The Debt Monster Daniel Stelter, Dirk Schilder, and Katrin van Dyken May
AT A GLANCE Unprecedented levels of debt are creating the conditions for higher-than-expected inflation. W G I N A In many countries, GDP growth is lower than the rate of interest on the debt, causing debt as a percentage of GDP to grow not decline. T D B A R By slowing GDP growth, austerity could actually raise the debt burden. And restructuring could damage the financial sector, which holds the debt. T I S Higher-than-expected inflation would reduce the debt burden for governments, companies, and consumers. P L F Inflation may be preferable to being devoured by the debt monster, but it will have profound negative impacts on company profits and enterprise value. T D M
I L recent performance of the world economy, senior executives could be excused for thinking that the worst is behind us. According to the International Monetary Fund (IMF), global GDP grew by a record 5 percent in 21 and is expected to increase by an additional 4 percent in 211. Has the recovery finally kicked into high gear? Can we expect smooth sailing ahead? We don t think so. Both private and public debt are at record levels, and they represent a huge burden on the global economy a burden that is likely to be a significant drag on growth in the years to come. Clearly, these high levels of debt need to be reduced, but that is much easier said than done. The only realistic way to reduce debt levels will also lay the foundation for disruptive new crises and a high-inflation economy that will sap business profits and company enterprise value. We call this intractable situation the debt monster. Like any other monster, the debt monster has two parents. One is the so-called Great Moderation the 26-year period from 1982 through 28, during which declining interest rates led to an unprecedented build-up of private debt. The other is the fiscal stimulus almost $6 trillion spent worldwide by governments in response to the global financial crisis and subsequent Great Recession. In many countries, especially the world s developed economies, the result has been a situation in which combined public and private debt as a percentage of GDP has reached unsustainable levels. Exhibit 1 charts both total government debt and government deficits in 21 as a percentage of GDP for 2 countries as well as the euro zone, which includes most of Europe. In a recent article ( Growth in a Time of Debt, American Economic Review: Papers & Proceedings, May 21), economists Carmen M. Reinhart and Kenneth S. Rogoff showed that once total public debt hits 9 percent of GDP, it begins to have a negative effect on economic growth. And keep in mind that Exhibit 1 shows only public-sector debt. When the private-sector debt of both companies and consumers is added to the picture, the total debt burden can be two times GDP (in the case of Germany, for example) to nearly four times GDP (in the case of ). In theory, there are four ways to slay the debt monster: grow out of debt, starve the monster through a policy of austerity, restructure it, or inflate it away. For reasons that we make clear below, the last option is the only one that s practical, and it s why the debt monster will be a major stimulus for global inflation in the years to come. In this article, we focus on the public-debt side of the debt monster. But the argument applies equally to private-sector debt. T B C G
E Public-Sector Debt in Many Countries Is at or Above the Reinhart-Rogoff Threshold Public debt burden (as a percentage of GDP) 21 18 15 12 9 6 3 Italy Belgium euro Germany zone Sweden Switzerland Canada Brazil Finland India Australia Denmark China Greece 1 2 3 4 5 6 7 8 9 1 11 12 13 14 15 21 annual deficit (as a percentage of GDP) U.K. Reinhart-Rogoff threshold Government gross financial liabilities ($2.5 trillion) Sources: OECD; BCG analysis. Note: All data are from 21 and include the accounts of central, state, and local governments; social security funds; and nonmarket, nonprofit institutions controlled and primarily financed by government units. Why Growth Is Not the Answer The ideal solution for slaying the debt monster would be for an economy to grow its way out of the problem. But as Reinhart and Rogoff point out, Seldom do countries grow their way out of debts. All else being equal, to grow out of debt, an economy needs to achieve a rate of real-gdp growth that is greater than its real-interest rate. When GDP grows faster than debt (as determined by its interest rate), then debt as a percentage of GDP declines. In many developed economies, however, refinancing costs are expected to be higher, not lower, than real-output growth, leading to an increasing debt-to-gdp ratio. This is the case, for example, in the most troubled economies of the euro zone: Greece,,, and. (See Exhibit 2.) Barring any changes in government spending, those countries will have to issue new debt simply to pay the interest on their existing debt. But even many of the countries whose estimated GDP growth is greater than the interest rate on their outstanding debt will not be able to grow out of their debt, for a simple reason: their debt burden is growing ever larger. In order to stop the growth of public debt, a government also needs to run a primary budget surplus that is, it must bring in more revenues through taxes than it spends in public expenditures (excluding interest payments). Unfortunately, in most countries, debt as a percentage of GDP is already too high and GDP growth rates too low for this to be a realistic option at current tax rates. For ten of the countries in our sample, Exhibit 3 plots the estimated 211 primary budget balance as a percentage of GDP against the required primary budget balance, given the estimated growth rates of these countries. Only Germany and Italy are close to generating the required surplus to stabilize their public-debt burden. The rest will actually increase their T D M
E For Most Countries, Growing out of Debt Is Not an Option Growth gap (percentage points) 15 1 5 3.4 2.3 1.6 1.5 1.2.8 1.5 5 6.6 1 9.1 11. 15 Germany U.K. Italy Greece Sources: Bloomberg; OECD; BCG analysis. Note: The growth gap measures the difference in percentage points between a country s expected GDP growth rate from 211 through 213 and the average yield to maturity of government benchmark bonds with maturities ranging from 3 to 3 months. E Most Countries Are Still Adding to Their Public Debt Expected 211 primary budget balance (as a percentage of GDP) 1 5 Germany Italy Greece 5 U.K. 1 5 5 1 Required 211 primary budget balance (as a percentage of GDP) Sources: IMF; BCG analysis. Note: The expected 211 primary budget balance is a government s income minus expenditures (excluding interest payments) as a percentage of GDP in 211. The required 211 primary budget balance is the primary budget balance necessary in 211 for the government not to increase public debt as a percentage of GDP. The calculations are based on interest rates and GDP growth. T B C G
debt load in the coming years. Clearly, very few countries will be able to grow their way out of the debt monster problem. The very policies that central banks are pursuing to counter deflation have the effect of greatly increasing the odds that an inflationary cycle will take hold. The Double Bind of Austerity and Restructuring Of course, another much-discussed option for slaying the debt monster is fiscal austerity that is, reducing government spending to such a degree that annual deficits and the overall debt burden decline. The problem with austerity, however, is that it has a major negative impact on economic growth, thus lowering the GDP growth rate and making the debt burden relatively bigger. Governments face the real possibility that the more they save, the more their austerity will cause GDP to shrink, and public debt as a percentage of GDP will grow despite reduced government spending. Whatever one may think of the adequacy of the current Greek government s austerity plan, Greece s economy has shrunk every quarter but one (the second quarter of 29) since the fourth quarter of 28. And in the U.K., another country whose government has embraced austerity, the economy shrank in the fourth quarter of 21 and barely grew at all (.5 percent) in the first quarter of 211. According to the IMF s World Economic Outlook Database, in both countries, public debt as a percentage of GDP is not expected to fall until 214. As an alternative, a country can reduce the value of its outstanding debt by restructuring its loan agreements, which would cause its creditors to bear at least some of the burden of the debt monster. In Europe, strong opposition to the restructuring of Greece s public debt illustrates why this option is unlikely, especially on a broad scale. The fact is that it is the already-stricken European financial sector that owns much of the public debt in Europe. Restructuring that debt, especially in a radical fashion, would undermine the recovery of the financial sector and maybe even throw Europe back into a financial crisis like the global crisis of 28. The Inflation Solution But there is another way to reduce the value of outstanding debt: inflate it away. Higher-than-expected inflation would result in reducing the debt burden not only for governments but also for companies and consumers. For that reason, it is an irresistibly attractive option for policymakers. To be sure, current output gaps, overcapacity, and slow wage growth make inflation seem unlikely. Indeed, these symptoms have many economists worrying about precisely the opposite: deflation. But we agree with the economist Milton Friedman that inflation is always and anywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output. The very policies that central banks are pursuing to counter deflation (for example, printing enormous amounts of money) have the effect of greatly increasing the odds that an inflationary cycle will take hold. The world economy is currently characterized by excess liquidity that is flowing into commodities and stocks. Although much of this excess money has yet T D M
to reach the real economy, muting inflationary pressures, history has taught us that when central banks rapidly expand the money supply, severe inflation is the result. The European Central Bank s recent interest-rate increase shows that at least some central bankers recognize that inflation is a genuine medium- to long-term threat. But we doubt that that move will be followed by similar moves in other developed economies. Why? The cost in terms of the impact on the debt burden is simply too high. We have created a simulation that shows the effect that rising interest rates would have on interest payments in, the, and eight European countries in our sample. On average, these countries spend about 12 percent of their GDP on interest payments on their total debt (that is, all debt of households, nonfinancial companies, and government) at an average rate of 4.4 percent. But there is a wide divergence around the mean. At one extreme,, with an interest rate of 7 percent, has annual interest payments that are 24 percent of GDP. At the other, has an interest rate that is slightly higher than 2 percent and interest payments that are 8 percent of GDP. Were central banks to, say, double average interest rates a reasonable scenario from a historical perspective a number of these countries would enter the dangerous territory now occupied by. (See Exhibit 4.) Specifically, Greece,, E Doubling Interest Rates Would Raise Interest Payments in Many Countries to Unsustainable Levels Interest payments (as a percentage of GDP) 5 4 3 2 1 U.K. Greece Italy Germany U.K. Greece Italy Germany = 25 percent of GDP 5 1 15 Interest rate (%) Sources: OECD, BCG analysis. Note: Bubble size reflects total debt (households, nonfinancial companies, and government) as a percentage of GDP. The green bubbles illustrate each country's interest burden at current interest rates. The blue bubbles illustrate the interest burden at interest rates twice the current rates. T B C G
, and the would each have a total interest burden exceeding 2 percent of GDP. Although there are no official thresholds indicating a point of no return, we believe that these levels are unsustainable. (For a country-by-country analysis of the impact of rising interest rates on interest payments, see The Debt Monster: By the Numbers, a supplement to this report.) Therefore, to keep the interest burden at a feasible level and facilitate deleveraging across sectors, central banks will likely keep interest rates low for some time to come. Higher inflation, despite its considerable costs, will be perceived as preferable to being devoured by the debt monster. Preparing for a Likely Future In conclusion, it seems clear that the debt burden will drive central banks to stimulate economic growth. As a result, they will continue to flood the economy with liquidity by printing money, creating an ever-larger monetary overhang. The widespread availability of cash will create higher volatility in financial and commodity markets and encourage the development of new bubbles as well as disruptive crashes when those bubbles burst. It will also contribute to a much higher probability of inflation, with its attendant corrosive effects on company profits and enterprise value. (See Time to Get Ready for Inflation, BCG article, March 211.) Far from being behind us, the worst may still be ahead. Senior executives need to start preparing for this scenario. (See Making Your Company Inflation Ready, BCG Focus, March 211.) They need to assess their company s vulnerability to inflation by determining its effects on profits and capital expenditures. They also need to assess their organization s readiness to respond. And they need to develop a holistic plan to protect the business from inflation s negative consequences. T company completes this process, the more likely that it will be able to limit the effect of inflation on its business and avoid the negative consequences of the debt monster. The longer a company waits, the harder it will be to respond effectively. T D M
About the Authors Daniel Stelter is a senior partner and managing director in the Berlin office of The Boston Consulting Group and the global leader of the Corporate Development practice. You may contact him by e-mail at stelter.daniel@bcg.com. Dirk Schilder is an analyst in the firm s Munich office. You may contact him by e-mail at schilder.dirk@bcg.com. Katrin van Dyken is an analyst in BCG s Frankfurt office. You may contact her by e-mail at vandyken.katrin@bcg.com. Acknowledgments The authors would like to thank Robert Howard for his contributions to the writing of this report, as well as other members of the editorial and production staffs, including Angela DiBattista, Elyse Friedman, and Kirsten Leshko. For Further Contact If you would like to discuss this Focus report, please contact one of the authors. The Boston Consulting Group (BCG) is a global management consulting firm and the world s leading advisor on business strategy. We partner with clients in all sectors and regions to identify their highest-value opportunities, address their most critical challenges, and transform their businesses. Our customized approach combines deep insight into the dynamics of companies and markets with close collaboration at all levels of the client organization. This ensures that our clients achieve sustainable competitive advantage, build more capable organizations, and secure lasting results. Founded in 1963, BCG is a private company with 74 offices in 42 countries. For more information, please visit www.bcg.com. For a complete list of BCG publications and information about how to obtain copies, please visit our website at www.bcg.com/publications. To receive future publications in electronic form about this topic or others, please visit our subscription website at www.bcg.com/subscribe. The Boston Consulting Group, Inc. 211. All rights reserved. 5/11 T B C G