Public debt is at a record high and at the same level as in 1945 post-World War II in advanced economies. Vice President and Corporate Secretary of the Asian Infrastructure Investment Bank (AIIB) Ludger Schuknecht emphasized the increasing relevance of the debt sustainability of advanced countries in a Policy Lecture of the Leibniz Institute for Financial Research SAFE and the Center for Financial Studies (CFS) on 27 January 2022.
According to Schuknecht, public debt is exceeding the financeable level. In the global context, it is not so much about indebted small emerging countries, but rather large economies and industrialized countries: Fiscal risks would be especially high in advanced countries and the growing debt would not financeable, even for large economies, Schuknecht said.
Financial stability and aging population
Financial stability remains one of the major risks, Schuknecht showed. A new financial crisis could also have massive fiscal implications. Risks in the banking sector have been reduced since the financial crisis of 2008. Now, with the higher private debt, debt in the corporate sector, or imbalances in pension systems, a new financial crisis cannot be ruled out, he said. Because of the internationally intertwined financial markets, a contagion across borders would be likely. "We do not know the safe havens of the future," Schuknecht warned.
In addition to financial stability, the aging of the population is a major challenge, he said. On the one hand, age-related public spending will increase significantly. On the other hand, public investments may have not the desired outcome: "The question is if bricks or brains count more," Schuknecht argued. Skilled workers would opt for countries where there was "more net from gross" and, therefore, for countries where per capita taxes to finance debt were lower. In his view, advanced countries, therefore, could lose competitiveness instead of expending it.
Schuknecht presented four scenarios on how to sustainably reduce debt. Realistically, he said, a mix of scenarios can be expected. Schuknecht described the first scenario of consolidation and reform as the "conventional wisdom" to date: If debt sustainability is no longer guaranteed, the debt would be reduced through consolidation. However, Schuknecht doubted that this common practice would be implemented in large advanced and emerging economies, as politically, the urgency of debt reduction is lacking. The second option would be debt restructuring. While, certainly, emerging economies reduce debt by restructuring, Schuknecht does not believe that it is also a solution for large high-debt countries: "A lot of fiscal, financial and legal issues would be raised," he said.
The third scenario is financial repression. With the current interest rates lower than growth rate, debt levels can be reduced significantly, but "it will not be big enough to solve the problems of high-debt countries," Schuknecht argued. Further, the stability of the scenario would be unclear. Financial repression could end in a fourth scenario of destabilization as a result of wrong political decisions or if the debt was too high. "The safety of advanced country debt markets has hinged on trust and confidence in the markets of the largest currency in the past decades," Schuknecht pointed out. It has been shown that this confidence could be lost even by large advanced countries and could lead to destabilization.