (60% to 90% of GDP) has been crossed or shortly will be.

OECD net government borrowing

As share of world savings and real government bond yield

Source: IMF, Independent Strategy

Part of the problem with sovereign leverage is that much fiscal spending is of the wrong sort. The state is borrowing at a cost which, although low, is higher than the returns that will be generated by much of its spending. If government spending is geared to prolonging excesses or boosting consumption rather than productive investment, then the problem is worse. If all this is clear to us, why is it not so to the markets? Despite exploding government debt, sovereign bond yields are at near 10-year lows. The market view is that the driver of bond yields is inflation. And this, it believes, will stay low, because of paltry economic recovery and the existence of large output gaps in terms of both spare capacity and labour.

Inflation is low now but big government and rising sovereign debt and deficits are a misallocation of resources that will generate inflation down the road. Big government does so because the low productivity and market meddling of enlarged bureaucracies always lead to lower productivity and growth and higher inflation. It’s just a matter of time.

As the crisis is widespread and its errors and excesses broadly shared, there will be no dynamic area of the global economy for the afflicted economies to lean on while they deleverage. China’s own credit bubbles makes it part of the problem, not the solution.

This risk of increasing cost of sovereign debt will push nearly all governments to try to lock in current low bond yields by undertaking longer-term borrowing. However, this also means that investors will have to make a long-term forecast of the solvency of governments whose debt they buy. They will have to price in the increasing likelihood of crisis or insolvency or any attempts to inflate away sovereign debt burdens. This will contribute to increasing the cost of borrowing to governments.

All this heralds a higher global cost of capital and weak economic growth, at best. But it could be worse. There is an increasing risk of a series of sovereign debt defaults. The crisis over Greek sovereign debt might spread to the other big-deficit/high-debt economies in the eurozone, such as Spain, Portugal, Ireland, Belgium and Italy. Even if the EU succeeds in drawing a line in the sand around the eurozone, the sovereign debt crisis will migrate elsewhere.

David Roche is president of Independent Strategy Ltd, a London-based research firm.

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