Macroeconomic Adjustment and Economic Outlook in Nigeria (2024)

Despite the new government’s commitment to macroeconomic adjustment, the economic outlook for the Nigerian economy will remain challenging in 2024 and 2025 amidst modest economic growth, elevated inflation and fiscal discipline; this will keep the risk of both socio-economic unrest and policy slippage high. The Nigerian economy will grow at around 3% a year in 2024 and 2025, which is only a tad higher than the population growth rate. This translates into only a very modest improvement of per capita income, on average. Given the substantial devaluation of the naira over the past year, per capita income in nominal dollar has actually fallen substantially, further adding to the economic pain. Meanwhile, continued high inflation will keep food insecurity high and will likely increase the poverty rate, as the government will be to fiscally constrained to maintain real income levels for the economically more vulnerable parts of the population. This, in turn, will lead to increasing political demands for the government to address socio-economic demand, which will increase the risk of policy slippage over time. Due to the continued downward adjustment of the naira, domestic per capita income measured in current dollars has declined from $2,000 in 2021 to $1,300 (in current dollars). In 2023, 25% of the population was at risk of food insecurity and the poverty rate was 37% in 2022.

Since coming to office in May 2023, President Tinubu has pursued fundamental macroeconomic policy reform with the aim of putting the economy on a sounder financial footing. In terms of fiscal policy, the government has pursued a tighter fiscal policy to reduce the deficit. It did so (initially) by removing fuel subsidies, even though it backtracked somewhat later on. The fiscal adjustment is essential if the government is to reduce its reliance on the central bank financing, which contributes to endemic inflation. As regards monetary policy, the central bank has begun to prioritize price stability and disengaged from some quasi-fiscal activities, such as the provision of loans and guarantees to domestic financial institutions. It has increased its policy rate several times. However, a combination of insufficient monetary tightening and significant nominal exchange rate depreciation has thus far failed to bring down inflation. Ex-post real interest rates remain deeply negative, thus contributing to high inflation. As regards exchange rate policy, the Central Bank of Nigeria (CBN) has moved towards a greater liberalization of the foreign-exchange regime and a unified, more market-determined exchange rate. In this context, the CBN has also been seeking to clear its overdue dollar obligations vis-a-vis domestic banks to ease the pressure on the naira and re-establish stability in the foreign-exchange market. At the same time, it seeking to address the backlog of dollar demand from foreign companies eager to repatriate their funds in the face of dollar scarcity and tight foreign-exchange controls.

Modest economic growth in the context of tight fiscal and monetary policies but high inflation will fuel demand for increased subsidies social spending. With the presidential elections more than three years away, the government faces solid incentives to stick with politically painful macroeconomic adjustment over the next 1-2 years in the hope of stabilizing the economy and creating sufficient space to accelerate economic growth in 2027. A lack of fiscal capacity and flexibility will make it difficult to generate the resources to support growth-enhancing investment or social spending to help offset the welfare losses suffered by high inflation and modest growth, unless it is willing to jeopardize economic and financial consolidation. The limited availability of international private and official financing further constrains the government. On the flipside, a roughly balanced current account will help limit the drain on Nigeria’s foreign-exchange rate reserves, and the IMF projects a gradual recovery of FX reserves in the context of limited dollar inflows. This will limit the risk of sovereign default in the next 12-24, not least because Nigeria retains the option of requesting a Fund program to avoid a broader balance-of-payments crisis.

Economics and Politics of Defense Spending (2024)

Absent entitlement reform, U.S. government debt will continue to increase in the context of large fiscal deficits, which will limit policy flexibility in terms of medium- and long-term defense spending. The Congressional Budget Office (CBO) projects large fiscal deficits and a continued increase of the debt-to-GDP ratio, driven by increasing (mandatory) entitlement and net interest expenditure. It is highly unlikely that the projected increase in government over the next two decades will cause any financing difficulties, let alone a financial crisis, not least due to the pivotal role of the dollar, the relative attractiveness of U.S. assets and a more favorable growth outlook than in most other advanced economies. However, a combination of more modest economic growth and large fiscal deficits will translate into greater defense spending constraints.

> U.S. federal government is $35 trillion, which translates into more than $100,000 per citizen. U.S. federal government debt has more than tripled since the beginning of the century, increasing from 32% of GDP in 2001 to 96% of GDP in 2023. The CBO currently projects the debt-to-GDP ratio to reach 116% of GDP by 2034 and 166% of GDP in 2054. Federal budget deficits will average around 6% of GDP.

> Mandatory spending will increase from 13.9% of GDP to 15.1% of GDP over the next ten years, while discretionary spending will decrease from 6.4% of GDP to 5.1% of GDP. If the decline in discretionary defense and non-defense spending were to be evenly split, U.S. defense spending would be less than 3% of GDP by the middle of the next decade and close to an all-time post-World War II low.

A significant fiscal adjustment involving a reform of social security is necessary would help create more space for significant defense expenditure increase, but such a reform is highly unlikely to take place in the short or even medium term. Mandatory spending covers spending for entitlement and other programs, such as Social Security, Medicare, Medicaid, and several other health and old-age programs. Discretionary spending is controlled by annual budget process and pays for the operations of most federal agencies and national defense programs. Discretionary spending as a share of GDP has declined gradually over time, mandatory has continued to increase. Reducing, less so limiting the growth of government spending invites a political backlash from those groups that will be negatively affected. Demographic change and the emergence of a “grey majority” is making it even more difficult to substantially reduce entitlement spending, as the affected groups is gaining electoral weight by the year. Psychological biases, such as the endowment effect, further strengthens opposition to reforms. At a minimum, this will require any entitlement reform to phase in a reduction of expenditure (relative to baseline) in a very gradual fashion. But even then, it will be difficult. It is no coincidence that neither party supports a reform of social security and other programs. The last significant entitlement reform that sought to balance the books took place in 1983.

> In FY 2023, the U.S. federal government spent $6.1 trillion dollar. The U.S. federal government spends more than what the Japanese economy, the world’s third-largest, produces.

> Mandatory spending accounts for 60% of federal spending, discretionary spending for 30% and interest on debt 10%. Discretionary spending includes defense and non-defense spending with defense spending account for 13-15% of federal spending (or roughly half of discretionary spending.

 

The constraints on U.S. defense spending are political, financial and economic, and these constraints and trade-offs will increase over time. Economically, high levels of defense spending are detrimental to long-term growth if spending limits the availability of national savings and investment. In the short run, however, a sharp increase in defense expenditure can help boost economic growth, particularly in the context of an economy with ample spare capacity. Financially, increased defense expenditure needs be financed through higher debt, increased revenues or reduced expenditure. With more resources allocated to consumptive defense spending and no offsets elsewhere, savings and investment will fall or private consumption will fall, or both. If the former, economic growth will suffer over the medium- to long-term. If the latter, political opposition to higher defense spending will increase. The end of the Cold War led most Western countries to reap the so-called peace dividend, meaning reduced military expenditure led to increased savings, investment, lower interest rate and higher economic growth. Faced with increased geopolitical competition, the need for increased defense spending will make for painful economic, financial and political choices, while increased defense spending (as a share of GDP) will weigh on the longer-term growth outlook. While none of this means that the U.S. will not be able to increase defense expenditure, it does mean that the economic, financial and political trade-offs and constraints will become more important.

> In the short run, government can almost always mobilize massive resources to support defense spending, if flanked by appropriate economic and financial measures, such as capital controls or central bank buying of additional debt issuance. U.S. defense spending (including Department of Energy spending on nuclear weapons) was 3.5% of GDP. In 1953 (Korean war), U.S. defense spending reached 11.3% of GDP. In 1968 (Vietnam war), 8.6% of GDP, In 1999, it fell to a post-1940 low of 2.7% of GDP before it increased again to reach 4.5% of GDP in 2010 (Afghanistan and Iraq wars). Defense spending exceeded 40% of GDP during World War II. 

> In the long-term, there are economic limits to excessive defense spending. The reduction of defense spending following the end of the Cold War led to the so-called “peace dividend,” allowing for more productive government spending, higher national savings and lower interest rates. Unsustainable defense spending drove the USSR into economic stagnation, financial failure and ultimately political collapse. The USSR spend a disproportionate amount of its GDP on defense as opposed to private consumption or investment, which led to both economic stagnation and contributed to growing political discontent. 

The United States remains the world’s top military spender by a wide margin, but Chinese defense spending has been increasingly rapidly on the back of rapid economic growth, which, in turn, is putting increased pressure on U.S. military spending. The U.S. remains the world’s largest defense spender. If a decade or so ago, it spent more on defense than the rest of the world combined, U.S. expenditure today continues to account for nearly 40% of global spent, while China accounts for less than half of U.S. spending. The size of defense spending matters, but it is not everything. Several caveats apply. First, comparing military spending, even if adjusted for PPP to take capture the effective spending power, is difficult, as different countries include and exclude different defense-related spending categories and items, and some countries’ defense expenditure figures lack transparency altogether. Second, even with a PPP adjustment, it is not obvious one dollar of defense spending buys an equivalent amount of security. Leaving aside that security is a relative concept, using PPP to compare spending is unsatisfactory due to differences in terms of what the money is spent on as well as what adjusted dollars can buy, given that advanced military technology is not traded on international markets and local production costs differ, and sometimes certain defense-related technologies are not available at all to allow for comparisons. Third, it matters not only what the money is spent on but how it is spent, and ultimately what “strategic bang for one’s financial buck” one get. For example, directing funds to procurement and development rather than outdated platforms or personnel, including veterans’ pensions may not translate into increased military effectiveness. Lastly, when comparing U.S. and Chinese defense expenditure, it is important to take into consideration differences in terms of force structure and military posture. The U.S. has world-wide commitments and a costly and extensive global footprint. China does not and its military forces are geographically much more concentrated. Military spending should therefore at best seen as a proxy for defense capabilities. In this sense, the constraints the U.S. the relatively greater and faster increasing constraints the U.S. is facing in terms of increasing defense expenditure is a constraint, but it is a constraint that can be also be alleviated, at least partly, by ways other than spending increases. Over the long term, however, significant differences in spending will matter from a security point of view.

> In current dollars, the United States accounts for almost 40% of global military. China and Russia account for a combined 17%. The big-4 European countries account for 9.5%, compared to Russia’s 3.9%.

> In 2023, U.S. defense expenditure accounted for 3.5% of GDP, China’s official defense expenditure for less than half at 1.6% of GDP. Due to much more rapid underlying economic growth, Chinese defense expenditure as a share of GDP has been growing much more rapidly without translating into higher expenditure. 

> In nominal dollar terms, the US spent about $900 billion and China $300 billion on defense. Adjusted for PPP, the difference would be far smaller, but Chinese spending would be only about half of U.S. spent. In 2010, the U.S. spent $740 billion, compared to Chinese spending of $100 billion. In PPP terms, China has been catching up even faster.

> In addition to faster economic growth, China has also greater scope to increase defense spending as a share of GDP without jeopardizing long-term economic outlook, because it has excess savings and limited profitable investment opportunities. This should allow it convert its excess savings into military consumption without unduly undermining the long-term growth outlook. The U.S. is far more constrained in this respect.

> U.S. defense spending currently breaks down into the following spending categories: $182 billion for personnel (25%), $338 billion for operations and maintenance (40%), $168 billion for procurements of weapons and equipment (20%), $143 billion for R&D (15%).

Governability and Dollarization - The Case of Ecuador (2024)

A challenging financial outlook and significant governability challenges make for a difficult economic and political outlook in Ecuador, leaving the government with little choice to agree to a another IMF program if it wants to avoid a destabilizing economic and financial crisis by 2026. Ecuador has a history of governability challenges and financial stability. The presidency of Rafael Correa (2007-2017) proved an exception, which can be largely attributed to a favorable international economic environment. A significant increase in oil revenues allowed for a significant expansion of social spending, which supported political stability. More typically, however, a combination of economic challenges, socio-economic discontent and, at the institutional level, legislative-executive deadlock circumscribe the ability of Ecuadorian governments to pursue a forward-looking economic policies and contributes to recurring financial problems. Most recently, President Guillermo Lasso was effectively forced out of office in the context of a stand-off between the executive and the legislature. Ecuador is also a serial defaulter and mostly recently restructured its international bonds as well as its debt owed to China in 2020-22. 

> In the past 30 years, many Ecuadorian presidents were ousted, deposed or impeached (e.g. Bucaram in 1997, Arteaga in 1997, Mahuad in 2000, Gutiérrez in 2005, Lasso in 2023). 

> Ecuador has defaulted almost a dozen times since its independence. Most recently, the government was in default on its international bonds in 1997-2000 and in 2008-09, and it restructured its international bonds in 2020, which economically translated into a default due to a reduction in the net present value of the bonds.

> In 2020-22, Ecuador also restructured its debt with Chinese banks, while an oil-based credit agreement with PetroChina was modified to allow for debt relief. In May 2023, Ecuador’s creditors also agreed to a debt-for-nature debt swap.

Governability challenges are compounded by a dollarized economy and commodity dependence, which makes the Ecuadorian economy more susceptible to exogenous shocks, while it limits its to pursue forward-looking economic policies consistent with the macroeconomic constraints imposed by dollarization. Full dollarization is constraining in macroeconomic terms because it effectively removes monetary and exchange rate policy from the government’s toolkit to stabilize the economy in the face of shocks, including commodity-related terms-of-trade or interest rates shocks. Dollarization also eliminates seigniorage. This forces policymakers to rely even more on fiscal policy to stabilize the economy and the financial situation. By severely curtailing the central bank’s lender-of-last-resort function and removing the ability to stimulate the economy through currency depreciation or lower interest rates, fully dollarized economies are more susceptible to greater economic and financial volatility as well as fiscal and debt crises. A fully dollarized economy that is subject to large terms-of-trade or inflation shocks will experience greater interest rate, price and inflation volatility, which can undermine the government’s financial position. Governments need to save oil-related windfalls so as not to be forced into pro-cyclical austerity during the next downturn. This requires a government that is able to pursue prudent, forward-looking fiscal policies. Failing to build up fiscal buffers when economic growth is high or keeping inflation under control when experiencing favorable commodity price shocks, governments in dollarized monetary regimes are then often forced into protracted low economic growth and fiscal restraint, which raises the risk of socio-economic and political instability. In face of increasing financial instability, governability challenges, such as the executive’s limited control of the legislature, tends to undermine market confidence further, as policymakers prove unstable to implement the measures necessary to counteract instability. This captures Ecuador’s experience under dollarization fairly well. Political stability and economic progress was relatively high when Ecuador benefitted from oil-related revenue windfalls under Correa, but instability increased after oil prices declined and the government had overspent and over-borrowed. 

> Ecuador’s export revenues are highly dependent on volatile commodity prices. According to the World Trade Organization, fuels and mining products account for almost 40% and agricultural products for more than 50% of total exports. Meanwhile, dollarized export markets, the United States and Panama, account for 40% of all Ecuadorian exports.

> Social spending doubled between 2007 and 2016 from 4.3% to 8.6% of GDP, the Gini coefficient declined, and both inequality and poverty fell. A fair share of the improvement has reversed in the past few years, while homicides increased sharply, as Ecuador was forced into fiscal adjustment in the face of external shocks (oil after 2015, COVID-19 in 2020).

> Government debt did initially decline when oil prices increased, but the government failed to save enough revenues when the times were good and failed to resist increasing difficult-to-reverse social spending. After the end of the oil price related boom in 2015, successive governments have failed to stabilize the economy.

 

Despite the recent debt restructuring in during 2020-22, Ecuador continues to face significant external financing challenges, which will give it little choice but to sign up for another IMF program if it wants to avoid broader economic instability, even if it will not necessarily help it avoid another restructuring of international bonds. Ecuador faces high interest rates due to high U.S. interest rates and weak economic growth. Although the fiscal deficit has declined following the COVID-19 pandemic and IMF-supervised macroeconomic adjustment, increasing oil prices explain a fair share of improved budgetary outcomes. Unable to implement a structural fiscal adjustment, the government often resorts to one-off measures. This casts doubt on the long-term sustainability of the fiscal adjustment. The government remains in domestic arrears and its remains locked out of international capital markets, forcing to rely on multilateral borrowing, despite the 2020-22 debt restructuring. External debt service is set to increase significantly in 2025 and 2026, including IMF loans. (e.g. drawing down deposits, tapping the central bank. 

> As Ecuador was already granted exceptional access under its previous program, net new financing will be limited, but it will be helpful to effectively roll over IMF loans. Ecuador owes IMF almost $ 8 billion, which will be coming due in the next few years. IMF roll-over. But effectively rolling IMF loans and unlocking additional multilateral borrowing will help support Ecuador’s external financing outlook. But this does not mean that Ecuador will avoid another debt restructuring. But another debt restructuring in the context of an IMF program would prove less disruptive than “hard” default.

> The IMF understands that macroeconomic adjustment in a fully dollarized economy is financially and politically difficult. The older staff members will remember how quickly the Argentina program went off trach in the late 1990s and 2000s and how the Fund’s reputation was tainted, suggesting the risk of supporting adjustment programs in macroeconomically constrained, dollarized, commodity exporters. While the Fund will therefore demand significant assurances from the government, it will also be keen to agree to a new program in order to reduce the possibility of Ecuador defaulting on its IMF obligations.

A new IMF program would ensure that the government continues to implement macroeconomic adjustment, help unlock additional, multilateral and possibly bilateral funding with the aim of avoiding broader medium-term economic and financial destabilization. If it is to avoid a default on its IMF and private external debt, it will need to reach an agreement with the IMF. Negotiations with the IMF will prove challenging, and it remains to be seen whether the IMF’s insistence on financing assurances will lead to yet another restructuring of Ecuador’s international market debt. The IMF has already granted Ecuador exceptional access under its EFF, meaning the Fund will not be willing to run financial risks in the context of uncertain ability of the current government to stick with implementation and commitment of next president. At the same time, the IMF will have an interest in a new agreement if only to avoid broader destabilization, including potential default of Ecuador on its IMF debt.

> After an initial IMF program was terminated prematurely (March 2019 – May 2020), Ecuador signed up to a new Extended Fund Facility (EFF) arrangement in December 2020, after also receiving COVID-19-related IMF financial support in the guise of the Rapid Financing Instrument (RFI). The IMF completed the final review of an 27-month EFF program in December 2022. Although the program helped improve Ecuadorian fiscal and debt dynamics and help put shore up the dollarization regime by reversing much of the institutional erosion in terms of the government weakening the central bank, Ecuador remains shut out of international bond markets in view of the increasing external debt service in 2025-27. All major international credit rating agencies rate Ecuador close to default (CCC+/ Fitch, Caa3/ Moody’s, CCC+/ S&P). 

> The 2019 and 2020 IMF program helped strengthen the central bank after years of weakening of central bank and foundation of dollarization (e.g. central bank lending to state-owned banks, direct government financing), which had led to weakening of central bank balance sheet (e.g. reserve coverage of banks’ deposit) and help put the dollarized regime on a sounder footing. While fiscal targets were met, this was primarily due to increased oil-related revenues and higher growth. Some of the structural fiscal measures fell short, largely due to domestic political opposition and the president’s inability to get the relevant measures approved by congress.

President Daniel Noboa will not be able to reestablish access to international markets before his term expires in May 2025, unless his government agrees to a new IMF program, and even then regaining access to international markets will remain highly uncertain in the near term (> 12-15 months). Since taking office in November 2023, President Noboa has sought multilateral loans and in March official requested a new IMF program. But Noboa’s National Democratic Action alliance holds only 10% of all seats, which will make it difficult to push through necessary reform and especially fiscal austerity. The upcoming 2025 presidential elections will also make it politically costly (CAN RUN AGAIN?). Continued socio-economic pressures combined with congressional fragmentation will make it difficult to implement the necessary reform, not least because the next presidential elections will take place in 2025. Rather than adopt structural measures that promise putting Ecuador on a sustainable economic and financial path, the Noboa government will be more inclined to implement one-off measures to address the financial challenges. Significant fiscal retrenchment would weigh on economic growth and employment outlook and will fund at best limited political support from the executive and the legislature. Negotiating an IMF program in view of Ecuador’s economic challenges and political situation will prove challenging, and if a program is agreed, it remains to see to what extent Ecuador will live up to its reform commitment. 

> Government debt peaked at more than 60% of GDP in 2021, but medium-term debt dynamics remain vulnerable, not least due to a strong dollar and high U.S. interest rates. The Noboa government has relied on one-off measures rather than structural adjustment (e.g. reprofiling public debt held at the central bank), while deposits continue to fall and domestic arrears continue to increase, pointing to very considerable domestic and external financing challenges.

Bank of Japan Raises Interest Rates in the Face of Declining Inflation (2024)

Bank of Japan (BoJ) ends negative interest rate and yield curve control policies in order to regain greater monetary policy flexibility rather than to tighten monetary policy to maintain price stability, which will nevertheless benefit the Japanese banking sector financially. On March 19, the BoJ announced that it would exit its negative interest rate policy and end its yield curve control policies, marking the first time in 17 years that it increased the interest rate. The BoJ expressed hope that it can sustainably reach its two-percentage inflation target in light of favorable recent wage growth dynamics. The BoJ also did away with its multi-tier deposit policy, which had helped shield banks from the effects of negative interest rates. The central bank also announced that will continue to intervene at the long end of the curve to prevent a spike in interest rates and it will continue its policy of buying JPY 6 trillion worth of government bonds a month, though the governor stated that “at some point” the bank planned to lower the amount of JGB purchases. Finally, the BoJ said it will refrain from purchasing ETFs and REITs. The decision to reform the operational framework and raise short-term interest rates was taken in the context of rapidly declining inflation but unusually strong wage inflation.

The central bank raised its main policy rate to 0-0.1% and simplified the previous multi-tier deposit rate system. It also abolished its long-standing yield curve control policy, which had been in place since 2016 and which the BoJ had modified several times in the 11 months since Ueda came to office. In October, the BoJ modified its yield curve control policy by switching from a 1% ceiling (with a 0.5%-point band) on ten-year government bond yields to a reference rate. Year-on-year inflation declined to 2.2% in January from 2.6% in December. Core inflation fell from 2.3% to 2%, down from 2.5% in November, registering the third month of consecutive decline. The BoJ’s inflation target is 2%. Last week, Japan’s biggest companies agreed to a major wage increase of 5.3% for 2024, the largest pay increase in more than 30 years. 

The BoJ has been keen to exit unconventional policies to provide the central bank with greater policy flexibility in case of another surge in inflation. The BoJ was caught on its backfoot following the 2021-22 supply-side and currency-driven inflation surge. The March 19 monetary policy adjustment and reform of the bank’s operational framework will give it more flexibility to respond to price shock. Recent inflation dynamics raise doubts as to whether monetary policy tightening was necessary. Both headline and core inflation have been declining. The Bank itself seems to harbor doubts as to whether it can reach its two-percent inflation target on a sustainable basis. With inflation falling, this was perhaps the last opportunity to exit its unconventional policy. Tightening policy while inflation is running below target would have been a harder sell. At the very least, the inflation outlook remains highly uncertain. The size of the interest rate adjustment and the fact that the BoJ will continue to buy Japanese government bonds suggests that the BoJ is equally uncertain.

Japanese core inflation peaked at a multi-decade high of 4.2% in January 2023. In January 2024, it fell to 2%. The combination of declining inflation and accelerating wage growth in the context of subdued economic activity create a very uncertain outlook for future price dynamics. Structurally, there is very little reason to expect an acceleration of inflation, not least because much of Japan’s inflation was largely due to a weak exchange rate, higher import prices and COVID-19 related supply chain disruption, all of which are transitory. Although the BoJ exited its yield curve control policy, it will continue to buy JPY 6 trillion worth of government bonds a month and it will stand ready to intervene in case long-term yield spikes. This suggests that the BoJ recognises the need to maintain policy flexibility to self-insure against future disinflation rather than inflation. 

The macroeconomic impact will be limited, but the Japanese banking sector is set to benefit from greater profitability on account of higher interest rates. The end of negative interest rates will help boost Japanese banks’ profitability and share prices. Meanwhile, the Japanese yen remains at multi-decade lows, but this is largely due to high U.S. interest rates and recent revisions of how quickly the Federal and by how much the Federal Reserve will lower interest rates this year. The ten basis point increase in Japanese short-term rates will have a negligible impact on the continued large US-Japanese interest rate differential. Once the interest rate differential narrows, the Japanese will appreciate and lead to lower import prices, which will exert further downward pressure on inflation. The risks to medium-term inflation are weighted to the downside, particularly once the Fed begins lowering interest rates. Finally, higher nominal interest rates, including higher long-term interest rates, would increase the government’s debt servicing costs. However, a ten basis point increase on the short end will make little difference. Meanwhile, ten-year yields have increased from virtually zero to 0.7%. However, this increase is more than offset by higher inflation and higher nominal GDP growth. A change in nominal interest rates will only negatively affect medium-term government debt dynamics if it translates into increasing real interest rates. In the short term, the BoJ’s decisions will have a very limited impact on debt dynamics. Much will depend on where real interest end up, and this is a function of both interest rates and inflation. 

The Japanese equity market index is near all-time highs, largely on account of a weaker yen, higher inflation and (maybe) recent corporate corporate reform. The shares of Japan’s largest banks have rallied as much as 80% over the past two years due to an improving outlook for profitability due to higher nominal interest rates. The Japanese yen remains near more than thirty-year lows against the dollar due to the large US-Japanese interest rate differential. The BoJ’s short-term rate is 0-0.1%, the Fed funds rate is 5.25-5.5%. Japanese ten-year government bond yields remained virtually unchanged at below 0.8%, roughly the same level as a month ago. Equivalent U.S. yields are 4.3%.

Global and US Economy in 2035 - More Fragmented and More Indebted (2024)

By 2035, the global economy will be more fragmented, less open and more politicized than it is today without however dividing into discrete economic blocs. Geopolitical competition and domestic-political demand for protection and discriminatory policies will lead to increased geo-economic fragmentation in terms of trade, less so in terms of financial flows. Fragmentation will be most pronounced with respect to trade in critical intermediate and final inputs.

Fragmentation will most affect US-Chinese relations, where investment and trade restrictions pertaining to national and economic security will continue to tighten. Both Washington and Beijing will continue to de-risk, but not significantly decouple. The U.S. will largely rely on inward, less so outward investment restrictions, as well as tighter export in an attempt to ensure national security and maintain technological leadership. China will similarly seek to reduce its dependence on and vulnerability to U.S. discriminatory policies by emphasizing “dual circulation” (greater reliance on domestic demand) and reducing its technological dependence on other countries as well as gain leverage vis-à-vis other countries.

Protectionist U.S. foreign economic policies may kick into substantially higher gear in 2025 in the event of a Trump victory. Instead of selective measures targeting geopolitical adversaries and aiming to enhance supply chain security, a Republican administration will threaten to introduce across-the-board tariffs (with substantially higher rates on Chinese imports) and more aggressive reshoring policies. This could lead to substantial trade conflict with geopolitical foe and friends alike. But even under a Democratic administration, the open, rules-based international trade and financial regime will continue to erode at the margin.

Adverse demographic dynamics in North America, Europe and East Asia will weigh on the medium-term global growth outlook. In addition to adverse labor supply dynamics, particularly in advanced economies in North America, Europe and East Asia, which accounts for the bulk of global GDP, increasing pension, healthcare and defense expenditure will make it more difficult for governments to subsidize investment and promote economic growth. Unless new technologies, such as Artificial Intelligence, lead to much faster productivity growth, global growth will continue to slow somewhat, as a greater contribution from emerging and developing economies will not be sufficient to offset a substantial slowdown in China and a slightly weaker economic growth in the United States, Europe and Japan. Regardless, China’s share of global GDP will continue to increase, despite slower growth and its importance will continue to grow. As US protectionist policies contribute to greater fragmentation, China will seek to liberalize its foreign trade with third countries in the context of bilateral and regional free-trade agreements, while promoting the international use of the yuan.

The US economy will continue to outperform Europe and Japan, and the growth differential vis-à-vis China will narrow on account of slowing Chinese growth. U.S. real GDP growth is set to average 1.5-2.0%, compared to 1.0-1.5% in the large European economies and less than 1% in Japan. Chinese growth is set to average 3.5-4.5% over the next decade. While an AI-led technological revolution may help support economic growth, it is unlikely to raise the US growth potential substantially in the face of increasing demographic headwinds, global economic fragmentation and declining fiscal space to support investment. Politically, a major reform of federal revenues and expenditure that might free up resources to support future growth remains unlikely, and most of the impact would be felt beyond 2035. The US will remain the world’s second-largest economy in purchasing power parity terms.

U.S., European and Japanese interest rates are likely to be higher over the next decade than the decade following the global financial crisis in 2008. Higher government debt, larger fiscal deficits as well as increasing spending pressure related to climate change, defense and especially mandatory pension and health programs will translate into higher interest expenditure and weigh on domestic investment. Despite increasing government debt, the risk of financial instability will be manageable, unless the U.S. Congress purposefully forced the government into default in case it fails to raise the debt ceiling. U.S. external debt will remain high, the continued attractiveness of the U.S. economy, the U.S. financial system and the U.S. dollar will make the situation manageable, not least due to manageable current account deficits and a favorable liability structure. While the U.S. dollar will remain the dominant international currency, the RMB will continue to make inroads over the medium term.

U.S. economic growth will average less than 2% a year and, barring black swan events, the rate is very unlikely to accelerate or decelerate significantly over the forecast horizon. In the context of higher nominal debt and continued large fiscal deficits, debt service will increase in nominal terms, which will limit the ability to increase discretionary expenditure, while mandatory federal spending will continue to increase as a share of GDP. The Congressional Budget Office (CBO) projects both mandatory social security and healthcare spending by 1 percentage, respectively by 2033. The fiscal deficit is set to reach nearly 7% of GDP by 2023, while federal debt (held by the public) will increase by a substantial twenty percentage between 2023 and 2035, reaching 120% of GDP. The risk to spending, fiscal deficit and debt are weighted to the upside in case of domestic or international emergencies. Mandatory federal government spending, which represent 60% of total spending at present, will continue to increase as a share of GDP. Given the unpopularity of social security reform, any fiscal consolidation, if it takes place, will need to focus on discretionary spending. As interest payments on debt cannot be changed, any fiscal adjustment would disproportionately affect discretionary spending, and, given the geopolitical outlook, primarily discretionary non-defense spending.

Euro Area Government Debt Is Manageable - In the Short Term (2024)

Although euro area fiscal deficits and government debt increased sharply during COVID-19 and both deficits and debt remain above pre-pandemic levels, government debt will remain manageable over the next few years, even if euro area interest rates remain somewhat higher than before the pandemic; over the medium-term, however, most euro area countries will need to implement expenditure reform to ensure sustainability, which will prove contentious at the domestic and the intra-euro-area level. At nearly 90% of GDP, euro area government debt is high, but compares relatively favorably to the United States (120% of GDP) and Japan (255% of GDP). The sharp, COVID-19-induced economic downturn, which translated into higher spending and lower revenues, sharply increased fiscal deficits and debt ratios. However, the inflation spike of 2022-23 helped reduce euro area debt from a peak of 97% of GDP in 2020 to 90%, despite disappointing economic growth performance recently. This compares to a pre-pandemic debt level of 84% of GDP. The average euro area debt level disguises significant intra-euro differences, which is reflected in different levels of sovereign credit and default risk. The debt ratio is highest in Greece (170% of GDP) and lowest in Luxembourg (28% of GDP). However, Greece’s debt ratio is lower today than before the pandemic when it stood at 186% of GDP. By contrast: at 110% of GDP, France’s debt ratio is 12 percentage points higher today than before the pandemic; at 143% of GDP, Italy’s ratio is 9 percentage points higher; and at 66% of GDP, Germany’s is 6 percentage points higher than in 2019.

The prospect of higher interest rates in the context of continued subdued economic growth and increasing non-interest spending pressures will require further fiscal adjustment down the line in order to ensure long-term debt sustainability. The near-term outlook will be manageable, however, thanks to an underlying fiscal stance that is broadly consistent with a stable or only slowly increasing debt ratios in the financially weaker countries. Economically speaking, long-term debt dynamics are a function of real economic growth, real interest rates and the underlying (structural or cyclically adjusted) fiscal stance. Assuming a long-term real interest rate of 1% and a real GDP growth rate of 1%, euro are governments need to generate a primary (before interest) fiscal balance of at least zero to stabilize the debt ratio. The primary deficit in 2023 was 1.7% of GDP, but the IMF projects the deficit to fall to zero by 2028, which, based on the above assumptions, would translate into a stable debt-to-GDP ratio after 2028. However, all euro area countries are faced with increasing pension and healthcare, climate transition and defense spending. Stabilizing the debt ratio over the long term will require higher taxes or a stabilization of non-interest expenditure as a share of GDP. This, in turn, will require politically painful domestic economic and financial reform. It will also lead to increased disagreement and tensions within the euro area over risk sharing. Countries with worse underlying fundamentals will need to pass more extensive economic reforms (France, Italy) than countries whose debt will be declining in the next few year (Germany).

In the interim, the substantial institutional reforms of the past decade and a half will limit the risk of major financial distress by providing the euro area with adequate tools to prevent a liquidity crisis from spiraling into a solvency crisis and thus buy distressed countries time to adjust their policies. Originally designed without a financial backstop, in part due to a no-bailout commitment, the euro area has undergone a dramatic institutional evolution over the past decade and a half. The reforms have created a potentially infinite liquidity backstop provided by the European Central Bank (ECB). They established a bailout fund in the guise of European Stability Mechanism (ESM), which allows distressed euro member to tap emergency funds to prevent a liquidity-driven default in the context of policy adjustment and conditionality. The reforms also updated the original Stability and Growth Pact (twice), renamed Fiscal Compact, which provides for greater transparency and surveillance and its sets more specific commitments to bring national fiscal policy in line with mandated targets. The euro area also took steps towards a banking union to prevent banking sector instability from causing sovereign distress. Taken together, this new institutional framework limits the risk of sovereign and systemic banking sector distress. However, the euro are does remain an “imperfect” monetary union due to limited resource transfers and insufficient joint resources to backstop the euro area banking sector, even though neither of these is strictly necessary to ensure the long-term viability of the common currency. 

Continued disagreements over issuing joint debt and creating a euro area deposit insurance scheme will continue to prevent significant institutional progress. There exists a sharp divide between “creditors”, countries with strong public finances, and “debtors”, countries at significantly greater risk of experiencing financial distress, largely on account of their higher debt levels. Debtors want more risk sharing, and creditors are reluctant to share risk with financially weaker countries, as they fear one-sided risk sharing and concomitant one-way resource transfer. Creditor countries prefer that risky countries assume the risks and costs of their own actions, and are only prepared to share risks if it helps increase systemic stability at limited potential costs. Debtor countries prefer to share risks with financially countries. Negotiations over further reform aimed at increasing systemic stability and resilience will require agreement on how to allocate the potential costs of further risk sharing. Short of a crisis that requires further reform to preserve monetary union, only limited and gradual institutional progress will be made in the next few years. But the current framework goes a long way in terms of limiting the risk of sovereign distress as well as mitigating the effects of sovereign distress.

The battle lines are drawn between “creditor” and “debtor” countries. By 2028, Cyprus, Germany, Ireland, the Baltic countries, Luxembourg, Malta and the Netherlands will have debt ratio below 60% of GDP. By contrast, Belgium, France, Greece and Spain will continue to have debt ratio of more than 100% of GDP. In Austria and the Netherlands, debt ratios will remain stable. This helps draw the “battle lines” in terms economic policy and institutional reform. The need for reform will be greater in Belgium, France and Spain, given less favorable debt dynamics. So will be the demand to share risk in the euro area. Calls from more highly indebted countries like France and Italy for greater joint issuance of debt will not be heeded by countries with lower debt and sounder financial and fiscal position, unless there is another major emergency (like COVID-19) or there is a risk of severe euro area destabilization. This is also why only very limited progress will be made in terms of further strengthening the euro area institutionally.

 

Of Systems, Organizations and Bureaucracies (2024)

Homer’s Iliad and Odyssey are the founding documents of Western culture. Its protagonists, admittedly often of divine descent, are depicted as individuals with agency, whose actions make a difference, sometimes changing the course of history. Think Achilles. Western belief in the centrality of the individual and individual reason in philosophy or a personal bond with a deity reflects this founding myth of Western culture. Our congregating-around-the-campfire ancestors may not have had a sufficiently good grasp of the importance of bureaucracies or organizations, though they certainly understood the importance of groups (and tribes). Perhaps due to a lack of sociological understanding, their stories revolved around heroes, their qualities and their flaws. Today, this narrative structure remains ever-present in Hollywood (as opposed to some Eisenstein) movies. Two millennia later, the Enlightenment put reason, and generally individual reason, at the centre of its intellectual preoccupations. In Hegel, it is the world spirit, but in Kant the focus is squarely on reason and the individual is the epistemic and moral focus. Romanticism elevated the individual even further, even if at some level it also subverted it as individual rationality and the individual itself gets replaced or subsumed by the Weltgeist. Ironically, the Enlightenment coincided with modernity, technological progress, industrialization and the emergence of mass society, which created ever more powerful bureaucratic organizations, including the modern state. The wider reach and power of the state (Tilly) and the more extensive role played by government bureaucracies made possible the major catastrophes of the twentieth century, like the Nazi mass extermination camps and the Soviet gulags as well as industrialized, total armed conflict. Bureaucracies were instrumental, if not causal in bringing about these catastrophes (Zygmunt Bauman). 

Today, bureaucracies both rule and structure the world. Until bureaucracies are replaced by computers or artificial intelligence, they will be populated by individuals. But well-functioning bureaucracies will be structured in a way as to be able to replace any individual at any point in time without jeopardizing its functioning – whatever this functioning consists of. Ironically, however, to the extent that individuals exercise power on a larger scale, it almost always depends on their position in a bureaucratic hierarchy or a larger organization. Not only do individuals stand on the “shoulders of giants” in the scientific realm, according to Newton. In the economic-political realm, most individuals, with exception of charismatic leaders (maybe) depend for their power and influence on their place in bureaucratic hierarchies. Individuals, trivially, are also reliant on the existence of broader systems, not just bureaucracies. If Mark Zuckerberg had not created Facebook, others would have done so. This insight refers to path dependency, particularly in scientific research. It is less individual brilliance, but an individual being part of a larger system, and often a bureaucracy, that allows it do important things or to exercise power. Scientific progress is highly path-dependent. Its increasing complexity also requires organizations and institutions and networks (and often bureaucracies like universities or research institutes). When it comes to political power, individuals accumulate or exercise power while depending on controlling organizations and bureaucracies. This is not to deny that, counterfactually speaking, individuals never tip the scale or never make a difference. Sure, there is Taylor Swift, or a charismatic preacher in 19thcentury in Brazil that caused mass uprising. 

There are other ways of looking at bureaucracies. There is Max Weber, Ludwig von Mises, Robert Merton, James Q. Wilson, Anthony Downs, William Niskanen, Gordon Tullock, not to mention Franz Kafka or Jaroslav Hašek’s Good Soldier Svejk and its titular protagonist. (Bureaucracies can be subverted, if not the bureaucracies themselves, then their goals.) Most bureaucracies are inefficient by design and are meant to provide first and foremost stability. Bureaucracies ossify. They find it difficult to deliver outcomes, as opposed to output. They are inflexible. A Navy seals unit is but a bureaucracy. Bureaucracies’ relationship with their sponsors throw up the principal-agent problem. To the extent that bureaucracies perpetuate themselves, they need to have access to outside resources, but they also need to prove resilient or robust in the face of shocks. Bureaucracies expand and they overreach because they expand. Bureaucracies are necessary to create a needed degree of stability and predictability. Bureaucracies both increase and lower transaction costs. Controlling them is difficult due to information asymmetries, the principal-agent problem and the difficulty of managing them through the tyranny of numbers and often civil service status and limited ability to set incentives to limit profit-seeking and ensure impartial behavior (while inviting corruption).