Debt looms over Covid recovery

After the Covid crisis comes the overwhelming mountain of government debt

With the worst of the Covid pandemic seemingly behind us, attention is shifting to the next threat looming over the economy – paying for the cost of lockdown. With public finances suffering with every new crisis, getting the government budget back into a healthy state is tricky when the underlying economy is already under pressure. Austerity measures have fallen out of favour and monetary policy does not seem to be able to do enough. If the economy continues to flag in years to come, more unconventional policies to help with the aftermath of economic downturns might be on the cards.

When something goes wrong with the economy, it tends to fall on the government to step in and provide support. This action by governments is like a type of insurance but one where the costs are borne afterward rather than funded in advance. So instead of building up a rainy-day fund (which seems to be something beyond most politicians), debt is used to get through any crises. Governments thus do what needs to be done to ride out any economic storm and then figure out later how to pay the bill.

This approach is becoming more difficult as even in good times the economy is already struggling to deal with the impact of globalization and automation. The economic difficulties are manifested through chronically low levels of inflation suggesting that demand for goods and services is relatively weak. The problem is worst in Japan where the central bank has been actively trying to push up prices in an attempt to end years of deflation. While not yet going this far, central banks in other developed economies have softened their stance towards rising prices and have been actively supporting the economy.

The likelihood of large debt repayments by governments in the years to come would go against these efforts. Austerity measures in the past have taken their toll on the economy and there seems to be an aversion to going down this road again. Yet, public debt that has piled up over the lockdown of the economy would have to be dealt with at some point. Central banks have already purchased large volumes of bonds from the government and are in no hurry to demand repayment. So, the debts could just be rolled over year after year (or more purchased if needs be) which would ease some pressure.

Rather than letting the overhanging debt stay in place, central banks could take a further step and right off some of the debt. The ability to print money means that it would be within the power of central banks to do so. Putting aside the rights and wrongs of such an action, the other major concern would be the impact on the money supply. The cash used to buy the government debt would remain in the economy and would have the potential to cause of spurt of inflation.

An increase in the money supply would normally stoke up demand as people rushed to the shops with the extra cash and supply would struggle to keep up. Along with the resulting higher prices, the value of the currency would also drop off, thus making imported goods more expensive and further exacerbating the problem. Countries such as Argentina and Turkey have often suffered such a fate, but countries with more sound economic management have increasingly gotten away with policies that could potentially spur on higher prices.

The use of unconventional policies, such as quantitative easing, has opened up a gap between what would be expected in the theory and what happens in practice. The economies in some of the richer countries seem to be able to absorb influxes of cash without inflation kicking in. The role of central banks and their firm stance against inflation is one aspect that has changed how the economy might respond to more money. Greater levels of wealth also mean that extra funds might go into financial assets rather than consumer spending. Other developments such as international supply chains also act to limit shortages brought on by a spurt of demand that would otherwise see prices rise.

While the economy might allow for such a measure by central bank, it is the politics that is likely to be the main sticking point. Overcoming the notion that debt could potentially be forgiven is likely to be a substantial hurdle. Not repaying back money that is owed seems wrong in an almost moral sense and only acceptable in terms of those for whom the debt burden is overwhelming. Yet, the cancelling of loans has a long history and has been used when the debts themselves are not sustainable.

A further complication would be the extent to which the role of the government would change. If debt was less of a limiting factor, money could be spent without having to worry too much about paying the bill afterwards. It would also take much of the meaning out of raising taxes and creates uncertainties over how the economy should be managed. But these are matters that could be dealt with as a new regime is implemented in small steps to gauge the impact. And it is central banks that would be in charge of how much relief should be offered up.

Any new measures such as this is typically not taken at a time when most optimal but when the needs arise. To override the aversion to debt forgiveness would take a prolonged slump where other options would have been exhausted. The time for implementation would come not during a crisis but in the years afterwards when attempts to repay the debts would weigh on the economy. Other demands on the government, such as the cost of pensions or healthcare, would add to the burden and potentially threaten to drag down the whole economy.

Monetary policy has been used to try and fill the gap but experience has taught us that central banks by themselves can only achieve so much. It is increasingly seen that a combination of monetary with fiscal policy is a more effective option. Using central bank cash to pay off government debt thus seems like the obvious progression in economic management. If the politics can be overcome, the hard-earned trust in central banks’ ability to manage inflation could then be put to use in cutting the mountain of government debt down to size.