The growth in public debt to finance the fight against the Covid-19 pandemic and to support national economies has been substantial. Total public debt, estimated at $ 66 trillion before the crisis, is now expected to exceed $ 92 trillion this year. Total global debt as a percentage of GDP has jumped 35% since the pandemic to over 360% of GDP today.
While many would say this build-up of public debt was inevitable given the unprecedented crisis, the fact remains that governments have been addicted to easy money and debt-financed growth for many years now. All of the major economies – the United States, Japan, China and countries in the euro area – have more debt than their total output as measured by GDP. In the case of Japan and China, it’s several folds.
With interest rates around the world at or near historically low levels, the cost of these debts to governments has so far been manageable. However, in the future, in a less calm interest rate environment, managing this massive debt distress is likely to pose many challenges, with the potential for a catastrophic banking loop a major challenge.
The catastrophic loop refers to the mutually beneficial symbiotic relationship that exists between governments and national banks. Governments seeking to fill budget deficits by issuing sovereign papers have domestic financial institutions as ever-greedy investors. Since banking regulations everywhere consider government debt securities to be “risk-free”, they impose no capital requirements on banks and would be counted in a bank’s reserves. The fact that these government-issued papers provide regulatory advantages while offering a “risk-free” return, makes them a much more attractive risk-return proposition for banks, compared to other financings.
Governments cannot in fact default on their debt denominated in national currency, because they have the possibility of printing the necessary currency to repay the loan. So, yes, the credit / default risk may be zero, but other risks – such as inflation risk, liquidity risk, rating risk, and political risk – remain. Thus, the “risk-free” label for public debts, as shown by the crisis in the euro zone involving the PIIGS (Portugal, Italy, Ireland, Greece and Spain), is a serious case of labeling error. What happened in Europe was a simple case of a catastrophic banking loop. National banks lent money to their governments by purchasing the bonds issued. But as public debt continued to rise and quality deteriorated, banks that had accumulated huge holdings of public debt began to falter. They were affected by the need to write down the value of their assets in order to comply with mark-to-market regulations.
The immediate impact would be a freeze on bank lending activities. But, even worse, the blow to the assets of banks’ balance sheets would result in equal offsetting on equity, which, if large enough, would require the banks to bail out. The result is the need for a government that is itself overwhelmed to bail out its banks. Banks now need government as much as government needs banks as a source of continued debt financing. The government and its banks become hostages to excessive debt. What once seemed like a mutually beneficial relationship is now turning into a deadly embrace – hence the loop of fate.
The catastrophic loop in the eurozone took all the firepower of the troika – the European Commission, the European Central Bank and the International Monetary Fund – and a lot of human suffering to put things back in order. Unfortunately, the lessons may have been forgotten. Today, with much of the world sitting in a powder keg of debt, the situation may be ripe for this catastrophic loop to repeat in other parts of the world.
There are two distinct possibilities by which a tipping point can be reached. The first is made up of inflationary pressures and the second is a forced revaluation of the public debt. Both will lead to an increase in the yield required for government bonds, causing bond prices to fall, which, if substantial, can trigger the chain of events leading to the catastrophic loop. The return of inflation is evident and the recent massive accumulation of debt is becoming problematic now that the exit from this pandemic seems less straightforward.
The catastrophic banking loop is just one of many problems with debt financing. Imagine how much the moral hazard problem grows when governments are forced to bail out banks, because banks have trouble holding government bonds. The clearest way out of all of this would be to move away from debt dependent systems.
Islamic finance risk-sharing contracts offer a viable, debt-free alternative for public finance, especially development infrastructure finance. But the current debt-based system, disruptive as it has been, is symbiotic, with each actor providing the conditions necessary for the other to exist.
As Andrew Haldane of the Bank of England said of the Federal Reserve’s action during the 2008 US subprime crisis: “If the government (the Fed) has been so quick and determined to save big finance, it is because finance. But each bailout fosters new speculation and bigger bets. The scale and scope of each rescue continues to grow. Hence the catastrophic loop.
With domestic currency debt, governments do indeed have the tools to delay, if not prevent, the catastrophic loop and keep the banks intact, but as always, society would bear the costs.
Dr Obiyathulla Ismath Bacha is Professor of Finance at the International Center for Islamic Finance Education (INCEIF)