Only during wartime has government debt in advanced economies been at a higher level than it is today. Seven years after the Global Financial Crisis (GFC) many advanced economies have barely begun to recover, particularly in Europe where many countries are still dealing with high unemployment, deflationary tendencies and debt overhang. The favourable global environment has taken a turn for the worse, as commodity prices have declined and the strengthening US dollar has raised debt servicing burdens for many emerging markets. Thought leader in international macroeconomics and Minos A. Zombanakis Professor of the International Finance System at Harvard Kennedy School, Professor Carmen Reinhart mapped the challenges for advanced and emerging markets towards global economic recovery in the 2015 David Finch Lecture at the University of Melbourne.
A snail's pace recovery
Of the twelve countries that experienced very severe systemic banking crises in the GFC, only two—the US and Germany—have now recovered to their pre-crisis level. The International Monetary Fund (IMF) projections suggest that even by 2021, Italy and Greece will be nowhere close to the per capita income levels of 2007. Comparing the aftermath of the most recent GFC to the worst 100 crises since the 1860s, Reinhart, in her address, says that the current situation, while not the worst in terms of the magnitude of output decline, is arguably the worst the world has seen in terms of recovery duration.
The concept of the lost decade is not just a concept, says Reinhart. It's looking a lot like a reality.
The most recent GFC followed a common trajectory of high debt growth before a crisis, but this was followed by only limited deleveraging after the crisis. Where sharp deleveraging is achieved post crisis we have seen regions recover at a faster rate. Such was the case of the Nordic financial crisis in the early 1990s and Asian crisis of 1997.
The simultaneous occurrence of economic downturn across a large number of advanced countries, coupled with an inability to allow the exchange rate to adjust and regain competitiveness in Eurozone countries, as well as a dearth of credit in affected countries, all significantly slowed potential recovery.
A sharp rise in public debt, resulting from governments assuming private debt, created a severe decline in bank credit for economic activity, even in terms of working capital. Public debt as a percentage of GDP is now at its highest level since World War II.
The rocky road to recovery
Reinhart argues that recovery will require additional tools that go beyond traditional structural reforms and austerity measures. A recent study by the IMF demonstrates a significant shift of debt from private to official hands.
When debt levels are high, [fiscal reforms and austerity measures] as necessary as they may be, may not be enough, explains Reinhart. You need more tools to reduce such high levels of debt. One such…is explicit restructuring. I don't think we have seen the last of [debt] restructuring in Europe, and I don't mean just Greece.
Financial repression—a combination of more regulated financial markets and persistent low interest rates that result in negative real inflation adjusted interest rates—may also need to be part of the discussion to overcome the current situation globally.
Whatever the method, some party must bear the cost, says Professor of Economics, Jeff Borland.
The key difference between the methods is who bears the cost, says Borland. For example, fiscal adjustment and austerity imposes the costs on the citizens of the country in debt; whereas restructuring of default imposes the costs on the citizens of other countries who are owed the money. This is why working out how to achieve debt reduction is so fraught—everyone wants someone else to pay.
Emerging markets—the hidden risk
While the GFC produced a very significant downturn for emerging markets, recovery was quick. Facing low and stable international interest rates, very high and rising commodity prices, and benefiting from rapid double digit growth in China, emerging markets became increasingly attractive international investment opportunities. However, credit booms and increasing asset prices often result in overheated economies and, following an extended period of large capital inflow, the probability of a banking crisis is now substantially higher.
A major stylised fact about the GFC is that developing countries avoided the worst effects, says Borland. Declining commodity prices, global investors turning back to equity markets in advanced economies, and a rising dollar increasing the burden on their dollar denominated debts, make for a less rosy future.
Many fear a repeat of the 2013 'Taper Tantrum' and Reinhart suggests there are missing ingredients that we're not seeing in the global financial system as regards emerging markets' finance sources.
China's economic slowdown is, and will continue to have, direct and indirect effects on the world economy. In particular, a decline in Chinese financing of emerging markets represents a new area of risk that has not been widely considered. The proportion of emerging markets with significant current account deficits has risen markedly and history suggests this is an important indicator of future banking and economic problems.
According to Reinhart, an era of greater emerging market turbulence lies ahead.
David Finch was an alumnus of the University of Melbourne, graduating with joint honours degrees in commerce and arts in 1944 and received his PhD from the London School of Economics. He was appointed to the newly established International Monetary Fund (IMF), where he held the position of Councillor and Director of the Exchange and Trade section of the IMF. He was awarded an Honorary Doctor of Commerce by the University of Melbourne, two years before his death, in 2000.