A decade after Lehman Brothers collapsed, the Federal Reserve Bank of St. Louis reviewed the economics literature and concluded that “one of the main reasons why the subsequent recession was ‘great’ was due to high levels of leverage and debt.” On the eve of the 2008 financial crisis, total U.S. domestic debt was a staggering 370 percent of GDP. The global debt load was similarly high, at more than triple the size of global GDP. Moreover, in the aftermath of the crisis, there was widespread agreement that excessive debt loads had helped cause the crisis.
Nevertheless, following the crisis, the world did not deleverage. Instead, it went in the opposite direction and became even more indebted. In the decade after the crisis, borrowing became extremely cheap as central banks lowered their interest rates to near-zero, and even below zero in some areas. As a result, companies, countries, and consumers gorged on cheap debt. By the end of 2019, global debt exceeded $255 trillion—more than $30,000 for every man, woman, and child on the planet.
Now, the COVID-19 pandemic is threatening to pop this global debt bubble.
As the COVID-19 crisis continues to disrupt global markets, credit rating agencies are also reassessing many companies’ debt exposure, raising doubts about the stability of these borrowers. There is a rising specter that much of the lowest rung of investment-grade corporate debt will fall into junk status. Already, more than $320 billion of this low-rung investment-grade debt is yielding more than 5%—a yield previously associated with junk status. In March, Moody’s and S&P downgraded Ford Motor Company’s debt to junk status. Other recent fallen angels—investment-grade companies that are downgraded to junk—include Kraft Heinz, Macy’s, and Renault. Entire industries, such as airlines and cruises, are going to be walloped. If the pandemic remains a threat for an indefinite period, it is uncertain whether these companies will be able to survive.
Companies cannot place all the blame on the “black swan” of coronavirus. In October 2019, the IMF warned that an economic downturn just “half as severe as the global financial crisis of 2007-08” could put nearly $19 trillion of corporate debt at risk of default. However, rather than save for the inevitable rainy day, S&P 500 companies spent more than $1.5 trillion on stock buybacks in 2018–19, funding a significant share of those buybacks with debt.
As COVID-19 is threatening to give rise to $1 trillion of distressed corporate debt, the contagion is spreading to the non-bank financial sector and, ultimately, banks themselves. Bond ETFs are experiencing historic price gaps, mutual funds are suffering from large redemptions, the European Central Bank is recommending that banks suspend dividends, and small American banks are bracing for significant losses.
Governments significantly increased their debt loads in the heady low interest rate decade after the financial crisis. In 2019, emerging markets borrowed almost twice as much in dollar-denominated bonds as they did in 2009, while the national debt increased by more $3 trillion during the first three years of the Trump administration – a number that will appear small by the time the pandemic is under control.
Nevertheless, because of COVID-19, many countries that sowed high debt loads are now reaping the whirlwind—the number of countries with distressed debt has more than quadrupled since the beginning of 2020. Dozens of countries are now at risk of default. By the end of this year, low- and middle-income countries are set to spend over $400 billion on debt repayments. Total sovereign debt repayments in 2020–21 amount to more than $2.5 trillion.
With many countries facing a Sophie’s Choice of either defaulting on their debt or failing to adequately protect their citizens from the pandemic, leading sovereign debt lawyers are urging “debt forbearance for emerging market countries with precarious finances and high levels of poverty.” The IMF and the World Bank are heeding this call and asking creditors to give debt relief to the world’s poorest countries.
At the end of 2019, American household debt was more than $14 trillion—roughly $1.5 trillion higher than it was in 2008. Down under, historically low interest rates have driven Australian household debt to 120% of GDP. France, Switzerland, New Zealand, and Nigeria all reached record-breaking household debt-to-GDP ratios by January 2020. Even the debt of China’s historically thrifty consumers more than doubled between 2012 and 2019. Globally, household debt now sits at $47 trillion.
As with corporate and sovereign debt, COVID-19 is proving Warren Buffett’s maxim that “you only find out who is swimming naked when the tide goes out.” The pandemic is dragging the tide out, leaving the highly indebted stark naked. The “global consumer default wave is just getting started.”
To try and stave off the impending COVID-19 depression, the world is becoming even more indebted. Central banks have relaxed capital requirements, enabling banks to make an additional $5 trillion of loans. The Federal Reserve has dropped interest rates to zero and is providing hundreds of billions of dollars in loans to companies and consumers. With the U.S.’s $2 trillion stimulus package, the federal government’s deficit for 2020 is set to surpass $3 trillion, bringing total federal debt to more than $25 trillion. Even balanced-budget obsessed Germany is suspending its constitutional deficit ceiling and is warming to the idea of the Eurozone issuing $1 trillion of “coronabonds.”
The current framework for crisis resolution may not be effective in this unique COVID-19 fueled economic crisis. In contrast to previous economic crises, this is a health crisis that has forced governments to put the economy into a “medically induced coma.” The question now is whether debt-fueled economies can ever fully recover from this coma.