«We’re really way out in
uncharted territory»

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Carmen Reinhart, how high are levels of public debt currently?

As far as I can tell, we are at record highs on a global basis, surpassing even the major wars of the last centuries. And that is just public debt, not to mention private debt that often becomes public debt after a crisis. If we take into account that private debt is also very high, then we’re really way out in uncharted territory.

How did this come about?

There is no single explanation, it’s certainly been evolving over a substantial period of time. Back in the 1980s, when Paul Volcker tightened monetary policy and was able to jack up rates very sharply, household debt in the US was about half of what it is today. Since then, we have had a 40-year period with different modalities of a steady rise in debt levels, but the last 15 years have been spectacular. Part of the story is certainly «low for long»: the exceptionally low-interest rates that have made borrowing cheap. In the case of Europe, the historical anomaly of outright negative nominal interest rates is an invitation to overborrow. For both the public and the private sector, highly negative real interest rates are nothing but a transfer from savers to borrowers. And of course, big events such as the global financial crisis and the COVID pandemic have also added a lot of debt.

You mentioned the exceptionally low interest rates of the last decades. The past year has seen a shift of mood: Central banks tightened their policy in response to inflation. What are the consequences?

Naturally, this came as a response to an inflation spike that reached levels not seen in the last 40 years. Most economists initially interpreted the spike as a transitory phenomenon caused by the aftermath of the pandemic, supply shocks and a variety of other transitory factors. Most central banks misjudged the situation: Instead of treating inflation as a serious threat early on, the tightening came a little too late. Personally, I have been fearing a more persistent level of inflation for a couple of years now. Historically, there have only been a few episodes since the 1800s where short-term real interest rates were persistently negative: The years around World War One, the years around World War Two, and the 1970s. The period since the global financial crisis is the fourth time we’ve been there.

What can we learn from the earlier periods?

In periods of low interest rates, you get more borrowing, meaning more money in circulation and eventually higher price levels: All of those episodes mentioned were inflationary. Exiting negative real interest rates is a must if we’re serious about inflation stabilization. The shift has been overdue. And let’s hope it lasts: With the adverse supply shocks still around, there is the danger that central banks get cold feet and back out early of fighting inflation.

Won’t the shifting environment in monetary policy cause economic problems in indebted countries? Are we in danger of a global debt crisis?

I would not yet call it global but we are definitely seeing debt problems surface more frequently and aggressively. The canary in the coal mine are the low-income countries: In these countries, there is a combination of rising debt levels in hard currency, now rising interest rates, and slower growth. In many cases, an outright shortage of foreign exchange means that debt servicing has faltered. Some Sub-Saharan African countries have applied for international support under the Common Framework, a G20 guideline for debt treatment. More than 60 percent of the 74 low-income countries are now either in debt distress or at high risk of it. We also have debt issues in middle-income countries: There’s the chronic issue of Argentina, and also problems in Ecuador and Pakistan. Egypt could also be mentioned and of course Turkey, where the human disaster of the recent earthquake has taken a heavy toll. In the case of Sri Lanka, we have also seen the tumble of a country that had no prior history of default. The list is long, but I could continue further.

How is the situation in advanced economies?

In terms of advanced economies, I don’t see the threat of an immediate debt crisis looming around the corner. But tighter financial conditions combined with a recession in Europe will strain the situation – you can never fully rule out the crisis scenario. Remember the aftermath of the global financial crisis in 2008 and 2009: The Greek debt crisis didn’t flourish immediately, it happened cumulatively. It can’t be neglected that Italy is in a very difficult position, with a complete lack of growth and growth prospects remaining dim, combined with rising debt levels. The ECB’s window of support through QE and bond purchases is now being scaled back. It’s difficult to foresee to what extent this will become a problem. But my greatest source of concern at the moment is the way that things have evolved in developing economies: These countries are facing increasing difficulties to service their external and domestic debt, which have also risen markedly during the last few years.

What can be done to avoid defaults in low-income countries?

That’s a very hard question. In many cases, it is now a little too late for prevention. What can be done is some kind of pre-emptive restructuring, something that has become fashionable to be called reprofiling: Extending maturities or limiting the bunching of repayment. These kinds of measures could mitigate distress in a number of cases. The initial gut reaction of people is to demand that multilateral institutions provide a lot more liquidity. This has to be taken with a grain of salt: More borrowing isn’t going to solve problems of solvency. They might delay a default but they do not offer a really constructive and sustainable solution.

Larry Summers has been criticizing the International Monetary Fund for its current inaction by calling it a fire brigade that is «still in the station». What should the IMF be doing right now?

The idea that the IMF can step in to avoid a debt crisis is highly overstated if we are to take history as a guide. Their programs are often seen as imposed upon by the affected governments, not as necessary medicine. Sri Lanka, for example, fought tooth and nail by refusing to go to the IMF for support – by the time they had no other choice, they were already in the emergency room. For the IMF to really have a shot at preventing something, timing is everything. But in numerous cases, the IMF only gets called upon when it’s already too late. The Fund is a bit like a vampire: Nobody wants them to be a guest at their house. What it can do is help to set up the discussion around debt restructuring. But at the end of the day, it is the creditors, public or private, that determine the conditions of an agreement. They are the ones sitting at the table, they’re the ones that determine on what terms a debt restructuring happens or not.

Regarding this, there is a new elephant in the room: China, which has become the world’s largest creditor nation according to your estimations. How did China’s rise come about?

China’s overseas lending began to take off in the early 2000s and really escalated about a decade later. One has to put in perspective that between 2003 and 2013, China’s average GDP growth rate was above 10 percent, a growth heavily driven by infrastructure. Many emerging markets and developing countries are commodity producers, and China needed these commodities. That is part of the explanation for China’s big lending expansion. Another factor is oftentimes underestimated: Many low-income countries had just had their house cleaned by the Heavily Indebted Poor Countries (HIPC) Initiative, an operation launched in 1996 by the IMF and the World Bank to ensure that no poor country faced a debt burden it couldn’t manage. So, all of a sudden, many of these countries suddenly didn’t have much debt on their balance sheet anymore. Commodity prices were high due to China’s large demand, causing the largest boom in commodity prices since the 1700s as far as I can tell from the data. The commodity-producing nations looked to be ideal borrowers, and China seized the opportunity, extending trade and geopolitically gaining a foothold of greater influence in various regions of the world. The situation reminds me of the 1970s when US commercial banks were doing the same thing: They were lending to countries that seemed like a good bet.

Where did things go wrong for China?

It all started to crumble in 2015 when commodity prices crashed. Right around the same time, China’s growth rate slowed. So, the reason for China’s spectacular lending expansion is fairly straightforward: Borrowers can become overconfident, as usually is the case during booms. I watched this all through the prism of having studied the crisis of the 1970s and 80s, a period where the surge in US commercial lending had ended badly. This is China’s first round as a global creditor, they are now facing a downturn in the cycle for the first time.

So, the Chinese lenders haven’t learned the lesson from the 70s and 80s?

Not yet, but they will. This precisely follows the logic of «this time is different»: In each phase in history, There is a very strongly ingrained tendency of believing that you are smarter than your predecessors, even though you’re doing very similar things. The notion is that we have better reasons and better control mechanisms – before things eventually end similarly. I think that US banks have internalized the lesson, we haven’t had a renewed boom in bank lending or exposure to emerging markets comparable to the 80s. But it’s a different story for China.

How optimistic are you that the world can find a way to deal with the debt overhang in developing nations this time around? Is this going to be a crash and burn or will we achieve a soft landing?

I am very pessimistic. History shows us that lessons from the past are not often learned. Official and private creditors alike, irrespective of whether you are a US commercial bank or the Chinese government, share one interest: They want to be repaid in full. That desire is understandable. Only when the realization drops that full repayment may not be in the cards will creditors accept that they are better off cutting their losses. Getting some partial repayment and moving on is possible, but that acceptance has been very hard historically: Any creditor is going to be slow to jump onto the bandwagon of debt relief. And in the case of Western creditors, there is a feeling that the successful write-offs of most of the debt should have been concession enough: For middle-income countries, you had the Brady Plan of 1989, and for low-income countries, you had the HIPC Initiative 1996. These two agreements also tell us something about how difficult and tedious debt negotiations can be: They both came as late responses to the crises of the 1970s and 1980s. For the countries in debt distress at that time, we’re really talking about two full decades mired in a debt overhang. Having seen this, I have a certain amount of pessimism as to how quickly the current overhang will be addressed this time around.

You were Chief Economist of the World Bank between June 2020 and 2022. How do you think that these turbulent years of global economic affairs will be remembered in the history books?

I don’t know yet what the final conclusion will be, just like people of the 1930s didn’t know about what we’d be telling ourselves about the Great Depression today. But I do predict at this stage that people will spend a long time discussing what we are currently doing to manage the shocks of the last few years and why they are taking so long to eradicate. I am confident that a century will pass, and people will still be studying and writing about what is happening right now. Because let’s face the facts: Never since 1900 have more countries witnessed a simultaneous contraction of per capita GDP at the same time as was the case in 2020 when the pandemic hit. In that aspect, the synchronicity and the magnitude of global contraction were bigger than World War Two and the Great Depression. These are extraordinary times we’re living through.