Saturday, May 8, 2010

Bank for International Settlements Warns on Government Debt

The central bankers' central bank, The Bank for International Settlements, is warning in a paper by  Stephen G. Cecchetti, M. S. Mohanty, and Fabrizio Zampolli on the serious implications of high government debt levels. This an extremely important paper. It is thorough and comes from an insiders perspective. Not all insiders will understand the implications of what is written in this paper, but the intelligent ones will.

 Here are key snippets:
Our projections of public debt ratios lead us to conclude that the path pursued by fiscal authorities in a number of industrial countries is unsustainable. Drastic measures are necessary to check the rapid growth of current and future liabilities of governments and reduce their adverse consequences for long-term growth and monetary stability....

Today, interest rates are exceptionally low and the growth outlook for advanced economies is modest at best. This leads us to conclude that the question is when markets will start putting pressure on governments, not if.

When, in the absence of fiscal actions, will investors start demanding a much higher compensation for the risk of holding the increasingly large amounts of public debt that authorities are going to issue to finance their extravagant ways?...

... associated with high levels of public debt comes from potentially lower long-term growth. A higher level of public debt implies that a larger share of society's resources is permanently being spent servicing the debt. This means that a government intent on maintaining a given level of public services and transfers must raise taxes as debt increases. Taxes distort resource allocation, and can lead to lower levels of growth. Given the level of taxes in some countries, one has to wonder if further increases will actually raise revenue.

"The distortionary impact of taxes is normally further compounded by the crowding-out of productive private capital. In a closed economy, a higher level of public debt will eventually absorb a larger share of national wealth, pushing up real interest rates and causing an offsetting fall in the stock of private capital.

This not only lowers the level of output but, since new capital is invariably more productive than old capital, a reduced rate of capital accumulation can also lead to a persistent slowdown in the rate of economic growth. In an open economy, international financial markets can moderate these effects so long as investors remain confident in a country's ability to repay. But, even when private capital is not crowded out, larger borrowing from abroad means that domestic income is reduced by interest paid to foreigners, increasing the gap between GDP and GNP....

A second mechanism by which public debt can lead to inflation focuses on the political and economic pressures that a monetary policymaker may face to inflate away the real value of debt. The payoff to doing this rises the bigger the debt, the longer its average maturity, the larger the fraction denominated in domestic currency, and the bigger the fraction held by foreigners. Moreover, the incentives to tolerate temporarily high inflation rise if the tax and transfer system is mainly based on nominal cash flows and if policymakers see a social benefit to helping households and firms to reduce their leverage in real terms. It is, however, worth emphasising that the costs of creating an unexpected inflation would almost surely be very high in the form of permanently high future real interest rates (and any other distortions caused by persistently higher inflation)...Our examination of the future of public debt leads us to several important conclusions. First, fiscal problems confronting industrial economies are bigger than suggested by official debt figures that show the implications of the financial crisis and recession for fiscal balances. As frightening as it is to consider public debt increasing to more than 100% of GDP, an even greater danger arises from a rapidly ageing population. The related unfunded liabilities are large and growing, and should be a central part of today's long-term fiscal planning.

"It is essential that governments not be lulled into complacency by the ease with which they have financed their deficits thus far. In the aftermath of the financial crisis, the path of future output is likely to be permanently below where we thought it would be just several years ago. As a result, government revenues will be lower and expenditures higher, making consolidation even more difficult. But, unless action is taken to place fiscal policy on a sustainable footing, these costs could easily rise sharply and suddenly...

....looming long-term fiscal imbalances pose significant risk to the prospects for future monetary stability. We describe two channels through which unstable debt dynamics could lead to higher inflation: direct debt monetisation, and the temptation to reduce the real value of government debt through higher inflation.
There you have it as clear a warning as you can get from the inside. It should be noted that Cecchetti, Mohanty, and Zampolli are warning about much more than the PIIGS. They clearly also have the U.S. and the U.K. in mind.

Curiously, though, the authors after this fine work, state that inflation is not an imminent threat:
Given the current institutional setting of monetary policy, both [inflation]risks are clearly limited, at least for now.
I am not as optimistic.  When interest rates start to climb, the climb could be dramatic. There is no evidence that U.K. central bankers or those in the U.S. will not inflate to halt a dramatic rate climb. Thus, the environment could be extremely inflationary.

The one difference between  the PIIGS and the "U"s is that the "U"s can print money and likely will do so.

Bottom line: There is absolutely no reason to hold long-term debt of the "U"s. One way, or another, it is all going to come crashing down. What's going on in Greece is just a preview.

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