Protecting people’s health during the pandemic will increase debt, but the economic consensus is that we shouldn’t be concerned.
A costly pandemic
19.03%. According to the OBR, that is the size of the budget deficit in the UK for 2020, double as big as the deficit at the height of the financial crisis of 2007-08. Most of this borrowing is a deliberate policy decision to mitigate the financial impact of lockdowns and shutdowns. There has been widespread worry, from influential experts in epidemiology and medical science, commentators including some on the government’s own scientific advice panel. By contrast macroeconomists, when polled, say that we should do nothing at all to address this—we should just let debt increase. This lack of controversy in the profession is surprising, given the past decade of debate over post-recession austerity, particularly in light of an increased public awareness over questions of fiscal sustainability and much higher debt levels. Though these concerns are understandable, they are misplaced in the current environment, and the economics profession is right to suggest that the focus now should be on addressing the pandemic, not worrying about public debt.
The economics of public debt
Following the financial crisis of 2007/08, economists once more turned their attention on the consequences of large public deficits and debt levels, with a particular emphasis on the debt to GDP ratio. This ratio measures the level of indebtedness of a country relative to its annual output, and is generally regarded as the best indicator of its ability to service this debt. In the aftermath of the crisis, the UK both massively expanded public borrowing and suffered a sharp GDP contraction. Together, these drove the debt to GDP ratio from 34.2% in 2008 to 62.9% in 2010.
One of the key planks of the coalition government from 2010 to 2015 was ‘austerity’: cutting government spending in order to reduce the deficit. This was intended to first slow down the rise in the national debt, then finally turn it around and see it shrink, at least as a percentage of GDP. Despite this, the debt to GDP ratio continued to rise during this period because the government could not reduce borrowing to zero too aggressively and the growth rate of GDP was very modest; both factors contributed to a high of 82.9% in 2017. On paper, the current outlook appears even more concerning; all of the effort made by previous governments to reduce borrowing and bring down public debt has been reversed in one fell swoop. Public debt is forecast to reach 108% of GDP by March 2022.
How costly is this debt? The financial burden of a high debt level depends not just on how much debt is owed, but also the real interest rate payable on that debt (r). Therefore, a better measure of the opportunity cost of debt is the total interest payment on the debt, as these are resources that might be employed elsewhere. This burden has halved from around 3.25% in 1980-81 to just 1.74% by 2019-20, with projections pointing to a further reduction in the over the next five years to just over 1% of GDP. Judging from recent issues of UK debt, falling debt interest costs over time seem to be a plausible assumption. As late as November 2020, the implied nominal interest rate for the coming 30 year period was 1%, with longer maturities (which typically command a premium) being snapped up by investors at even lower rates. This implies the government could issue more cheap debt and lock in low rates.
The true burden of a debt is not only driven by r – the interest rate you’re paying on it – but also how fast you’re growing, or the growth rate of real output (g). The larger the difference (written as r-g in shorthand), the greater the economic burden of debt; the debt to GDP ratio grows exponentially. When r-g is negative, this ratio decays exponentially.
Let’s use a concrete example with recent UK data. In the decade to early 2020, r-g averaged -1.77%. If the next ten years were the same then this year’s 19% debt will actually shrink to 16% if we just wait – even if we don’t pay any of it back. If we wait 50 years that same 19% will be worth only 7.9% of output then.
Maybe this sounds unreasonable. Can we really assume interest rates will stay the same? It doesn’t matter if they will: the UK can lock them in right now by selling debt with long enough maturities. By contrast, economies practically always jump back to growth after temporary setbacks – like pandemics. A one-off “fiscal surge” therefore implies a very small long term burden when rates are low.
This compares favourably to the post financial crisis period. From 1999 to 2008, the difference between r and g averaged only -0.28%, implying that this year’s 19% deficit would have ‘naturally’ shrunk at only a snail’s pace. Fifty years on, it would have been 16.6% – still higher than current projections of the current deficit only ten years from now. In other words, while we can at present reasonably expect a “fiscal surge” to have a limited long term impact, we could not have known that when the policy response to the financial crisis was being drawn up. Indeed, from 2007 to the end of 2010, only temporarily (and very occasionally) did the yield on 20 year UK government bonds drop below 4%.
The difference r-g is also important in another way: it tells us whether the existing debt to GDP ratio will gradually stabilise without any additional measures or whether it will explode and require a combination of tax increases and spending cuts to keep it in check. In the current context, higher spending will mean a stable debt to GDP ratio in the long term given r-g, even if we allow for a moderate increase in interest costs over the coming years. That was not the case in the aftermath of the financial crisis.
Should we worry that the increase in spending isn’t just an isolated event, but part of a long-term deterioration on restrictions to deficit spending, which would mean permanently higher deficits for the foreseeable future?
One way to answer this question is by thinking about the largest primary deficit the UK government could run indefinitely while retaining a stable level of debt relative to economic activity. We can estimate this quantity by multiplying r-g by the total amount of net assets for the UK economy, which gives us a measure of how many assets could be converted to government debt.
Using ONS data for the UK’s aggregate balance sheet, we can approximate this by taking the net worth of the entire UK economy and subtracting the value of land, which yields a figure of approximately two times the size of the UK economy. Multiplying this value by the r-g of 1.77% previously discussed, gives us a maximum sustainable primary deficit of around 3.5% of GDP. Right now the OBR thinks the primary deficit will stabilise at around 3% of GDP over the next five years. This means the UK government will be using around 85% of the country’s available fiscal capacity into the indefinite future.
While this isn’t yet cause for alarm, it suggests a permanent reduction in available fiscal capacity that may limit the UK’s ability to respond to future crises. Governments can run perpetual deficits as long as the interest rate on government debt is lower than the rate of growth of the economy, but the closer the government cleaves to its fiscal limits, the more likely a reversal becomes in the future.
The view of a significant number of economists polled in 2013 was that very high levels of debt could trigger worries over debt sustainability, but the mainstream view was nevertheless that fiscal support measures were desirable in the aftermath of the financial crisis. This was not unanimous, however; with an alternative view prevailing in many policy and academic circles. Some economists, notably the late Alberto Alesina, argued that a consolidation of public finances through spending cuts allied to expansionary monetary policy was a more desirable policy mix in the aftermath of the crisis. This view supported the approach of “fiscal austerity” followed by the coalition government in the UK, which met considerable opposition both from within and without the economics profession, both on the grounds that it was bad macroeconomic policy and directly responsible for thousands of lives lost.
A notable feature of the current policy response to the COVID-19 pandemic is that while the mainstream view hasn’t changed significantly with respect to the long-term risks of high levels of debt, there is much more widespread support for fiscal policy measures than there was a decade ago, with near unanimity among economists that additional spending is desirable. While low borrowing costs mean concerns over debt sustainability were more appropriate a decade ago than they are today, that does not fully account for why there are differences of opinion on fiscal policy.
Fiscal policy now but not then
In general, economists agree that spending more increases growth when the economy is in a recession. They agree that extra spending is necessary to put idle resources, like workers, land, and machines to work. Not all economists agree, however, with the old Keynesian view that the government should spend more, or raise less in taxes. If the additional spending raised inflation above target, the central bank would raise interest rates, and the extra spending by the government would be cancelled out by lower borrowing by households and firms. In other words, the central bank needs to ‘accommodate’ this spending with ‘looser’ monetary policy for it to have the proper impact.
The key debate in 2010 was over how additional stimulus should be delivered; the mainstream view in economics was that monetary policy had done as much as it could, which meant that fiscal stimulus was necessary. Another group of economists – most prominently market monetarists – contended that central banks had ample room to enact more stimulative measures and, given concerns over the sustainability of public debt, that they should have done so.
Under the mainstream view, even if national governments were poor at allocating spending wisely and threw it all away on white elephant grands projects and bridges to nowhere, there would be such large benefits to reducing the roll of unemployed workers that it would net out as worthwhile nonetheless. Since even the worst government spending programmes usually have some benefit, they were relaxed about building up debt if the extra spending was getting them out of the recession.
In the market monetarist view, this spending is wasteful. If central banks took more aggressive measures, they said, we could return to full employment faster without worrying about the misallocation of resources through government spending or the risks of higher debt. A popular policy recommendation that gained support in policy circles suggested replacing the central bank’s inflation target with a nominal spending target: as long as spending was below a predetermined target, the central bank should do whatever it takes to get nominal output back on target.
Why then do all economists – from Keynesians to market monetarists – now advocate aggressive fiscal policy measures?
The first reason is that the nature of the spending is fundamentally different. In a normal recession, the goal is to return the economy to full employment as quickly as possible. However, because spending is unlikely to be evenly distributed and because fiscal multipliers are different across different sectors of the economy, it will end up producing inefficiently much of some goods and inefficiently little of others, compared to letting people spend their own money.
Central bank interventions are broadly neutral with respect to which industries do better or worse, or which businesses survive. While there is an ongoing debate on the impact of unconventional policy measures on inequality, the main way monetary policy operates is by affecting the various interest rates that households and businesses face, which are in turn partly determined by banks and other financial intermediaries. On the other hand, government spending plans usually involve funding projects that the private sector would have never financed..
The second reason is that the current recession is different in that the objective is not one of stabilising nominal output. During a pandemic, consuming and producing normal goods and services is actually bad, because it increases the chances of spreading the disease. Consumption has ‘negative externalities’ – negative effects on others not involved in the decision to do it. Thus, this time we don’t want to ‘stimulate’ the economy. We want to put it on ice so when we’ve sorted the disease, it can restart in an almost completely preserved state.
The ideal outcome in terms of public health would involve a complete halt of any economic activity which required individuals to share a physical space indoors so that new cases could be brought down to zero as soon as possible, leading to the complete suppression of the virus.
Debt and the pandemic
With worldwide suppression proving infeasible, how should individual countries respond? Many governments have tried to “flatten the curve” of the epidemic by reducing the effective transmission rate, R, and distributing cases over a longer period of time. This involved a combination of restrictions on economic activity and targeted government support. Other countries followed a bolder strategy to “crush the curve” by implementing very restrictive measures while developing tracking and tracing programmes that identified emerging clusters. Combined with broad income support measures, this approach allowed these countries to return to something closer to normality sooner.
Regardless of whether countries frontloaded these economic costs, most resorted to fiscal policy as the primary mechanism for delivering support to business and households.
Unlike running deficits in a recession, the aim of pandemic fiscal policy is to stabilise nominal incomes to enable households to continue to be able to meet their debt repayments and afford essential goods, while deliberately restricting their consumption of other goods and services. The goal is to ensure that as few businesses and households suffer extreme financial difficulties as possible for as long as it is desirable to keep output lower, so that they can resume activity as restrictions ease. It would be nearly impossible for a central bank to provide this kind of support with its usual tools.
Over the last century, only the two world wars saw larger increases in public borrowing than the COVID-19 pandemic. The recession that followed the financial crisis of 2007-08 triggered a highly contested, and in hindsight likely unnecessary, attempt to bring down the primary deficit, which was nevertheless grounded on uncertainty over the recovery path of the economy.
A repeat of those concerns over the policy response to the pandemic would be misguided because there are clear market signals that indicate borrowing costs will remain low into the foreseeable future, especially if the increase in spending takes the form of a “fiscal surge” rather than a persistently larger primary deficit. One of the most important lessons of that crisis was to take price signals seriously, and to insist that there is calamity just around the corner, when markets are sending the opposite message, would be a mistake.
Our aim should be to suppress the virus as quickly as possible rather than stimulate economic activity, and fiscal policy is the best tool to ensure that the recovery happens as quickly as possible when we finally emerge on the other side of the pandemic. While it is encouraging that the public and policy-makers worry about fiscal sustainability, this is not the financial crisis. Not only can we afford to bear this debt, but there is no other way of keeping the economy on life support while keeping output down aside from spending freely. The alternative is that we may kill tens of thousands of people more. The government must look through all 19.03%.