Breakingviews - The debt supercycle has reached its final leg

Reuters

3 days ago

LONDON, July 24 (Reuters Breakingviews) - British politicians know that their workplace, the Palace of Westminster, is in a shambolic state. The 19th-century complex of buildings suffers from an infestation of vermin, falling masonry, leaking water from lead piping, and worn-out electric wiring. There's a constant danger of fire. Yet the occupants cannot summon up the will to tackle the problem. They shelved elaborate and costly renovation plans several years ago. Instead, the decaying structures are temporarily patched up. Yet the longer the delay, the higher the estimated costs of the building works and the greater the risk of a catastrophic incident, Parliament's Public Accounts Committee has warned.
There's another challenge that Britain's political class seem incapable of rising to. Since the pandemic, UK public borrowing has been on a sharp upward trajectory. By the end of last year, the national debt approached 100% of GDP and the fiscal deficit was over 5%. The Office for Budget Responsibility warns, opens new tab that if nothing changes the public debt will reach 270% of annual output over the next 50 years. A recent relatively minor act of fiscal restraint – the Labour government's proposal to cut winter fuel payments to wealthier retirees – was reversed after it ran into fierce opposition from the party's own lawmakers. Last month, the state borrowed a further 21 billion pounds, its highest ever monthly net borrowing (aside from the pandemic year), and 3.6 billion pounds higher than the OBR had predicted.
Britain is hardly an outlier among the large, developed economies. France's public debt is even higher at 112% of GDP and last year's budget deficit was 5.7% of economic output. U.S. public debt last year reached 121% of GDP and its fiscal deficit hovers around 7%. In its latest Fiscal Monitor, opens new tab the International Monetary Fund exhorts governments to 'put their fiscal house in order.' In principle, sovereign insolvency is not inevitable. Governments could raise taxes, cut spending and act decisively to boost economic growth. If they took these tough measures, pesky fiscal deficits would gradually evaporate.
But the political resolve is lacking. Britain's OBR notes that 'public expectations of what government can and should do in response to emerging threats and future emergencies seem to be rising.' French Prime Minister François Bayrou warns that his country is addicted to borrowing and just 'one step away from the cliff.' Yet France's latest, faintly comic, plan to reduce the fiscal deficit involves cancelling two national holidays, an act which is strongly opposed on both the left and the right. Across the Atlantic, whatever savings were achieved by Elon Musk's Department of Government Efficiency have been completely overwhelmed by President Donald Trump's One Big Beautiful Bill Act, which the Congressional Budget Office predicts, opens new tab will add a further $3.4 trillion to U.S. deficits over the next decade.
The root of the problem appears to be cultural. In his book, opens new tab, 'The Fourth Turning is Here: What the Seasons of History Tell Us about How and When This Crisis Will End', demographer Neil Howe posits that human societies pass through multi-generational cycles. In the first generation, society is strong, cohesive and optimistic. The next generation experiences an 'awakening' in which established values come under attack. There follows an 'unravelling' as institutions weaken, civic order decays and society becomes increasingly polarised. 'Incompetent governance, ebbing public trust, and declining public compliance all feed on one another in a vicious cycle,' intones Howe. The resolution finally comes with a 'fourth turning' when a new civic order replaces the old one.
Howe's long cycle originates with the work of the 15th-century Arab historian Ibn Khaldun, who traced the rise and fall of ruling dynasties through changes in group cohesion. By Khaldun's fourth generation the founders' collective spirit has become widely despised, complex laws are evaded, vast riches are hoarded by the few and 'destroyers' preside over the dynasty's collapse. Hard-nosed financial types may find this civilisational cycle somewhat nebulous. But it appears to complement the broadly accepted notion of a debt supercycle – a multidecade period in which total borrowings ratchet ever higher.
In his latest book, 'How Countries Go Broke: The Big Cycle', Ray Dalio takes issue with 'the insouciant belief that there's no limit to government debt or debt growth, especially for countries with a reserve currency.' The veteran hedge fund manager's 'big debt cycle' lasts around 80 years (roughly the same periodicity as Howe's revolution). Over the course of Dalio's cycle, sound money gives way to government-issued fiat money, the private sector takes on too much debt, at which point the government steps in to bail out borrowers, and total debt keeps on rising.
As the cycle nears its end, a country is typically beset by chronic fiscal deficits. Low domestic savings and current account deficits render it dependent on foreign lenders. As lenders become wary, the average maturity of the public debt shortens. The central bank finds it impossible to set interest rates at the level which balances the needs of both creditors and borrowers. Once interest rates rise, governments' debt servicing costs become increasingly onerous. Government finances come to resemble a Ponzi scheme, with new debt being issued to service old borrowing. That pretty much describes the situation which several advanced economies, including Britain, France and the United States, find themselves in today.
The investment conclusions from Dalio's historical study are unsurprising. Owning government bonds at the end of a debt supercycle is not a good idea. Faced with a crisis, central banks usually bail out their governments. When inflation picks up, currencies depreciate on the foreign exchanges. Real assets are a safer bet. Stocks tend to decline into the crisis but generally recover their losses in the aftermath. Gold shines, beating bonds on average by 71% during crisis periods, according to Dalio.
'History is seasonal, winter is here,' writes the dismal prophet Howe. Dalio does not think a debt crisis is imminent, but believes one is likely to arrive within the next decade. Bondholders are forewarned. On the bright side, it's possible that by then a more resolute generation of parliamentarians will have started work on fixing the Palace of Westminster.
Follow @Breakingviews, opens new tab on X