As at 23 June 2020
Author: Gavyn Davies, Executive Chairman
There is unanimity about macroeconomic policy for now, but not about an exit strategy
Since Covid-19 disrupted global growth early this year, the major advanced economies have made some of the biggest policy changes ever seen in such a short time. As Lenin put it, “There are decades where nothing happens; and there are weeks where decades happen.” We have just experienced several of those weeks.
Even more notable has been the unanimity among macro economists that massive fiscal and monetary stimulus is the appropriate response to a “wartime” economic emergency. Almost no one seriously disputes that policy should be doing “whatever it takes” to overcome the shock from the virus.
This agreement reflects a key conclusion from public finance theory: that higher government debt is the correct shock absorber for the private sector in the face of unpredictable, temporary economic crises. It avoids the distortions that would follow the big variations in marginal tax rates that would otherwise be needed to finance a surge in public spending over a short period.
The chorus of approval from the macroeconomics profession has helped fiscal and monetary policymakers introduce massive stimulus packages almost instantly, in contrast to the much slower response to earlier recessions, including the 2008 financial crisis.
Markets have been very volatile but overall they have largely endorsed these decisions. Despite the rise in public debt, long-term US government bond yields are expected to remain below 1 per cent until at least 2022. Equities have rebounded from their lows and may revisit them only if policy support for the recovery is withdrawn too soon.
But once the recovery is established, the public debt overhang is likely to divide economists along familiar lines.
Most New Keynesian economists, including Paul Krugman and Lawrence Summers, believe high debt levels will not in themselves be a problem for advanced economies. They even suggest further rises in debt would be desirable, as that would help reverse the trend towards secular stagnation in Europe and the US.
A key reason for their optimism is that the annual cost of servicing the debt will be clearly below the nominal grow rate in the economy and the central banks seem set to keep it there. If the interest rate keeps below the growth rate, the debt/gross domestic product ratio will eventually stabilise, provided governments’ non-interest — or “primary” — budget balance remains stable.
Assuming the high public debt strategy succeeds, real bond yields will probably rise gradually towards more normal levels. In addition, equities will respond positively to improved growth prospects as inflation returns to the 2 per cent central banks’ targets. Debt could be managed without a crisis.
That may be the most likely path for the advanced economies in coming years — but it is not guaranteed.
John Cochrane and Kenneth Rogoff are among the influential economists who warn that most advanced economies, notably the US, could soon be running on balance-sheet public debt ratios higher than anything seen before, even following the 2008 crisis. Off-balance sheet commitments in social security and health increase potential government spending even further.
This group concedes that interest rates have remained below growth rates for long periods before, helping to control public debt. But they argue that politicians are beginning to respond to lower debt-servicing costs by adding to primary deficits through tax cuts and long-term spending commitments. This feedback loop can cause indefinitely rising debt ratios, even with interest rates below the GDP growth rate.
Furthermore, low debt-servicing costs have not prevented previous fiscal crises from erupting without much warning when the financial markets suddenly deem public debt and deficits too high. In the advanced economies, especially in the US, this could be triggered by a sharp rise in inflation, forcing central banks to sell their government debt holdings back into the market at a time when higher interest rates are needed to control inflation
That kind of step could cause a run in the government bond and foreign exchange markets that would be catastrophic for the financial system and for asset prices. Mr Cochrane says this would be an “immense disaster” — and that is no exaggeration.
The recent explosion in public debt is not a problem right now. But one day, perhaps out of the blue, it could become a serious crisis. As Stanley Fischer has argued, a coherent exit strategy will be needed to mitigate these risks.
