Rising debt and the great divergence
The covid-19 pandemic has triggered a forceful policy response across most countries, with governments moving fast to avoid bankruptcies and permanent job losses. The result has been significant increases in debt and deficits across the globe. Central banks have also played a key role in absorbing the tremors caused by the pandemic, intervening to prevent a liquidity squeeze and credit crunch. Global government debt had been rising fast for years, particularly since the 2008 global financial crisis delivered a powerful shock to the public finances. The pandemic has accelerated this trend, with general government debt in advanced economies now at record highs (see chart 1).
There is no consensus on when precisely public debt reaches too high a percentage of GDP and needs to be brought down. Empirical analysis suggests that public debt begins to impinge on economic growth once the debt-to-GDP ratio exceeds a certain threshold. Other studies stress the non-linear impact of debt on growth.
As long as the increase in debt goes toward productive investment, some will argue that public debt is actually good. But history has shown that governments have failed to boost growth significantly in the past decade, despite increasing debt. Indeed, there is evidence that successive waves of new debt have progressively produced less growth. The growing gap between growth rates and debt is what we call the Great Divergence. Whether the debt build-up associated with the pandemic will produce different results remains to be seen. It will be particularly interesting to watch the result of the massive fiscal stimulus introduced by the US, most of which is being financed by new debt.
A new economic consensus on public debt?
In the years following the financial crisis of 2008, politicians, worried about the rise in debt, opted to tighten fiscal policy. The aim was to generate persistent primary surpluses, while growth was to be supported through expansionary monetary policies and structural reforms. But the mix of tight fiscal policy and loose monetary policy produced the weakest economic expansion in modern history in the western world. Today, spurred by the pandemic, governments in the main industrialised countries have largely abandoned fiscal austerity, with new thinking about the role of fiscal policy gaining traction instead.
There is a growing consensus that fiscal policies need to be more expansionary to boost growth and inflation, particularly as monetary policy seems to be reaching its limits. In other words, countries need to take advantage of today’s persistently low interest rate environment to stimulate the economy.
One prominent version of this thinking called Modern Monetary Theory (MMT) has emerged in the US. Its proponents argue that the size of a country’s fiscal deficit and debt burden are of little relevance. In an extreme version of MMT, central banks would forfeit their independence and focus on capping public borrowing costs rather than fighting inflation. For the moment, we believe we are in a soft MMT regime in major western countries, with supposedly independent central banks influenced by their governments but not yet under their direct control. This means central banks, most prominently the US Federal Reserve, have been adopting a more relaxed stance on inflation as part of their policy mix and seem intent on keeping rates low to ensure financial conditions remain relaxed for debtors, including governments.
For the time being, the low rate environment—with possibly only a very gradual normalization of policy rates over the next 10 years—could continue to grant governments fiscal space.
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