Could debt forgiveness be interim solution for world’s economic malaise?

There is a growing perception that monetary policy is losing its power to solve the world’s economic problems. This may be misleading. What is probably true is that incremental policy easing is experiencing diminishing – and, possibly, negative - returns. Therefore, central banks – and governments - may need to get even more unconventional to reverse the tide.

Although the developed economies have recovered somewhat from the Great Recession, they are still not growing at their pre-crisis pace. The emerging economies bucked this trend for a while, helped by the seemingly unending rise of China. However, in the aftermath of the financial crisis, China’s boom also became increasingly debt-financed. 

With global debt levels very high, and rising, the world is likely to experience continued sluggish growth, at best, for years to come. So how do we deal with this? In theory, there are several ways in which one can reduce debt financing concerns. 

1) Cut funding costs

2) Pay off debts 

3) Grow our way out of the debt 

4) Write the debt off

There are problems with all four options. Let’s take the first one - interest rates are already extremely low and it is difficult to cut funding costs much further. 

In the second option, if everybody tries to pay off debt it would reduce spending and investment, undermining demand, corporate revenue and economic growth. This can lead to a negative spiral, especially if it incurs deflation. 

The third route – through faster growth - is clearly the optimal outcome. Here, it is nominal growth that matters (real growth plus inflation). However, the high debt levels make this outcome difficult to achieve. 

This leaves us with the last option – debt write-offs. Historically, this has been done by governments defaulting on their debt obligations. Argentina and Greece have been serial defaulters and the pain that this causes to the economies is clear for all to see. 

One idea that is getting some airtime, but is not yet being taken seriously, is that of debt forgiveness, rather than default. In practice, there are significant constraints: it is likely to be politically unpalatable and there may be genuine fears that doing so could spark uncontrollable inflation - direct monetary financing of government deficits rarely end well. But one has to believe there is a potential tipping point at which the downside risks of such action (hyperinflation, or at least much higher inflation) is less than the downside risks of inaction - ie. a depression. After all, central bankers have better tools to tamp down inflation than to fight deflation. 

Are we there yet? Clearly not. No central bank is seriously considering such action. Japan is probably closest – its economy and inflation are currently faltering and the Japanese yen rallying despite massive amounts of monetary stimulus. Would more bond (and equity) purchases or more deeply negative interest rates really help? I doubt it. But if the Bank of Japan were to write off significant chunks of government debt, it would eradicate the need for fiscal consolidation and take the brakes off the economy. 

Of course, longer term, other constraints would have to be dealt with as well. Economic reforms, both in the developed and the emerging world – which would ultimately boost productivity, reduce inequality and raise overall global demand for goods and services – are the real answer to the world’s problems. But reforms take time to deliver. Meanwhile, a debt write-off may buy significant time for the authorities to implement innovative measures to increase supply-side efficiency and revive global growth.

* Chief Investment Strategist, Wealth Management, Standard Chartered