Morgan Stanley
  • Thoughts on the Market Podcast
  • Jul 26, 2021

Will a Debt Hangover Hamper Recovery?


Welcome to Thoughts on the Market. I'm Chetan Ahya, Chief Asia Economist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be sharing some historical lessons on government debt sustainability and what it means for the current cycle. It's Monday, July 26, at 7:00 p.m. in Hong Kong.

Will a debt hangover hamper the global economic recovery? Since the beginning of the pandemic, governments around the globe have launched an aggressive fiscal response to the outsized economic shock from COVID-19. This policy support has laid the foundation for the V-shaped recovery that is currently underway, but it brings with it the challenge of managing public debt in the coming years.

Although public debt ratios are elevated in most parts of the world, the aggressive fiscal response in the U.S. has placed it at the forefront of the debt sustainability debate. In the U.S., large fiscal deficits have lifted the public debt to GDP ratio to post-World War II highs of about 127%. And as we move deeper into the recovery, investors are debating whether a debt overhang will come back to haunt the global economy, as it did post 2011.

If we look back to 2008 and the global financial crisis, governments responded to growing public debt with spending cuts. However, this premature belt tightening clearly had substantial adverse effects. Growth was anemic, and inflation and inflation expectations remained low. This low growth, lowflation environment, meant that it actually increased the challenges for public debt ratios to move lower.

So if austerity isn't the answer, what is?

To understand what leads to a sustainable path for public debt, the economics team at Morgan Stanley analyzed more than a century of historical data. We found 76 instances when economies experienced a buildup in public debt that is comparable to 2020. We then divided the sample into debt expanders - i.e., instances where public debt to GDP continued to climb - and instances of debt reducers. This helped us identify the drivers that had the greatest impact on public debt in the decade after the buildup.

As we dug into the path of debt reducers, we found, somewhat counterintuitively, that they kept expansionary monetary and fiscal policies in place for slightly longer periods than the debt expanders. This helped the economy reach maximum employment faster, and after the economy had reached a self-sustaining path, policymakers could then change course. A stronger foundation for growth and moderate inflation, then set the stage for a virtuous cycle which eventually produced lower debt ratios.

How can we apply these lessons to the current cycle?

Again, using the U.S. as an example, in today's context, stabilizing public debt to GDP ratio would require the Fed to keep real rates in the range of -0.5% to +0.5% on average over the coming decade, with the assumption that the real GDP growth average is 1.5% to 2.25%.

One final note on the risk from inflation. A key to debt reduction will be to manage inflation rate in a moderate range of 2-2.5%. In the US today, the Fed's monetary and fiscal policy objectives are focused on moving the economy towards maximum employment. However, this delicate balance could be upset if inflation threatens to breach the Fed's implicit annualized 2.5% threshold. While policy actions can be taken to quickly stem this overshoot, they will naturally disrupt expectations of the Fed's policy path, with real rates moving sharply higher, leading to tighter financial conditions and adding to the challenge of achieving that sustainability.

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How can governments worldwide manage the historically high debt incurred in response to the COVID-19 crisis? The answer may be a bit counterintuitive.

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