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The global debt overhang and interest rates
After the financial crisis, investors intensively discussed the large amount of new debt accumulated by governments during the crisis and how this debt could be reduced over time (financial repression was the fashionable expression back then). Somehow, very few people seem to realise what the lessons from back then imply for the next couple of years and where interest rates can go.
After the financial crisis, the main problem for central banks was that they couldn’t hike interest rates in any meaningful matter because banks and households were in a pitiful state of too much debt that needed to be reduced gradually. If interest rates had risen too fast, it would have significantly reduced the ability of governments, banks and households to service this debt and possibly created a wave of defaults. After all, this is what the European debt crisis of 2011 and 2012 was all about. Countries like Italy or Spain couldn’t cut their interest rates unilaterally because they were part of the Eurozone and subject to the rate regime of the ECB.
Today, the advantage we have is that banks and households are in much better shape than after the financial crisis, so as far as these actors are concerned, central banks can hike interest rates without having to worry about a wave of defaults. But these actors are just one part of the economy. Ayhan Kose and his colleagues from the World Bank have done a very good job showing how the amount of debt has grown faster in 2019 to 2020 than at any other time since 1970. The chart below shows how much additional debt (measured in % of GDP) has been accumulated in the nine years from 2010 to 2019 and compares this to the newly accumulated debt in 2020. This data is the average of developed countries, but in his note Kose also shows the numbers for emerging markets. Furthermore, they show that he buildup of new debt in the last decade was about the same as a share of GDP as during the 2002 to 2009 period.
Change in government and private sector debt
Source: Kose et al. (2021)
What we are stuck with now, is a significant debt overhang both on the government side and in the private sector. The difference is simply that the vulnerable players are not the banks and households but private companies and governments.
Average level of government and private sector debt in developed economies
Source: Kose et al. (2021)
But that means that the job of central banks hasn’t got any easier. If central banks hike interest rates too much, these higher interest rates will gradually flow through to businesses and governments and increase the cost of debt for these actors. And if the cost to service debt rises, there is less money for investments from businesses and governments. And this in turn leads to lower economic growth, which leads to lower revenue growth, which leads to even less money for investment, etc.
In my view, this debt overhang creates a glass ceiling for interest rates. If central banks break through this glass ceiling, the economy stalls and the slowdown in the economy will eventually force central banks to cut interest rates in order to avoid a recession. Where this glass ceiling is, is impossible to know, but I think it is somewhere between 2% and 3% in the United States and the UK and probably lower in the Eurozone. Of course that means that we are going to see quite a few more rate hikes before we reach that glass ceiling, but it also means that investors who expect the Fed to hike rates fast and aggressive throughout 2022 and 2023 probably are getting ahead of themselves.
Looking beyond 2022, if interest rates can’t go much higher than 2% or 3% this means that we will be stuck for longer with the low interest rate environment we have been living in for the last decade. In fact, the only way to get rid of the debt overhang we have today is the same way that porcupines kiss – very carefully. This means we need to have low interest rates for quite a long time and zero or negative real interest rates for even longer. If interest rates rise too fast, central banks kill growth. If real interest rates rise too far above zero, they kill growth as well. What we need is another decade of the same environment as we had the last decade. Everything else would lead to catastrophe. I find it hard to believe that central banks will lead the global economy into another financial crisis just to get rid of excess debt quickly. To central bankers, another crisis like 2008 simply cannot happen and as one of my mentors liked to say: “What cannot happen, will not happen”.