The cocktail of unconventional monetary policy — namely inflated central bank balance sheets and negative interest rates — along with expansive fiscal policy and the trend of electing politicians espousing populist messages promises to make global economic management more complicated than usual.
And those factors are playing out even before Donald Trump — with his plan to spend big, to cut taxes, to curtail trade and to reduce regulation — is sworn in as the U.S. president.
One way out of the mess, argues Scott DiMaggio, director of global fixed income for money manager Alliance Bernstein, is higher inflation, a so-called silent killer that reduces a currency's value but makes it easier for borrowers to pay their debts.
“Central banks have been trying to get inflation higher,” said DiMaggio, who was in Toronto Wednesday. “The notion that the world needs inflation to help deal with the debt problem will be a prevalent theme over the next several years.”
Aside from inflation, faster economic growth, defaults, restructurings, financial repression (which could include pegging interest rates below nominal GDP growth) and monetization (either explicit or implicit) of the debt are also possible options.
In his presentation, DiMaggio referred to the “debt cycle” or the trend over the past 15 years for rising debt by all sectors relative to the size of the economy. “There has been no deleveraging, even if the lines have turned down a bit. The notion that low interest rates will help cure the amount of debt outstanding has been a fallacy,” he said, noting Canada is near the top of the pile.
Even so, DiMaggio doesn't view the situation “as a problem yet,” because interest payments relative to GDP are still manageable. “For the G4 countries (the U.S., U.K., Germany and Japan) the government debt has risen (but) the cost of servicing that debt hasn't been a problem.”
In DiMaggio's view two factors have to be at work for debt to become a problem: when it can no longer be serviced because of higher interest rates; and when the asset underlying that debt falls. He notes that Japan, the “poster child for debt,” is a special case because large government debt has replaced the large private sector debt taken on 25 years ago. His charts show a similar trend is underway in the U.S. and Europe.
And in a situation that is “frustrating for policy makers,” the accumulation of debt hasn't led to the “productive use of debt,” meaning there's been no equivalent rise in nominal GDP growth over the past decade. For DiMaggio, this situation is known as the “debt trap,” which generates its own set of unintended consequences, including income inequality, inflated asset prices, no incentive to save and the continuation of “unproductive zombie companies.”
Given that central banks have implemented two stages of policy — the first being to save the world economy after the financial crisis of a decade back and the second being to try and generate growth — DiMaggio reflected on a possible third stage. Options include a policy U-turn (considered unlikely) and more of the same in terms of negative interest rates with yield caps in some countries. More likely is what he refers to as the “fiscal highway” where the burden of growth is moved to the fiscal authorities from the monetary authorities. If that doesn't work, more drastic solutions — including incomes policy, fixed exchange rates and capital controls — could be part of the tool kit. In other words it could get quite ugly.