Mark Lister, 21 May 2021

Thursday’s budget painted an upbeat picture of the New Zealand economy, with growth estimates upgraded substantially and government borrowing forecasts for the next few years reduced.

However, one big question regarding our post-COVID future is how we’ll pay back the very large national debt we will have incurred.

The latest Treasury forecasts suggest our Government debt has increased to 26.3 per cent of GDP, up from 19.0 per cent in 2019. Despite the more optimistic outlook, that’s still expected to surge to 48.0 per cent in 2023.

That’s high by our standards, but it’s still well below most other countries.

The International Monetary Fund estimates net debt to GDP for the world’s major advanced economies will be 108.5 per cent next year.

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It expects Europe’s government debt to hit 82 per cent of GDP, the UK to rise to 99 per cent and the US to reach 110 per cent. Japan has been at the extreme end of the spectrum for many years, and net public debt is forecast to rise above 170 per cent in 2022.

There are fundamental differences between all these economies, and one important distinction is that all these countries have much lower household and mortgage debt than we do.

Debt serviceability is not an issue while interest rates are as low as they are. The 10-year bond yield (which is the interest rate the Government can borrow at) is 1.9 per cent. That’s about 50 per cent lower than the average of the ten years leading up to the COVID-19 pandemic.

In theory, that means you can carry double the debt burden for the same cost. Many would argue structurally higher debt is simply part of the “new normal”. After all, debt levels have blown out across the board and we still look good in a relative sense.

However, I would rather see our collective debt a little lower. We are a small, open economy with numerous vulnerabilities, and it has always been comforting to have a ‘war chest’ of low government debt.

This has provided the firepower to fight unexpected crises when they’ve emerged, such as the GFC more than a decade ago and the COVID-19 pandemic last year.

So what are our options to lower our debt levels in the years ahead?

The best way to reduce our debt as a proportion of GDP would be for the economy to simply get bigger, or for inflation to run a little hotter than usual, or both.

In theory, stronger growth and higher inflation would see the value of everything else (including wages) rise, while our debt levels would stay the same. That’s where the phrase ‘inflating your way out of debt’ comes from.

Mind you, sustained economic growth could be harder to come by than we would like, while a substantial rise in inflation could bring with it some unwanted side effects.

Outside of the more desirable solutions, the only real options for debt repayment are the ones politicians don’t like to talk about.

Just like a household that has borrowed more than it can afford, a government can either reduce its debt by cutting costs, or by finding a way to bring more money in the door.

Spending cuts don’t tend to be a vote-winner, especially when parts of the economy are fragile and the services in question are relied on by very broad groups across society.

One elephant in the room is the retirement age and the burden superannuitants will put on future generations. There are few politicians brave enough to tackle this one.

That leaves higher taxes.

A new, higher personal income tax rate of 39 per cent is now in place. This only affects a very small group of extremely high earners, and many would argue it was merely a symbolic move.

We’ve also seen property investors hit with higher taxes, although these are a world away from a comprehensive capital gains tax.

High debt levels look here to stay over the next several years. This could mean policymakers are highly incentivised to keep borrowing costs down, while it could also mean central banks will take a more relaxed approach to higher inflation.

If the “new normal” of higher debt levels is matched by a “new normal” of persistently low interest rates, the status quo is manageable.

If it isn’t, future governments might find themselves under increasing pressure to bring additional revenue in.