by Elliot Campbelton
Sept 2020
The covid-19 pandemic has forced governments around the world to borrow and spend at an almost unprecedented rate Between April and June. America alone has borrowed $3trn the largest amount borrowed in a single quarter since records began.
Economists have warned against high levels of borrowing but new thinking suggests much higher levels of debt might now be sustainable. The fact that there’s been such a dramatic change in the consensus makes some people nervous.
How much of a cause for concern should the world’s rising public debt be?
Governments have borrowed to finance their spending for hundreds of years At the end of the Napoleonic wars in 1815 Britain’s debt was 164% of GDP And after the second world war it was even higher at 259% of GDP.
Historically, governments have borrowed for a few main reasons (probably the biggest one was to fight wars), but in the past 100 years governments have increasingly used their debt as a way to try to keep the economy on track. To raise money, governments issue bonds to investors. These are in effect IOUs that are repaid over a fixed term with interest at a rate that depends on the length of the bond. How desirable these bonds are to investors depends on the country’s creditworthiness. Once a bond has been sold by the government out into the market it can be swapped and traded, giving a sense of how markets view the creditworthiness of the government.
Government bonds are bought by many different investors, including pension funds, hedge funds, banks and individual investors as well as a country’s own central bank and local government. Foreign governments also buy bonds, the biggest foreign holders of America’s public debt are China and Japan.
If a government has a safe asset with many prospective buyers, like US government bonds, a government can sell those bonds, receiving dollars which can then be spent to evade the downsides of a lack of liquidity in a crisis.
Governments’ willingness to issue bonds, and increase public debt has changed over time. After the sky-high debts of the second world war many governments were wary of going further into the red, however they continued to borrow. In the 1970s, this was blamed for high inflation. A lot of economists spoke to governments associating high rates of inflation to exuberant borrowing. This ushered in a sea change in the way that governments thought about debt, as such, the use of borrowing as a macroeconomic tool slowly petered out until the advent of the global financial crisis.
Now in a recession, Major financial institutions have teetered on the edge of collapse and some have failed, the financial crisis pushed public debt from 74% to around 105% in the decade following the financial crisis. In emerging economies it rose from roughly 35% to 48% of GDP. This ballooning debt caused political panic with some governments pursuing strict austerity to try to bring their budget deficits down during the decade that followed, this didn’t go entirely to plan. By about 2014 the consensus had changed, austerity in a time of economic weakness hurts economies as a country is not able to earn enough in tax revenues to make it worth it.
New thinking.
In 2019 former IMF chief economist, Olivier Blanchard gave a game-changing speech. He argued governments could borrow far more than previously believed possible. Blanchard observed interest rates on government bonds have been falling making it cheap for some governments to borrow money, at the same time, the economy was growing. Given the example of America, the rate of nominal GDP growth (which is GDP before it has been adjusted for inflation) has generally been higher than interest rates for the past 30 years.
This matters, because as long as GDP is growing faster than the country’s debt is accumulating interest and governments keep additional borrowing in check then a nation can effectively grow its way out of debt at no fiscal cost. Not even a year after Blanchard gave his speech coronavirus emerged in Wuhan and the greatest exercise in public borrowing for generations began. Government borrowing hit a record £55bn Ballooning public debt around $300bn or 16% of GDP, however not every country can borrow its way through the pandemic.
Almost every government has found it easier to borrow now than it was 30 or 40 years ago, but the difference between a rich country and a poorer country, which doesn’t have a long record of borrowing on foreign markets, cannot get the same interest rates on loans to bankroll a recovery. It could be said that this represents a significant inequality in terms of how countries face the pandemic, some places can borrow as much as they need to support their economies and others cannot.
The mystery of low interest rates.
Borrowing on this scale is not without risk, as there is always the threat that interest rates could rise again. Economists aren’t entirely sure why these rates have been low for so long In general, interest rates on mortgages, government bonds or savings accounts are driven by demand If the desire to save is high, then interest rates will be low as banks, or governments issuing bonds don’t have to tempt investors with favourable rates.
There are several factors driving the desire to save which might be keeping interest rates down. The ageing population might be one cause as people tend to save for retirement and pension funds buy government bonds, coupled to the fear of global financial instability causing investors to seek safe assets (like bonds).
An alternative theory could be promoted that given the heightened levels of debt accrued by all countries, by buying others debt, it in someway allows them to justify monetary policy, that relies on a high level of debt relative to GDP.
The risks
If interest rates suddenly soared then all the countries that had accumulated a lot of debt would suddenly face imminent hardship. Despite these risks, the pandemic has left many countries with no option but to keep borrowing.To cut deficit spending now while the global economy is still crippled by the pandemic would inflict lasting damage.
The question remains how much, and for how long countries can continue to borrow, the colossal debt built up in the past six months will be one of the greatest legacies of the pandemic.