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A world awash with debt: can governments learn to rule while drowning in the red?

The pandemic has landed treasuries everywhere with whacking great overdrafts—in the UK alone the figure is £2 trillion. Debt denialism is dangerous, but panicked prudence is self-defeating. There’s no easy escape
October 2, 2020

Covid-19 changes everything, or so it is said. It is certainly true of public finances, which have been drastically changed and not for the better. The United States entered the Covid crisis with federal government debt held by the public of 80 per cent of GDP, already twice what it was in 2008 before the financial crisis blew a hole in the books. This debt will now approach 100 per cent of GDP by the end of 2020, according to the country’s bipartisan fiscal watchdog, the Congressional Budget Office. It will reach 110 per cent of GDP by the end of the decade, assuming that nothing more is done, and continue rising.

In the UK, public sector net debt hit £2 trillion this summer for the first time in history. According to the Office for Budget Responsibility, net debt was up by 20 per cent of GDP on a year earlier, to 100.5 per cent, more than keeping pace with the US. As for the next few years, even before the Covid crisis hit, public debts were set to grow—the Office’s latest fiscal forecast, which dates from March and scarcely allowed for the virus, envisaged a rise of 15 per cent over the coming five years. The crisis will now mean slower growth and even heavier debts. So how worried should we be? And what are the prospects for repairing the damage?

We know how the last great shock to hit the public finances was handled in the UK: by the austerity programme of the Cameron government, which was heavily tilted towards retrenchment in public expenditure, with taxation playing only a supporting role. This time, with public services already palpably frail, Chancellor Rishi Sunak, former investment banker though he is, was said to be contemplating tax rises to “repay” the government’s coronavirus support in his autumn Budget. In the end, as a second wave hit, he abruptly cancelled the event, and substituted an emergency statement which introduced a new wage subsidy scheme and extended one temporary tax cut, all told loosening the purse strings by an estimated £5bn, and at a time when new social restrictions will likely depress the economy and with it government receipts. The continuing lack of any official plan to reduce the debt, or even official costings for the new policies, adds to a sense that Britain will be living in its shadow for a time to come.

Meanwhile in the US, the jumble of promises that is an inevitable feature of election season does not conceal that the two parties are contemplating different approaches to the same problem. Joe Biden is proposing higher taxes on households with incomes above $400,000, while Republicans in Congress are looking to limit spending. But just looking at the numbers and the way they have risen, it is natural to wonder whether any of this is going to be enough to bring down the liability. The prospective US debt levels are much higher than anything in recent memory.

But take a longer view, and we have been here before—“here” being debts exceeding 100 per cent of national income—including after the First and Second World Wars and, in Britain’s case, after the Napoleonic Wars. Over nine decades ending in 1913, Britain’s Napoleonic-era debt was reduced from nearly 200 per cent of GDP, twice current levels, to just 28 per cent. The US reduced its post-Second World War debt ratio from 121 per cent of GDP in 1946 to just 34 per cent in 1973, the UK from a staggering 270 per cent to 55 per cent over the same period.

So, can we again “repair the damage” in anything like the same way? Don’t bet on it. Circumstances today are, as we shall see, different in ways that will prevent us from replicating these historic achievements. Instead, we need to accept the reality that we’re going to be rolling debts over for many years to come, and managing them by resisting the dangerous appeal of premature prudence while also being ready to make tough choices the moment they are required.

A long squeeze?

A first theoretical option would be to accept the long squeeze needed and repay the debt, not unlike what Britain did in the 19th century. But when Britain’s post-Napoleonic debt consolidation began, the franchise was still limited to just 2.5 per cent of the British population. There was huge overlap between the government’s creditors on the one hand, and an elite electorate and its Members of Parliament on the other. Even after the Reform Acts of 1832 and 1867, it was hard to find a Member of Parliament who was not also an investor in government bonds. After the third Reform Act, in 1884, three in five Englishmen had the vote, but Gladstone’s doctrine of sound finance, which meant running surpluses and limiting the debt, remained firmly entrenched.

As a result, through the long and often-deflationary Victorian era, spending on social programmes, mainly welfare relief for the disenfranchised, was held in check. Creditors who wanted the value of their claims respected and their loans repaid could insist that the government do so by running budget surpluses, not for years or decades, but for the better part of a century.

Circumstances today are different. Every interest group is now enfranchised, and potential tax increases will be strenuously resisted by those groups upon which they would fall. Pressure to maintain or increase social spending will be intense, the coronavirus crisis having laid bare inequalities of opportunity and gaps in the safety net. It is fanciful to imagine that democratic societies emerging from a public-health emergency will—over the long decades that would be required to bring public debts down to earlier levels—now commit to paying off the government’s creditors at the expense of health, education and infrastructure.

Even the deep and controversial cutbacks of the austerity years never yielded an overall budget surplus: they merely reduced the overdraft. Indeed, if one asks which countries in the modern era have succeeded in running a so-called primary budget surplus (net of the interest payments required to keep the debt ticking over) of at least 5 per cent per annum for a decade, which is how long it would now take to halve the UK or US debt ratio, one finds just three: Singapore after 1990, Belgium after 1995, and Norway after 1999. Norway’s surpluses were associated with a passing North Sea oil windfall, and the government paid revenues it knew would flow for just a few years into its petroleum fund for the benefit of future generations. Singapore had a strong, technocratic government insulated from popular pressures and concerned to build up a reserve against contingencies, and so paid current revenues into its sovereign wealth funds. As for 1990s Belgium, a country whose modern identity is bound up with the European Union, it had the highest debt/GDP ratio of any member state, and so felt an urgent need to pay down the debt in order to convince its partners that it deserved to be admitted to the developing Eurozone. Special circumstances all, none of which prevails in the US or UK today. Any government that sought to pay down the debt in the way it was done after Waterloo—by asking the populace to take the pain, year after year, decade after decade, generation after generation—would be inviting the electorate to punish it at the ballot box.

Inflating away?

The main practical alternative to austerity without end is growing the denominator of the debt-to-GDP ratio. This can be done by actually growing the economy so the debt weighs less heavily, by raising inflation such that debts issued in yesterday’s money are simply worth less, or by a combination of the two.

Faster economic growth is the painless solution to this as to other problems. It was a large part of the answer to debt after the Second World War. Alas, we lack the magic elixir to produce faster growth. Compared to the mid-20th century, our demography is less favourable, and productivity growth has slowed. Economic dynamism, as measured by rates of firm entry and exit, has declined, and follower firms are more sluggish than they used to be in catching up with technological leaders. Educational attainment is rising more slowly than in the 1950s and 60s—past expansion means there are now far fewer uneducated folk for schools and colleges to enrol.

What about inflating away the debt? For a start, there are questions over the ability of the authorities to generate inflation today. Central banks produce inflation by purchasing government bonds with cash. At the moment, they’re purchasing them big time, yet struggling to get inflation up to 2 per cent.

[su_pullquote]“The idea that the central banks can keep inflation safely in that range for an extended period is the equivalent to thinking you can be half pregnant[/su_pullquote]

These circumstances lend a superficial plausibility to so-called “Modern Monetary Theory,” the newly-fashionable strand of thought that questions whether central bank bond purchases, whatever their amount, will produce faster inflation. However, the explanation for the absence currently of higher inflation lies not in the fact that governments and central banks have magically discovered the ability to engage in limitless spending without causing inflation, but rather in the offsetting behaviour of the private sector. Although governments are spending more, households and firms are spending less: the many threats to income posed by the Covid crisis have reminded them of the inadequacy of their financial reserves. In the same way that the Great Depression impressed on the 1930s generation the importance of prudence, inculcating caution in personal spending and hesitancy in commercial investment, those who have endured the Covid crisis will have been taught, by painful personal experience, to spend less and save more. Insofar as current government largesse is simply offsetting the resulting reduction in private spending, there will be no excess demand. No inflation need result. And judging from the pricing of assets such as index-linked bonds in financial markets, investors envisage this offsetting continuing for years, with inflation remaining on or near the floor for as far as the eye can see.

Investors could be wrong; it wouldn’t be the first time. In a newly-published book, Charles Goodhart and Manoj Pradhan predict that inflation will rise in short order to “more than 5 per cent, or even on the order of 10 per cent…” But even then, inflating away the debt would not be straightforward. Between a third and a half of the central UK government’s sterling debt is either index-linked (and hence can’t be inflated away, because repayments rise with prices) or else borrowed short-term (and so will need to be refinanced on new and costlier terms, as soon as investors see they need compensation for inflation). The Bank of England would have to maintain inflation rates of 5 to 10 per cent for the better part of a decade to reduce the overall debt ratio by half. Many economists see the idea that the central bank can keep inflation safely in that range for an extended period without having to raise rates as the equivalent to thinking you can be half pregnant. The risk is that workers, not unreasonably, will respond by demanding higher wages, pushing inflation up further. The government, meanwhile, would soon be forced to pay higher interest on new bonds it issues. The central bank will then be forced to push inflation up even higher to engineer the same reduction in the real burden of the debt. Every existing contract would be second-guessed. Double-digit inflation would not be good for investor confidence. It never is.

Irrespective of whether or not engineered inflation is an attractive answer to debt in theory, there would be serious resistance to overcome before it could be pursued in practice. The idea that a low and predictable rate of inflation is a prerequisite for growth is at least as deeply ingrained in official circles as is the belief that indebtedness should be contained. And that is before we get to the politics of interest. If central banks were to boost inflation suddenly and significantly, they would be inflicting large financial losses on the pension funds, insurance companies and banks who hold government bonds. These are big and powerful players in our economies, and the retirees who save through them are a big and powerful voting bloc in our ageing electorates.

In sum, it is doubtful that inflation ever was a “get out of jail free” card for states with big debts. Even if it were, it doesn’t look like one that can be played today.

Thinking the unthinkable?

If growth, inflation and sustained austerity are all implausible strategies for rapidly dealing with the debt, then one other logical avenue remains open, at least in principle: namely default. It sounds shocking, but some analysis has suggested that in the extreme circumstances of the 1930s, countries that refused to repay some or all of what they had promised to lenders, including much of Latin America and parts of Europe, actually did better than those that honoured their obligations. So could things get to the point where nations again think the unthinkable?

In judging whether there is even a potentially practical option here, it is first necessary to distinguish between domestic and foreign-held debts. Outright default on domestic debt has historically been rare, because people with significant funds to lend to their own government will, inevitably, be a powerful interest group. As a historical survey by Carmen Reinhart and Kenneth Rogoff concludes, “overt domestic default tends to occur only in times of severe macroeconomic distress.” Given the temporary nature of the Covid lockdown, there must be doubts about whether our current slump will qualify. We can at least hope that it won’t be as severe and extended as that of the 1930s! Even if it is, in modern stakeholder societies—where individuals manage their own retirement accounts, often invested in government bonds—outright default would be seen as an affront, and would engender more powerful resistance than engineered inflation.

As for defaulting on foreign-held debt, this may have been a least-bad option for countries in the unhappy circumstances of the 1930s, when international markets were collapsing and economic life was being reorganised to emphasise what Keynes called “national self-sufficiency.” In those circumstances, the inevitable costs—loss of access to foreign finance and to export markets—were things countries were anyway having to live with. Today, trade and financial globalisation may have hit a rough patch, but no one thinks it’s about to unravel entirely. Hence the calculations of governments have to be different. A 21st-century country’s prosperity is intimately bound up with the way it fits into the world economy, and so—especially for an open economy like “Global Britain”—telling the rest of the world that debts won’t be repaid is not a sensible risk to run.

The last-gasp “unthinkable” option for getting rid of the debt, then, turns out to be unthinkable indeed. The conclusion is now inescapable: there is no quick way out. High post-Covid debt levels are not going to be reversed out anytime soon. They will be with us for many years. So what results should we expect? And how should we approach them?

Turning Japanese

To see how things might play out, look at Japan. In one sense at least, Japan is in precisely the position the US, UK and other highly indebted countries will find themselves in once coronavirus is history. Its public debt exceeds 150 per cent of GDP, even higher than in western nations. (And that figure is net debt, subtracting the government’s assets, both liquid and illiquid, from its total liabilities: subtracting only liquid assets as such, following UK practice, would make its debt look more formidable.)

For some years prior to the Covid-19 crisis, Japan’s debt ratio was going neither up nor down, anticipating the stasis we are now likely to see in the west. Private spending was chronically weak, consumers having lived through an extended economic and banking crisis and learned prudent habits from the experience. Risk-averse Japanese corporations built up their reserves, while households ploughed their savings into government bonds. Thus, interest rates on those bonds remain low despite the huge debts. And inflation still remains subdued, even though the Bank of Japan has been buying government bonds for years and now owns fully half the outstanding stock.

The consequences for Japan of being saddled with this vast public debt have been negative but not catastrophic. There is an uneasy awareness that extraordinary measures—the Bank of Japan holding vast amounts of government debt—have become the indispensable precondition for ordinary financial conditions. There are worries that the liquidity of the bond markets has been damaged by the central bank having taken so many bonds out of the market. A tempting path back towards normalcy might seem to be to somehow pressure banks, insurance companies and pension funds to increase their bond holdings so that the central bank no longer needs to mop them all up and can gradually contract its balance sheet. But going down this route can be fraught: push too hard, and the banks become sorely exposed in the event of any rise in interest rates: it would push down the value of their stock of bonds, and so ramp up the dangers of a financial crisis.

As for the broader economy, since 2011, GDP per capita has risen at about two-thirds the rate in the US, and at just about the same disappointing pace as in the UK. While low investment is partly to blame for sluggish productivity growth, and while it may be tempting to ascribe this to the public debt overhang, doing so would be mistaken. To the extent that government debt “crowds out” private investment, it does so by raising interest rates and borrowing costs. But Japan has seen no rise in interest rates. Rather, firms have been hesitant to invest because of the chronic weakness of consumer demand, the problem that the US, the UK and other advanced economies are about to confront.

[su_pullquote]“Underlying differences with indebted Japan mean inflation could pick up here in a way that’s not been seen there”[/su_pullquote]

Conceivably, the costs of Japan’s high public debt could be lurking elsewhere. Because its government is already so heavily indebted, it may be constrained in responding to the next crisis. But this fear can be overdone as well. Like other countries, Japan was heavily affected, economically and in terms of public health, by the Covid-19 pandemic. Yet the fact that it entered the crisis with a public debt in excess of 150 per cent of GDP did not prevent it from mounting an aggressive fiscal response. According to the IMF’s Covid policy tracker, the combined additional spending and foregone revenue in Japan represents a larger share of its national income than in any other G20 country except the US. To be sure, if and when interest rates rise to more normal levels, it will be much more difficult, even impossible, for the Japanese government to respond in this way. Again, however, this hasn’t happened yet.

Revenge of the Austerians

In practice, Japan’s problems have been gratuitously compounded by a series of government own goals. Perplexing as it may seem, given the staggering size of the debts and the regularity of Japan’s deficits, Tokyo has in fact contributed to the problem of stubbornly weak demand by failing to substitute adequately for the missing private spending. Worries about the debt have led to premature belt-tightening, in the form of tax rises before the sustained recovery of private spending.

It has done so not once but repeatedly. It raised consumption taxes in 1997, which hit consumer demand, and overall growth weakened by 3 percentage points over the subsequent 10 quarters. It raised them once more in 2014, and in a fiscal year where 1.4 per cent growth had been forecast, the economy ended up contracting by 0.3 per cent. It raised them again in October 2019, leading to a sudden slide in consumer spending and an overall economic contraction at the sharp annualised rate of 6 per cent in the final quarter. As a result, measures intended to lower the debt ended up leaving it weighing even more heavily on a stagnant economy.

There are echoes here of the post-financial crisis debate over austerity. A favourite argument of the Austerians was that fiscal consolidation could be expansionary in heavily indebted economies. Since high debt posed all manner of risks, narrowing the deficit, they argued, would inspire confidence and, through that channel, boost investment and growth. The experience of the world’s most heavily indebted country is inconsistent with this view. Japan’s experience thus serves as a warning that a panicked scramble to shrink debts prematurely—before private spending has durably recovered—would be damaging and counterproductive.

Will history rhyme?

But maybe Japan’s history is not, in fact, Britain and America’s destiny. Perhaps the scar of the Covid-19 crisis will heal more quickly than that of Japan’s banking crisis and extended economic slump, and British and American households will quickly revert to their earlier spending habits. Perhaps the main explanation for the caution of Japanese investors and the subdued spending of consumers is not the demoralising effects of the country’s banking and economic crisis but rather its aged population, the older simply being more cautious and thrifty. Perhaps there is even an upside to the notorious inequality of the Anglo-Saxon economies—if it produces more “hand-to-mouth consumers,” who can be relied on to keep spending instead of saving, because virtually everything they earn has to go on paying the rent and putting food on the table. And perhaps corporate investment will recover more quickly in the west, where CEOs do not share the temperamental caution of their Japanese counterparts.

But if any of these potential differences is indeed important, and Britain and America do not go Japan’s way, that is not necessarily reassuring. All of them imply that at some point or other, private spending in the west could bounce back from Covid-19 in a way that Japan never did from its earlier crises. If so, inflationary pressures will intensify in a way that they have not in Japan. And one thing we know about heavily indebted countries is that when such pressures begin to be felt, inflation and interest rates will tend to pick up especially sharply, unless and until public policy grips the problem. Central banks will then have to stop financing deficits and governments would be forced to rein them in. Specifically, they will have to turn to some combination of higher taxes and lower public spending—and quickly—to avert a spiral of rising inflation and rates.

Raising taxes and cutting public spending will not be easy in politically polarised societies recently traumatised by an historic pandemic. Do so too late, and inflation will take off, putting the sustainability of recovery at risk. Do so too early, however, and there will be no recovery to jeopardise. It is said that in politics, as in love, timing is everything. The same is true of fiscal policy.

Hopefully, the pandemic will soon pass into history. But the debts racked up as governments sought to cushion its effects will remain facts of economic life for the foreseeable future. Bringing them back down to pre-crisis levels will take decades, even generations. While economic collapse would have been worse, this shouldn’t blind us from the consequences of the actions taken to avert it. The preservation of financial stability will become more challenging, and stretched governments could well be more constrained when it comes to confronting the next emergency, whatever that may be. Governments must be ready to make painful decisions on tax and spending—potentially at short notice—but they must also resist tightening before the recovery is established, because premature shows of prudence are doomed to self-defeat. In a world awash with debt, hawkish rigidity and dovish denialism are equally dangerous.


Barry Eichengreen is, with Asmaa El-Ganainy, Rui Esteves and Kris Mitchener, currently completing a new book on public debt. His last book was “The Populist Temptation: Economic Grievance and Political Reaction in the Modern Era” (Oxford)