1. The size and influence of the global bond markets.
2. How governments, corporates and individuals use debt.
3. The dangers of having too much debt in an economy.
4. Why the credit crisis happened and the implications for investors today.
Chris Iggo, Chief Investment Officer, AXA Fixed Income
PRESENTER: This unit on global debt and the role it plays on the economy is one of a series sponsored by AXA Investment Managers. Please do keep an eye out for the others, including UK monetary policy and its impact on investment markets.
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Hello and welcome to Akademia, we’re looking at global debt and the role that it plays in the economy. I’m Mark Colegate and to discuss the topic I’m joined now by Chris Iggo. He’s CIO for fixed income at AXA Investment Managers. Chris Iggo, I suppose to start with, define debt for us and why is it so important?
CHRIS IGGO: Well debt is really a contract between borrowers and lenders, and it allows capital to be used effectively in the economy. I would say that debt’s nothing new; there were references to moneylenders in the Bible. So debt’s been with us as long as economies have really functioned, and it’s always and continues to play a very important role in facilitating consumption and investment.
PRESENTER: And what’s the danger with debt that actually you’re sort of borrowing tomorrow’s growth and using it all up today?
CHRIS IGGO: Well that really is the danger that borrowers can borrow too much, and that creates a problem for them, because they have to pay interest on their borrowing, and that interest has to come out of their revenues or their income, so it can eat up a greater proportion of their revenue, leaving less to spend on other things. But also eventually they have to pay the debt back and that can lead to problems if the capital isn’t available to be repaid.
PRESENTER: And how do governments use debt to manoeuvre the economy around?
CHRIS IGGO: Governments use debt very effectively in most cases, because as we know economies go through periods of growth and recession. And politically there’s a vested interest in making sure that unemployment remains relatively stable through the economic cycle for example. So governments borrow money when they economy’s weak so that they can continue to pay for essential goods and services that keep the economy going. Ideally, they’d be borrowing less when the economy is strong, but as we’ll see that’s not always the case.
PRESENTER: And I suppose if you’re the level of private individual you’re often using debt to sort of match things like future liabilities with things like annuities?
CHRIS IGGO: Of course, in a sense debt can be seen as an investment, so you’re investing in debt to provide you with future cash flows. But as a consumer you take on debt because you want to buy something, and that usually is big-ticket items like cars or importantly for most people housing. So mortgages tend to be the biggest single piece of debt that individuals own, but they play a very important role, because few people can afford to pay for house out of cash.
PRESENTER: And a big section of the bond market is corporate bonds, what do companies issue debt for; is it for big-ticket items, their equivalent of a car or a house?
CHRIS IGGO: Well companies borrow for a variety of reasons. They borrow for working capital purposes. That borrowing tends to be fairly short term. It can be in the form of borrowing from banks or it can be in the form of commercial paper and other kind of money market type debt instruments. But the more important borrowing is to grow the business. So companies borrow so they can invest in a new factory or in new technology, and that tends to be big projects and the borrowing tends to be done over a number of years.
PRESENTER: As a rule of thumb for individuals, they always say if you have no debt that’s the best place to be. If governments and corporate had no debt, would the world be a better place?
CHRIS IGGO: No, it wouldn’t, I don’t think, because you’d have an excess of savings which wouldn’t be being used productively. If nobody was borrowing those savings, those savings would just sit there in a bank account accruing very little interest and they wouldn’t be put to productive purposes. So I think that the role of debt is crucial to how the economy functions. Because always you will have people who generate a surplus, i.e. savers, and that can be individuals and it can be companies, and you’ll have other sectors of the economy that need to borrow so that they can grow. And that happens at the individual level and also at the corporate level.
PRESENTER: Well let’s take a look now at some of the borrowers and the lenders in a bit more detail. If we come to the borrowers, first just talk us through with all of those groups why they’re interested in borrowing?
CHRIS IGGO: Well let’s take individuals as a starter, because we’re all familiar with our own personal borrowing. There’s a theory in economics called the lifecycle theory of consumption, and it tends to rest on the kind of observation that as you get older and you move through your career your earning capacity increases. So when you’re young and you’re not earning that much you need to borrow in order to buy a house, buy a car and establish a family. As you get older, your earnings start to grow and you can become more of a saver, you’re thinking about retirement and so on. And then when you get to retirement you start to dissave; you’re not exactly taking on debt anymore, but you’re using your accumulated savings.
So individuals go through this cycle. At times in their life people borrow money for different things, to take a holiday, to buy a car, most importantly to buy a house, but most individuals at some point need to borrow. When you go to a restaurant you pay with a credit card. That is some kind of taking on debt. It’s short-term debt, but it is debt.
PRESENTER: And this sort of lifecycle of going from being a borrower to a saver, similar with companies as they mature?
CHRIS IGGO: Indeed, yes, when companies start up, they typically don’t make any money, so they need financing. They can go to the equity market for financing, which is not always that easy when you’re a new company. You can borrow from a bank or you could borrow from private equity, investors or other lenders. So companies go through the same kind of lifecycle. Of course when a company matures they tend to want to keep on growing, so they do keep on borrowing in order to make acquisitions or to make investments. And we look at the corporate bond market today, some of the biggest companies in the world still borrow, even though they make very strong profits and they could finance a lot of the activity themselves from profits.
PRESENTER: And you’ve got banks here, but traditionally they had all their money from our current accounts, why are they big issuers of debt?
CHRIS IGGO: Well back in the day that was the case. You know, your small town bank took in deposits from the locals and it would use that money to lend to sound local businesses, but of course in the last 30 years the banking model has changed radically. So banks are still taking deposits, but that only forms a part of their overall funding, the rest comes from borrowing in the bond market. So in the run-up to the financial crisis there was a huge amount of growth in bank debt. Banks borrowed in the bond market and then they used that money to finance other activities. The problem was of course they got very leveraged and they were lending to parts of the economy which were fairly opaque and we had a problem.
PRESENTER: And as we get out of the financial crisis we hear a lot in the headlines about governments borrowing to stimulate growth, what are governments doing as borrowers these days?
CHRIS IGGO: Well in an all economic cycle a government will borrow through the cycle to stabilise the economy during a recession, and that’s fine as long as the overall level of government debt doesn’t grow too much. There’s typically a rule of thumb that suggests that having an annual borrowing requirement of about 3% of GDP is okay and that’s sustainable over the long term, as long as your economy is growing. Of course in the crisis governments had to borrow a lot more, because the private sector ran into severe difficulties. And since the crisis governments have been trying to slow the pace of their borrowing, if not, reduce the level of overall debt. So borrowing from governments is still pretty high, but governments are trying not to borrow as much as they did in the past.
PRESENTER: And what’s your definition of international organisations?
CHRIS IGGO: That’s things like the IMF or the World Bank or the European Bank for Reconstruction and Development. They borrow in the bond market. They’re typically AAA-rated borrowers, so they’re fairly safe in terms of their credit rating. And those funds are then used to finance development projects or such like in poorer parts of the world.
PRESENTER: Well they’re the borrowers, let’s turn to the lenders now, you’ve got pension funds at the top of the list, how important are they in the market?
CHRIS IGGO: Pension funds are very important. I mean they are one of the two biggest sources of long-term funding that flows through the debt markets. Of course a pension fund is an accumulation of people’s pension contributions, organised in such a way as to deliver pension payments in the future. So there’s a need for long-term investment, there’s a need for fairly flexible maturities in terms of when the cash flow will come in, and debt provides the perfect instrument really for pension funds, because it’s fairly safe relative to equities. It’s diversified, there’s an income component, because companies pay interest on their debt, and you can create a ladder of payments in the future through using different maturities of bonds and loans.
PRESENTER: And under that you’ve got insurance companies, how are they using bonds?
CHRIS IGGO: It’s a similar thing to pension funds really, it’s long term in focus, but obviously insurance companies are borrowing money to match their liabilities which are claims on their insurance policies. Some of those are short-term claims, for example motor insurance is a relatively short-term business; others are long term like life insurance and annuity programmes.
PRESENTER: And then very quickly you’ve got banks there and all of us as individuals.
CHRIS IGGO: Yes, well banks lend money because they borrow money and then lend it on and that’s how they make their money. Individuals are a source of savings. We all save either through our pension funds or directly in savings products. And those savings products can be invested in the debt market, so they are financing borrowing.
PRESENTER: Well I want to move on now, we touched on it before, but when does debt become a problem for an economy?
CHRIS IGGO: I think debt can become a problem in a number of ways. First of all within an economy a particular sector could borrow too much. So we’ve seen this in the past where maybe the household sector, individuals are borrowing too much to finance a housing boom, and then that becomes a problem when interest rates rise, because individuals can’t afford to make their mortgage payments, and that means consumption suffers and we have a recession. If it’s the company sector that’s borrowing too much, at a point they won’t be able to borrow anymore, investment will fall off and growth will suffer. So there are a number of reasons why inside an economy too much debt can be a problem.
Secondly is you have to pay for debt, you have to pay interest on debt, and if your debt is rising that means your interest burden is rising as well, and it may come to be such a burden that you can’t make those interest payments and certainly you’d have to cut down on other areas of spending. Eventually, if you take on too much debt and you can’t repay it, as a company you could go bankrupt, and as an individual you could go bankrupt as well, and therefore there’s a lot of wealth involved in taking on too much debt.
PRESENTER: As a rule of thumb, the more debt you’re carrying as an individual the bigger the risk you are, the higher the rate of interest you have to pay?
CHRIS IGGO: Absolutely, and that doesn’t just apply to individuals, it applies to companies as well.
PRESENTER: All right, well moving on from that then let’s have a little look at what’s happened recently, 2008 we all know is the big crisis, the US are the biggest economy of all of them, what happened to it and has it recovered?
CHRIS IGGO: Well it’s interesting, because you have to put all of this into some kind of historical context, and in the ten years before or even longer, before the financial crisis, we had the deregulation of capital markets. We had a strong trend towards lower interest rates and monetary policy, which was quite accommodative. This encouraged borrowing. It encouraged borrowing by individuals, by companies and by the financial sector. And we saw growth rates of debt in the few years before the financial crisis of 10 or 20% per year.
Now that was a much stronger growth rate of debt than the economy was growing at and it came to a peak in 2007, 2008. We all know the story too much lending in the housing market, debt instruments became very opaque and there was a liquidity crisis and some defaults, and that caused the collapse of a couple of financial institutions. What happened then was that the private sector went into a very deep recession, because debt was everywhere and many institutions couldn’t repay the debt, so the government had to basically take over.
There was a transfer of debt from the private sector to the government sector and the chart shows a big jump in the dark blue line, which was the US Federal Government’s growth of its own debt. So it had to take on debt from banks, it had to take on debt from companies, and it had to borrow for its own account because the economy was in recession. So we had this huge growth in debt. Since then it’s all been about deleveraging or trying to reduce debt.
PRESENTER: And what does that do to the economy? I mean presumably if you’ve got an economy where there’s deleverage taking place it’s much harder to grow it.
CHRIS IGGO: Absolutely, and that’s why growth has been disappointing in the last seven years or so.
PRESENTER: And as a fixed income fund manager you were talking about this great rise in the amount of growth before 2008, at what point did it start to concern you?
CHRIS IGGO: Well I think when you look back, and looking back’s always easier, it became very clear that debt was being sold at the wrong price. Interest rates became too low, credit spreads became too low, and the complexity of the debt instruments meant that I think investors weren’t fully understanding the risks that they were buying.
PRESENTER: And what about this argument, which often happens in a so-called sort of new normal that actually as the markets get more sophisticated they’re better at working out the amount of stress you can put a system under without it collapsing; in the same way that, I don’t know, in the old days if they built a bridge they really built it not to fall down, whereas with computer modelling maybe you don’t need as much material.
CHRIS IGGO: Yes, I think there is a danger that we’re currently kind of revisiting some of the problems of the past. We are seeing a growth in these more complex credit instruments again, which are packages of debt, which are trying to diversify the risk but often create risks of their own, and I think we’re moving back into that kind of environment.
PRESENTER: Well, just sticking with the US, you’ve talked about deleverage and debts coming down, but then you’ve got this chart which suggests debt’s still going up.
CHRIS IGGO: The reality is we’re not dealing with the debt as much as politicians would have us believe. Debt is still rising in most major economies, and that’s because it takes time. The way to reduce debt is to cut spending and start to pay back debt - now that is politically very difficult, particularly in advanced economies like the United States. So in the seven years since the crisis the government has been taking on more debt, the private sector has perhaps levelled off a little bit, the financial sector is actually reducing its own debt, but if you add it all together total debt is still rising. And I think this is going to be an ongoing policy problem. If you look at an economy like Japan the government debt there is over 200% of GDP and it’s been constantly rising, even though Japan is not thought of as being a kind of gung-ho economy as certainly in recent years.
PRESENTER: Well if it was higher level today than it was in 2008 why hasn’t it all come toppling down?
CHRIS IGGO: I think part of the reason is because the balance of the debt has shifted towards the public sector, towards governments, which are seen as being safer, they tend to be much higher credit rating, and essentially they are, because they can use taxes to repay the debt, but what we’ve seen of course in this cycle is they can print money, and that’s given the market a lot of confidence that this level of debt can be sustained.
PRESENTER: And moving on from there, so we looked at the US, but let’s come a bit closer to home, again talk us through this chart and what the implications are.
CHRIS IGGO: Well the UK saw a similar process to the United States in that we had a crisis. It was concentrated in the financial sector; a number of our institutions ran into severe problems. The Government had to step in and use its own balance sheet to bail out banks. But also the economy went into a deep recession, so the Government had to borrow more. So the Government has more debt today than it did seven or eight years ago, and you can see the slope of the line there. In the last couple of years, it’s kind of stabilised, but one would expect if you take the stories in the media that debt would be falling again. It isn’t. We’ve had some austerity, but not enough to actually get debt levels to actually start declining. And this is just the government sector; if you look in the household sector debt is still a pretty high level.
PRESENTER: And how does this level of debt compare to sort of previous crises we’ve been through in the UK? I don’t know, the amount the Government borrow, I don’t know, in the First World War or in the 1920s and ‘30s.
CHRIS IGGO: It’s similar when you go back historically you find that when debt hits around 100% of GDP then it becomes a real problem. Because you have to have a growth rate of the economy which is significantly above the cost of interest on that debt in order to make it sustainable, and we’re kind of teetering on the edge of that being a problem at the moment.
PRESENTER: But the other argument that’s out there in the headlines is borrow more, really kick-start the economy, if the economy’s growing then you can pay it back. It sounds like you don’t buy that argument.
CHRIS IGGO: No, that’s a tactical or a short-term view and I think it’s preferable to, and we may talk about this in a moment, it’s preferable to the deep austerity that some countries have chosen to follow. The problem is if the economy doesn’t respond, so we’ve had QE, we’ve had a lot of debt. It’s made it very easy for governments to borrow money and to try to stimulate the economy. What we now need to see is that come through in terms of higher growth.
PRESENTER: We talked about borrowers and lenders in the background, let’s move on to the lenders and where the opportunities are for them to make money. You’ve got bond market and loans, could you just quickly define the difference between them?
CHRIS IGGO: Yes, well the bond market is really the securitisation of borrowing. So you have a piece of paper that says I’ve lent you money and you’re going to pay it back over so many years and at this level of interest rate. And it’s tradable. It’s tradable very easily through the bond market. So we have different kinds of bonds issued by governments, issued by companies. We have short-term and long-term debt. We have debt that comes from developed economies and debt that comes from emerging economies. And in total the market’s around $80 trillion, so it’s massive, and it does provide that facility for global savings to be used in a productive way.
PRESENTER: You said $80 trillion, how does that compare to the equity market?
CHRIS IGGO: It’s much bigger.
PRESENTER: Right, so very proud of that as a bond manager. And you were saying there divide it up into short and long, what’s the definition of short and long-term debt…?
CHRIS IGGO: Well it’s fairly arbitrary, short-term debt is something less than a year and longer term debt is beyond that, but clearly five year debt is different to 30 year debt, and companies tend to issue really in the kind of medium-term space, so between five and 10 years. Some companies are able to issue debt for much longer maturities. There have been some 100 year bond issues in recent years, but they tend to be very very secure, well-established companies who have got a long history of borrowing.
PRESENTER: But if you took a huge company today like say Apple for the sake of example, how do you make a calculation whether you want to lend it money for 50 years, because that tech space changes over so quickly?
CHRIS IGGO: Yes, well, you have to consider the long-term credit rating, the long-term model, the outlook for the sector, what you think will happen with interest rates over that period. That’s why when you lend for 50 years you expect to receive a much higher coupon than if you lend for three years, because there’s more uncertainty about the future. So the shape of the yield curve if you like is steep always, because the longer you lend for, the more return you’re required.
PRESENTER: And is it a similar thing with countries? I mean sort of as you look around the world today countries are splitting up. You know, there are wars, changes of regime, how does that all impact on your return?
CHRIS IGGO: Well of course when you’re lending to countries you have to consider the political aspect as well. There was a huge debate recently in the UK about what would happen to UK debt if Scotland did vote for independence. We see it with Russia and Ukraine today. Particularly for emerging markets you have to take into account the political aspect and the kind of macroeconomic volatility if you like, which often means that emerging market countries borrow at much higher interest rates than developed market economies.
PRESENTER: But is there a tendency if you get a totally new government, there’s been a revolution, they just say all of that was the problem of the last regime, it’s got nothing to do with us, it’s ground zero and off we go. Does that happen or do people tend to honour the debts of their predecessors?
CHRIS IGGO: It depends and sometimes the debt’s been written off. I mean if you look at a country like Argentina, which has had a volatile political history, it’s had a series of defaults as well, which means it’s very difficult for them to come back to the capital markets to raise money again, and normally they can only do that with the help of international institutions like the World Bank.
PRESENTER: But if you default as a country, and you mentioned Argentina, what does it then do to all the companies and the individuals under that, because presumably they’re quite reliant on flows of capital from outside the country?
CHRIS IGGO: It depends whether their debt’s in local currency or in foreign currency. If it’s in foreign currency they usually go through the same process as the government, because they won’t have access to the foreign currency to repay their debt, so they would be high default. If it’s local currency, you know, normally what happens is the local central bank prints money to provide that liquidity.
PRESENTER: And in terms of how the shape of the world bond markets are changing, we hear so much about the rise of emerging markets, China, India and so forth, are they becoming a larger and larger part of the global bond markets?
CHRIS IGGO: Absolutely, yes. I mean not so much those two, funnily enough, even though they’re the largest emerging markets, but countries like Brazil, Turkey, South Africa have been big issuers of debt in recent years, Russia as well. More importantly I think those countries are our source of savings, which are now starting to be utilised in the global bond market. So you get this coming together of borrowers and lenders. For example in Hong Kong there’s an offshore Chinese renminbi bond market, which people like Caterpillar from the United States will issue debt into and investors who want access to the Chinese currency will invest in.
PRESENTER: Right and well that’s bonds, you’ve mentioned securitisation, how do they differ from loans?
CHRIS IGGO: Loans tend to be less liquid. There tends to be a smaller secondary market for loans. They tend to be based on floating interest rates and they tend to be for kind of specific projects or to finance a particular business expansion. Loans are interesting, because they tend to be more senior, so they’re lower risk in a sense in many cases. But they’re not as liquid as bonds, so the opportunity set is much smaller for investors.
PRESENTER: And can you as a fund manager get access to them and how do you do it given it’s not publicly available…?
CHRIS IGGO: No, in a number of ways. Banks are still very much involved in the creation of new loans through syndications, so a number of banks will come together, organise the loan for a company and then look for other investors to come in and join. On the secondary side banks of course because they want to deleverage are selling baskets of loans that exist on their balance sheet to other investors, and insurance companies and pension funds have been very active in buying those baskets of loans. But the banks are still very very much involved in the loan market.
PRESENTER: Well, I was going to say, as banks have started to lend less money, what new sources of lending have started to come into the global economy?
CHRIS IGGO: Yes, we call this the disintermediation of the banking sector. So we look at things like insurance companies and pension funds, trying to bypass the banks and looking at the private sector directly. The difficulty is if you want to lend to a bunch of companies, you have to do the credit work, you have to understand the risks in lending directly to companies, which banks have always typically done. So there are partnerships now between insurance companies and banks, providing the insurance companies provide the capital, the banks provide the facilitation of the lending, but the money is coming from a non-banking source if you like.
PRESENTER: The final one I want to pick you up on is leveraged loans. I thought that was something we all heard about in the middle of the 2000s, but are they back?
CHRIS IGGO: They’re back, yes, and this tends to be very similar to the high yield bond market. It’s smaller, perhaps more risky or more cyclical companies who rely much more on debt financing rather than on equity financing for their businesses. So again a leveraged loan is a way to get access to high coupon or high interest investments in what are riskier companies.
PRESENTER: Okay, well moving on from there, I want to move on to the Eurozone. Lots of different economies, one currency, that seems to have thrown up some quite interesting spins on the traditional bond markets and what it does. Where are we in the European sovereign debt crisis at the moment?
CHRIS IGGO: Well, it’s interesting. I think the European debt crisis was the third domino to fall in the global financial crisis. We had the housing market and the impact on the financial industry, then we had the recession and then we had the European debt crisis, and it came about because EMU created a single currency and there was a perception that everybody who borrowed in euros had the same credit risk. So countries like Spain and Italy were able to borrow and ultimately the same interest rate as Germany, and the perception was it’s all one currency so it’s all one credit risk. And that turned out to be wrong. So countries that needed to borrow or wanted to borrow a lot did. Their debt levels increased and the underlying credit rating deteriorated, and that then became obvious and crystallised in the crisis in 2009 when these economies fell into deep recession.
PRESENTER: I suppose somebody might have said well couldn’t the market sort this out and say well something that’s denominated in euros has got to have a credit risk roughly speaking of somewhere between Germany and Portugal, but why did it all end up at the perceived German level of risk?
CHRIS IGGO: Because there was a perception that EMU was a non-reversible project and it will ultimately mean that there would be a single fiscal authority, a single lender of last resort, and therefore all risks would converge on the best credit risk which was Germany in this case. The problem is that perception in the markets ran faster than the reality, because there wasn’t a single fiscal authority and there still isn’t, and the lender of last resort, which ultimately is the ECB, only became apparent in the crisis itself.
PRESENTER: Well that was the background, so where are we on it now? How do they deal with it if they couldn’t manoeuvre their currencies around?
CHRIS IGGO: Yes, maybe if we can move to the next slide. You can see the kind of background here. The EMU was launched in 1999, before that there were differences in borrowing costs between the countries on the chart here. We’ve got France, Spain and Italy as an example. France being the core country within Europe, slightly higher rate than Germany, but not very much, and then in that decade or so of EMU working very well everybody basically borrowed at the same rate.
Now that meant that Spain, Greece, Italy, Portugal borrowed much more than anyone else, because they were starting from lower standards of living, they wanted to boost their economy, they wanted nice roads and railway systems and hospitals, same standard as Germany, so lot of investment went into those economies. Then we had the crisis in 2008 and the markets woke up to the idea that actually they weren’t all the same credit risk and therefore started to differentiate again.
So the period in 2010, 2011 was when we thought EMU was going to collapse and the euro would break up, because questions were asked about the ability of Spain or Portugal to repay their debt, now would they go bankrupt? We saw Greece really default or effectively default on its debt. So there was a crisis the ECB had to step in, the European Union had to step in, and now we’re in the kind of repair phase, where countries are trying to stabilise their debt or reduce their debt, where the ECB is very active in providing liquidity into the debt markets, and we’ve seen some progress in that borrowing spreads have started to come down again.
PRESENTER: But do you think those spreads are about where they should be given that these countries do have different risks or is it jury’s still out?
CHRIS IGGO: Personally I think they are. I don’t think over the long term Spain is as good a credit risk as Germany, or Italy as France. So those spreads are probably close to where they should be now. The countries with the higher levels of debt and with the worse economic model should pay higher for borrowing, and that’s where we are.
PRESENTER: Who enforces all the rules here? Because my memory originally when the sort of EMU and stuff was coming together was the Germans wanted some very strict rules on what you had to be able to do to be in the club. They really want to avoid what’s happened. So who told some untruths to get…?
CHRIS IGGO: Well everybody in a way, I mean there was a Growth and Stability Pact, or actually it’s the Stability and Growth Pact, stability was the key thing there.
CHRIS IGGO: But unfortunately when Mr Schroeder was Chancellor of Germany he himself ignored the rules and Germany had a bigger deficit than it was supposed to have. So nobody enforced the rules and nobody played by the rules. Now I think the rules are harder. We have a much stricter regime in terms of the European Union, the IMF and the ECB being involved in monitoring government borrowing, monitoring deficits and signing off on medium term fiscal consolidation plans. Of course the risk is that governments change and they say we didn’t agree to that, but so far so good in that most countries have stuck by their medium-term plans.
PRESENTER: What’s the implication of that for the economic shape of Europe if these poorer areas have borrowed too much, now there’s huge amounts of cutback, does Labour move to the richer parts of Europe?
CHRIS IGGO: Well it’s negative for those borrowers. If we think about Greece, you know, Greece’s borrowing really stole economic growth from the future, and now there’s payback. So growth is much weaker today than it was five years ago, average living standards are much lower today than they were five years ago, unemployment is higher. So there is that potential for economic migration within Europe. The problem is most of Europe is in the same boat, so the question is where do people go to find jobs - unemployment’s 11% throughout the euro area so that’s a difficulty. And secondly there’s a political response of course. People get fed up of austerity and falling living standards, so there is the potential for political extremism, and we’ve seen that in a few cases, it’s not amounted to a real challenge to the political hegemony yet, but it’s always something on the margins.
PRESENTER: Well that’s where we are at the moment, but what are some of the solutions if you’ve got too much government debt?
CHRIS IGGO: Well I think it’s simple and if as an individual you’ve got too much debt, what do you do? I mean you can work hard to get a second job to try and grow your income, or you can hope that your income grows, because you get big pay increases, or you can basically stop spending on going out and so on and prioritise paying back your debt. That’s the same at the national level. So I think economic policyholders have a few choices.
You can try and inflate your way out first of all, and that’s been seen in many cycles in the past, where central banks have tried to create inflation, which reduces the real value of the existing debt. And in a way you could argue that’s the Fed and the Bank of England have done with QE and a little bit successfully.
Secondly, you could try to get economic growth. If your economy’s growing faster than your debt then it’s manageable. But as we’ve seen it’s hard to get economic growth when private sectors deleveraging and governments themselves are deleveraging. Austerity, now that was the first policy choice that many European governments took in 2010. So we had these big cuts in public spending and changes to retirement benefits and unemployment benefits, the whole gamut of government finances was looked at. That’s tough. Politically, it’s very tough, we’ve seen falling living standards in many countries. It’s only now that it’s actually starting to sort of bear some fruit in terms of economic growth.
Reducing interest rates always helps, and that’s what we’ve done everywhere in the world, get interest rates down to as low as possible. So even though you’ve got a lot of debt you’re not paying very much in interest. But ultimately you may be forced to default and restructure the debt, and that means getting some relief from paying back the coupons and paying the interest. And that’s what Greece did. It’s what a lot of emerging market economies have done in recent years. For Greece as an example they were able to extend the maturity of their debt, reduce the overall present value of that and reduce their interest payments.
I think in the future the default and restructuring option may be something that we have to look at again in some countries.
PRESENTER: One thing I was going to ask is I suppose how does the independence of a central bank affect the choices that you make? And we were talking last time on Akademia about the Monetary Policy Committee here in the UK. Does having an independent authority if you like mean that you’re more likely to make better choices than if it’s a political one?
CHRIS IGGO: I’d like to say yes, but evidence doesn’t suggest that that’s the case, because most central banks in the developed world are as independent as you can get, certainly compared to history, yet we’ve still gone through a big debt crisis. Central bankers can warn politicians about the issues of having big deficits or borrowing too much, but in the end politicians are only thinking about the electorate, so they kind of do what they were going to do anyway. And I think then the crisis, the debt problem in a sense backfires on central banks and makes them less independent, because in the end they are the lender of the last resort. They’re not going to let the economy completely collapse or the financial system collapse. So there is a kind of a moral hazard issue there that central banks are always called upon in the end to save the day.
PRESENTER: And just on the inflation point there can you successfully let a bit of inflation into the system or does inflation have a tendency once it’s out there to do what it wants to do and not be controlled?
CHRIS IGGO: I think the answer to that is it’s not clear, because we’ve had periods in the past where inflation has become very rampant. But it’s not clear that that was because it was a policy choice, it may have been a combination of different factors. The problem we have today of course is there’s too little inflation, so we are trying to get 3, 4% inflation, but unfortunately we’re running at 1%. 3 or 4% inflation would be very useful in that it would mean nominal GDP growth of 5 or 6% against borrowing costs of still very low, 3%, and that means that the debt dynamics if you like would start to improve, because nominal growth would be much greater than the amount that would be needed to pay on the debt.
PRESENTER: Everything you’ve mentioned here, they’re sort of pros and cons to all these different tools and levers that you use, in the round are you confident that the developed world’s monetary authorities have got enough room to manoeuvre us through all of the unwind from the 2008 crisis?
CHRIS IGGO: I think there’s a bigger issue here is that we are not really dealing with a debt problem, debt is continuing to increase, and because it’s not a problem in the markets at the moment the pressure is off politicians and policymakers to do anything about it. We’ve had 20-odd years of growing debt in the western world, in most individuals, amongst governments, amongst companies, and ultimately that’s not sustainable, because you have to have economic growth to support that debt.
So I’m not that confident to be honest. I think that at some point in the next decade we’ll have another debt crisis and that may mean that some countries have to again restructure their debt, or we will have inflation, because inflation ultimately may be the only tool available to deal with debt.
PRESENTER: We have to leave it there. Chris Iggo, thank you very much. And thank you for watching. Please do keep an eye out for the other units in this series, including one on monetary policy and its impact on investment markets. Do as well keep an eye out for the learning outcomes, they follow shortly. From all of us here, goodbye for now.
In order to consider the viewing of this video as structured CPD, you must complete the reflective statement to demonstrate what you’ve learned and its relevance to you. Among the topics covered by this Akademia learning unit are the size and influence of the global bond market; how governments, corporates and individuals use debt; the dangers of having too much debt in an economy; and why the credit crisis happened and the implications for investors today. Please now complete the reflective statement to validate your CPD.
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