Hard choices on global growth, fiscal austerity needed now to avoid a new debt crisis

The market’s severe reaction to Britain’s mini-budget shows investors have had enough of never-ending streams of government borrowing and private-sector debt
Delaying fiscal correction exposes the world to a potential doom loop of rising bond yields, spiralling into recession, and risks of a major debt default

David Brown

Published: 1:30pm, 24 Oct, 2022

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The world is heading into a new financial crisis unless global policymakers take evasive action soon. Since the 2008 financial crash and the 2020 Covid-19 pandemic, there has been a huge explosion of debt to pay for the crises and help soften the blow to the global economy. The world has ended up bulging at the seams with record levels of debt and left investors stuffed to the gills with bonds when global sentiment is diving.

The 40-year bull market for global debt has collapsed, and it couldn’t have come at a worse time for the UK government trying to stage a go-for-growth fiscal stimulus policy based on too much borrowing. It was a car crash waiting to happen.

The UK government was forced into an embarrassing U-turn, sterling markets crashed and the country’s financial credibility was seriously undermined. It will take years to repair the damage through painful tax increases and spending cuts, which will drag on future growth, but the UK is not alone as a new age of global austerity beckons.

Bond market vigilantes have had enough of never-ending streams of government borrowing and private-sector debt. The scale of the proposed UK fiscal stimulus might have seemed small compared to the huge size of global debt markets, but the speed at which contagion spread into other major bond markets was a disturbing feature and underlined that investor appetite for fixed income has reached a turning point.

Outgoing British Prime Minister Liz Truss’ dash for growth at all costs came apart at the seams as it failed the basic test of market credibility. Unfunded tax cuts and uncontrolled deficit spending, even by governments like the previously fiscally correct UK, will have major consequences for financial markets and global stability. The party is over for excessive, bond-funded spending sprees.

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The fact that 10-year US Treasury yields surged in reaction to a 14-year high of 4.24 per cent, above pre-2008 crash levels, underlined the event’s severity. Global policymakers and central banks want a gradual return to more normal rates of borrowing, but not in one shock move.

Following the mini-budget disaster, British government bonds were slapped with a hefty liability risk penalty with UK yields. At one stage, they were pushing higher than debt-ridden Greece and Italy.

Britain will need to dig deep to find the extra tax revenues and spending cuts to balance the books and close the black hole in the government’s coffers. Already feeling the pinch from Brexit’s fallout and the inflation spike, austerity measures are likely to tip Britain’s economy into deep recession.

There is no magic formula to undo the long-lasting damage from the 2008 crash, the 2010 European debt crisis and the pandemic, and there is no fairy-tale cure from suboptimal growth in the world economy during the past 14 years. Global policymakers have been asleep at the wheel for too long.

According to figures from the Organisation for Economic Cooperation and Development, the level of outstanding government debt for all OECD countries rose to 125 per cent of total gross domestic product by the end of 2021, compared with 74 per cent in 2007 before the global crash. That is a massive expansion in indebtedness.

This happened despite years of austerity cutbacks that were levied between 2010 and 2019 and that were blamed for years of low growth before the pandemic. The world is so overburdened with debt that it must be reined in soon for the sake of global financial stability.

It’s a huge challenge while borrowing rates and bond servicing costs are pushing higher and global growth is losing momentum, but it can’t be rushed considering the fragile state of global economic confidence right now. A crash course in global debt deflation, monetary tightening and fiscal austerity is out of the question.

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But delaying fiscal correction too long exposes the world to a potential doom loop of rising bond yields, a spiral into recession and rising risks of a major debt default. The world is between a rock and a hard place, and it won’t take much to spark another extreme credit event like the 2008 global financial crisis.

If the major nations persist with tighter money to combat inflation and double up the pain with a shot of fiscal austerity, global growth prospects will be relegated to less than 2 per cent in the next two years. Policymakers have tough choices to make and time is running out.

David Brown is the chief executive of New View Economics