We are experiencing unprecedented times. Less than one year ago the pandemic triggered the worst economic and financial crisis ever. At the end of 2020, the world is in an extremely indebted position. My understanding of debt issues is based on my personal experience.
I had to deal with the Latin America crisis, the Polish, Egyptian and Soviet debt crises in the 80’s and beginning of 90’s as chair of the Paris Club. I was president of the European Central Bank at the eruption of the Great financial crisis (GFC) from 2007 to 2011. There was a pattern in these crises. They were following three episodes.
Episode 1: before the eruption of the crisis, the mood was very much one of euphoria. An emblematic illustration of episode 1 was the “Great Moderation”. Then there was a large consensus on the efficiency of financial markets in all circumstances. A period marked by the belief that economic cycles had been eliminated, a period of benign neglect vis-à-vis the rapid accumulation of public and private debt outstanding.
Episode 2 starts with the eruption of the financial crisis – Mexico in August 1982, Lehman Brothers in September 2008. In a matter of days, mainstream financial analysis makes a U-turn. Private and public debt overhangs are recognized as the main cause of the crisis. Hyman Minsky and his instability hypothesis (which were ignored before the crisis) are becoming fashionable. The recommendation is made to economic agents and market participants to beware of the risks associated with excessive financial leveraging. The international community focuses rightly on financial prudentials. But debt temptations are still there. A solid risk management culture in the private sector is difficult to establish durably. Governments are on the verge of succumbing again to the facilities of higher borrowings. After a while, episode 3 can start.
In episode 3, the memory of the crisis is progressively vanishing. Keynesian “animal spirits” are back with a vengeance. And the delights of embarking on financial leveraging again are impossible to resist. Resistance is all the more difficult because the recommendations of many economists are back to episode 1. Indeed since the last GFC and before the pandemic, a new argument was in play. The assumption that real and nominal interest rates are extremely low for a very long period of time was justifying a high level of additional leverage whatever the starting point of indebtedness would be.
The pandemic comes exactly at the end of episode 3 of the GFC. Seen in a global perspective, the extreme difficulty of the debt issue in the pandemic is threefold. Firstly, the public and private debt outstanding had significantly increased over the previous ten years. The IMF estimates that global debt augmented by around 30% of global GDP from the GFC (from around 195% of GDP up to 225% in 2019). The Institute for International Finance (IIF), with a different methodology, sees an increase of around 20% of global GDP over the period, from 300% up to 320%.
Secondly, thanks to extremely prompt and audacious responses of Central banks and Governments, most of the economies avoided an immediate, dramatic depression. Central banks, Governments and Parliaments must be thanked for their swift and necessary actions. But the price to be paid was an unprecedented additional layer of debt in the context of the 2020 global recession. The combination of a considerable increase of the numerator (global debt) and decrease of the denominator (global GDP) under the stress of the recession might result in an unseen transitory jump from 320% last year to 365% in 2020, according to the IIF.
Thirdly, contrary to what was observed in the previous crisis, the eruption of the pandemic did not call for an “episode 2”, namely a U-turn in the mainstream financial analysis and the recognition that the debt overhang was not sustainable. The reason is simple: the pandemic crisis is totally exogenous; it is a pure healthcare problem. The immediate source of our present major difficulties was not a crisis of the financial system. This explains why many economists remain of the opinion that very low interest rates and very accommodating monetary policies for a very long period of time will not only enable us to cope with the present debt, but could also help finance additional public spending and deficits.
To be clear, I think it is plain wrong. The belief that the debt issue will be diluted progressively overtime, thanks to present and future extraordinary accommodative monetary and financial policies, is an illusion. Even before the pandemic, it was clear that the advanced economies were not in a sustainable functioning mode over the long term. Through courageous structural reforms, they had to correct their trajectory, namely redress their productivity, increase their growth potential, post higher inflation and experience higher real and nominal interest rates. It is even more true with the pandemic.
That being said, what would be the main recommendations in the present circumstances? I see three.
First, the international community cannot afford to be divided like in the last four years. Active, determined and confident global cooperation is of the essence. Without such healthy global governance, particularly within the G20, chaired by Italy in 2021, there would be no chance to solve the global debt issue.
Second, the first priority at a global level is to help the many vulnerable economies in the developing world, particularly the Low Income Countries (LIC’s). The recommendations made by the recent report of the G30  are highly pertinent, in particular: the IMF deciding on two new 500 billion dollars allocations of Special Drawing Rights; the World Bank maximizing its concessional “surge” capacity; all creditors embarking on early treatment on LIC’s debt on the basis of comparable contributions.
Third, the advanced economies have a particular responsibility. They did well, for them and for the global economy, in countering the crisis massively and effectively. They should manage their own debt in a responsible fashion: sound public and private management, with a view to diminishing, progressively but regularly, debt outstanding as a proportion of GDP. It is the condition for global savers, investors and market participants to keep confidence even in a period with a very high level of absolute debt outstanding. On the other hand, it would be a recipe for catastrophe for advanced economies to think they can embark on permanent monetary financing of their ballooning public debt or on public debt cancellation by Central banks. Leveraging without limit on their signature’s creditworthiness and on their currency’s confidence is a non-starter. The confidence of the rest of the world is not available whatever the advanced economies do.
 “Sovereign Debt and Financing for Recovery after the COVID-19 Shock: Preliminary Report and Recommendations” (2020)