Will public debt be a problem when the Covid-19 crisis is over?

Updates on the global economy

The writer is president of Fulcrum Asset Management

Since Covid-19 disrupted global growth earlier this year, major advanced economies have made some of the biggest policy changes ever seen in such a short time. As Lenin said: “There are decades when nothing happens; and there are weeks when decades happen. We have just lived through several of these weeks.

Even more notable was the unanimity among macroeconomists that a massive fiscal and monetary stimulus is the appropriate response to a “wartime” economic emergency. Almost no one seriously disputes that politics should do “everything that’s necessary”To overcome the shock of the virus.

This agreement reflects a key conclusion of public finance theory: that a higher public debt is the right buffer for the private sector in the face of unpredictable and temporary economic crises. It avoids the distortions that would follow large changes in marginal tax rates that would otherwise be necessary to finance rapid increases in public spending.

The chorus of approval The macro profession has helped fiscal and monetary policymakers introduce massive stimulus packages almost instantly, unlike the much slower response to previous recessions, including the 2008 financial crisis.

The markets have been very volatile, but overall they have largely endorsed these decisions. Despite the increase in public debt, in the long term U.S. government bond yields are expected to remain below 1% until at least 2022. Stocks have rebounded from their lows and could only see them again if political support for the recovery is withdrawn too soon.

But once the recovery is established, public debt overhang risks dividing economists along familiar lines.

Most New Keynesian economists, including Paul krugman and Lawrence summers, believe that high debt levels in themselves will not be a problem for advanced economies. They even suggest that further debt hikes would be desirable, as it would help reverse the trend of secular stagnation in Europe and the United States.

One of the main reasons for their optimism is that the annual cost of servicing the debt will clearly be below nominal growth rate of the economy and central banks seem determined to maintain it. If the interest rate remains below the growth rate, the debt-to-gross domestic product ratio eventually stabilize, provided that the governments’ non-interest – or “primary” – fiscal balance remains stable.

Assuming the high public debt strategy is successful, real bond yields are likely to gradually rise to more normal levels. In addition, equities will respond positively to improving growth prospects as inflation returns to central banks’ 2% targets. Debt could be managed without crisis.

This may be the most likely path for advanced economies in the years to come, but it is not guaranteed.

John cochrane and Kenneth rogoff are among influential economists who warn that most advanced economies, especially the United States, could soon post higher than ever public debt to balance sheet ratios, even after the 2008 crisis. social security and health further increase potential public spending.

This group admits that interest rates have been below growth rates for long periods of time, thus helping to control public debt. But they argue that politicians are starting to respond to falling debt servicing costs by increasing primary deficits through tax cuts and long-term spending commitments. This feedback loop can lead to an indefinite increase in debt ratios, even with interest rates below the growth rate of GDP.

In addition, low debt servicing costs did not prevent previous fiscal crises from erupting without warning when financial markets suddenly deemed debt and government deficits too high. In advanced economies, particularly the United States, this could be triggered by a sharp rise in inflation, forcing central banks to resell their holdings of government debt in the market at a time when higher interest rates. are needed to control inflation.

This kind of step could cause a rush into the government bond and foreign exchange markets that would be catastrophic for the financial system and for asset prices. Mr Cochrane says it would be a “huge disaster” – and that’s no exaggeration.

The recent explosion in public debt is not a problem at the moment. But one day, perhaps out of the blue, it could turn into a serious crisis. As Stanley fischer argued that a coherent exit strategy will be needed to mitigate these risks.

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