The Europeans and global economies have proved more resilient this year than many economists had feared.
Yes, stubbornly high inflation has sapped consumers’ spending power. Yes, economic activity has slowed in the face of higher interest rates and the lingering effects of the war in Ukraine.
Yes, there was a wobble in the banking sector on both sides of the Atlantic, and we still don’t know how that will affect credit availability. But, there is little sign of the feared recession. Yet.
Still haunted by our housing crash during the global financial crisis, Irish borrowers have spent much of the past decade paying down loans rather than taking on new debt. This at a time of historically low interest rates. But, Ireland was something of an outlier in this respect. Globally, households, businesses and governments have continued to rack up debt to historic highs. Even more than in the most advanced economies – which already had relatively high debt levels – the debt buildup has been most striking in emerging and developing countries.
No more easy money
Taking on debt is not a bad thing per se, particularly if it supports investment that supports long-term growth, and ultimately capacity for debt repayment. Even if borrowed money is being squandered, it may not be a big problem so long as interest rates are low, economies are growing, and there are enough lenders ready to refinance debts as they come due.
Again, this has been the case for most of the past decade. Even the pandemic hardly caused a missed beat.
Having learned lessons from the early stages of the global financial crisis, central bankers and other economic policymakers slashed interest rates and flooded economies with liquidity in early 2020. Debts continued to mount.
Famed investor Warren Buffett once quipped that “only when the tide goes out do you discover who’s been swimming naked.” Over the past year, the tide has gone out on easy money. Interest rates have been rising faster than at any time since the early 1980s. We could be about to see who has been swimming naked, racking up debts in the expectation of easy refinancing.
The last time interest rates increased this fast it led to a lost decade in the global south. Latin America and Africa were particularly hard hit, and some countries have never really recovered. IMF bailouts to make private lenders whole piled further debts on developing countries while imposing what Naomi Klein has called ‘shock therapy’. Bailouts came with strict conditions, including privatisation of state enterprises, fiscal austerity and opening up to foreign trade and investment.
Among the countries that have recently sought bailouts – or could be on the brink – are Bolivia, Chad, Ecuador, Egypt, El Salvador, Ghana, Laos, Lebanon, Malawi, Pakistan, Sri Lanka, Tunisia, Ukraine and Zambia. The IMF estimates that more than half of low-income countries are at risk of debt distress.
This is not merely an academic concern for faraway places. European countries with high debt burdens and weak economic growth are at risk of fiscal crises if interest rates go higher for longer than currently expected. Italy’s public debt is nearly one and a half times the size of its economy. In the two decades before the pandemic, its economy never once grew by more than 2%. It would not take much for future financial contagion to put Italy in the sights of bond vigilantes. Unlike Portugal, Greece and Ireland, Italy is too-big-to-fail. It could even be too-big-to-bailout.
The good news is that Irish households and businesses are not among the most exposed. As mentioned, we have not partaken in the private sector debt buildup. The public finances are in rude health, even with the caveat that a large and unknown share of surging corporation tax receipts could dry up in the years ahead. The bad news is that we are a small, open economy bobbing on the waves of global finance. We would not be immune to a global debt crisis.
What can be done?
First of all, central banks need to be very careful about further rate hikes. Having floored the accelerator during the pandemic, they have slammed on the breaks to try to tackle inflation. With ice on the road ahead, pressing ever harder on the brakes increases the risk of the economy careening out of control. Interest rates are already restrictive, while the full impact of the past year’s hikes has not yet even been felt.
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Secondly, more needs to be done at a global level to make sure the system is ready for what’s coming. During the pandemic, bilateral debt repayments were suspended for the poorest countries. The G20 Common Framework for Debt Treatment was supposed to build on this arrangement, but it is ripe for reform to extend eligibility to middle income countries and to ensure participation of private creditors in debt relief and restructuring. Sometimes ‘burning the bondholders’ is the least bad option! Concerted efforts are also needed to engage China, now a leading lender to other emerging and developing countries. The Global Sovereign Debt Roundtable – chaired by the IMF, World Bank and India as G20 President – was established earlier this year to address some of these issues, but it is important it leads to concrete action and doesn’t just languish as a talking shop.
Thirdly, at EU-level Italy needs ratify reforms to the European Stability Mechanism so that it can fulfil its role as a backstop to failing banks and governments facing a fiscal crisis. But, the ESM needs to be made bigger and better. If a country like Italy were to get in trouble, it would not have anywhere near enough financial firepower to bail it out. And because the conditions attached to precautionary credit lines are so stringent, there is a risk that countries will not seek help until it is too late and a full-blown crisis can’t be avoided.
The ESM should also become a fully-fledged EU institution, making it accountable to the European Parliament. Even if it never has to be used, the existence of a credible backstop can boost financial market confidence and reduce the likelihood of a speculation-driven crisis. But, it needs to be made fit for purpose.
As for Ireland, we may not be among the most exposed countries this time around, but our bitter recent experience should inform our engagement in those organizations in which we are players, whether that be the ECB Governing Council, the IMF Board of Governors or the ESM Board of Governors, currently chaired by Paschal Donohue. We know what it was like to go through painful – and some would say excessive – austerity. We can bring lessons learned to the table to help avoid the repeat of past policy mistakes.