Thirty years of bailouts leave the global economy more exposed than ever

For decades, the unspoken but self-evident contract between Western governments and voters has been unequivocal; when crisis strikes, the state must absorb the blow.

Financial collapse, pandemic, energy shock; each systemic challenge to the economy has been met with fiscal largesse and the reassuring hum of the printing press. Facing the most economically disastrous energy supply crisis since the 1970s, that contract is now under severe strain. Reaching for their usual tools, Western governments are finding the drawer is worryingly empty.

The comparison with the 1970s is instructive. Like then, the present crisis encompasses spiking energy prices and stubborn inflation. But when former presidents Nixon and Carter grappled with Arab oil embargoes, the fiscal position of the US was manageable, with a budget deficit of merely 2% and total debt to GDP of the G7 roughly 35% of GDP, according to Bloomberg.

Now, the picture could not be more different. Average budget deficits across the G7 have more than doubled since the 1970s, while total debt levels have ballooned to more than 100% of GDP. Global debt in aggregate reached a record $348-trillion last year, more than three times world output, having risen at its fastest rate since the pandemic.

These are not merely bad numbers. They mean that the ability of the global economy to cushion the effects of this crisis is lower than at any time in the past 80 years.

This is a crisis of crises

The lineage of this situation is clear. The Great Financial Crisis of 2008 prompted the largest injection of fiscal and monetary liquidity in history. Banks were bailed out, balance sheets were refinanced and the global financial system was plugged into life support. In China, a colossal infrastructure binge served the same essential function.

The crisis passed, but the debt remained.

In Europe, the aftermath was messier. The incomplete fiscal and monetary infrastructure of the Eurozone left peripheral economies exposed. Spain, Portugal, Ireland and Greece all required bailouts. However, the ideological commitment to avoiding “moral hazard” led European policymakers, led by hawkish Germany, to impose years of grinding austerity instead of relief, deflating real wages and hollowing out public services for a generation. The social wreckage of such fiscal idolatry – youth unemployment rates of more than 50% in Greece and Spain – proved fertile ground for the populist movements that have since reshaped European politics.

Then came the pandemic. Rich-world voters, unwilling to endure the economic devastation of the lockdowns that poorer countries like South Africa absorbed, were showered with fiscal support. American households received cheque after cheque in the post. European workers were maintained on furlough schemes instead of being retrenched. Debt rose sharply again. When Putin sent his tanks into Ukraine, sending European gas prices soaring in 2022, governments reached once more for subsidies and price caps. The pattern held; after crisis came bailout, and more debt.

As we can be sure the people running Iran know, that game is up.

Exhausted arsenals

Central banks find themselves in a similar bind. In every crisis, they have reacted by script, cutting interest rates and expanding balance sheets at the first sign of slowdown. That option, too, is out of reach. The Federal Reserve has missed its 2% inflation target for 60 consecutive months. Across the developed world, three out of four central banks are also off target. The SA Reserve Bank (SARB), with its newly self-imposed 3% target, is even more compromised than it would have been with a broader framework.

An oil supply shock of the type now playing out is inherently stagflationary – it slows growth while exacerbating inflation – leaving policymakers without a clean response. Cutting rates to support the economy risks inflaming inflation; holding firm could tip an already teetering economy into recession.

Bond markets are already registering their apprehension. In normal downturns, long-term yields typically fall as investors anticipate slower growth and monetary easing, resulting in the notorious inverted yield curve. Now, unusually, yields are rising.

Interestingly, though, it is not inflation expectations that are pushing them up; those remain largely anchored. Instead, it is fears that governments will borrow yet more to cushion the energy price shock. The so-called term premium – or the extra yield investors demand to hold longer-dated bonds – is climbing as markets take fright.

US markets illustrate this dilemma most starkly. While its energy self-sufficiency offers some insulation from the immediate supply shock, its fiscal position is among the most exposed in the developed world. Interest payments on federal debt now exceed the defence budget. Should the war drag on, sending defence spending even higher than current record levels, deficits may top 7% of GDP this year.

Washington has long behaved as if budget constraints only apply to lesser countries. As long-term US rates edge towards 5%, the bond market is beginning to disagree.

Who is most exposed

Not all countries are, however, equally vulnerable. The most at risk combine high debt and deficits, with a central bank already struggling to hit its inflation target. In the developed world, the US and the UK fit those parameters alarmingly well. Among emerging nations, Brazil, Egypt and Indonesia are potentially acutely exposed.

Poorer countries that rely on fuel imports and lack the fiscal capacity to assist their populations are the most precarious of all.

South Africa occupies an uneasy middle ground. Its public finances, while hardly untarnished, are at least in better shape than during the Zuma years of State Capture and fiscal incontinence. The SARB, often accused of excessive hawkishness, now looks prescient; at least its persistence in getting inflation down means price pressures are likely to be lower in South Africa than in many peer economies.

Yet the country remains highly exposed. Importing all its crude oil means fuel price increases feed rapidly into the cost of living, hitting the poor hardest as they spend a disproportionate share of income on transport and food. With unemployment above 30%, and debt to GDP approaching 75%, there is little room to help with subsidies or transfers. The GNU’s fragile political arithmetic makes bold fiscal responses harder still. South Africans might find that their relatively prudent policymakers may have bought them relief at the margins, but in a shock of this magnitude, that is not enough.

What happens to a nightmare deferred?

Doom-mongers have been predicting a day of reckoning in global bond markets for decades, but have been persistently wrong about the timing. No precise threshold exists beyond which debt levels are guaranteed to trigger a crisis. Bond markets can be remarkably pliant at times, especially in the US, which benefits from the dual blessing of the dollar’s reserve currency status and a Treasury market being the only bond market large enough to absorb the savings of the world’s current account surpluses.

But warning lights are flashing. For three decades, voters forced developed world governments to treat each crisis as an exception to be managed with bailouts. The exception became the rule. But current debt levels have changed the playing field.

The old rule book, as much as we might crave it, no longer applies. DM

Natale Labia writes on the economy and finance. Partner and chief economist of a global investment firm, he writes in his personal capacity. MBA from Università Bocconi. Supports Juventus.