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One thing is for sure: the global economy will come out of this crisis with even higher levels of public debt and fiscal deficits.
At the end of last year, the combined public debt of the G-7 countries stood at around 120% of their Gross Domestic Product. By the end of 2020, this figure will be close to 140%. Government decisions to close down their economies to contain the coronavirus led to a halt in economic activity and the authorities responded by launching massive spending programs. In the financial crisis 10 years ago, we got used to hearing about billions; in this crisis we are getting used to trillions. To the average person, the sums announced to save the banks, the financial system and the global economy sound more and more abstract. Coincidentally, there is very little talk about who's going to pay for this expenditure.
Like all economic agents, governments have two ways of financing their expenditure:
- through revenue (mainly tax receipts)
- through debt.
If a government confines itself to the first of these, it will only be able to increase its expenditure if its receipts increase, and this will only be possible if economic growth accelerates or if the tax rate is hiked.
Obviously, recourse to debt significantly extends the government's leeway. If it wants to spend a billion more than a balanced budget would allow, it will raise funds from the public by issuing a billion of debt. In normal times, it would have no trouble finding investors (pension funds, insurance companies, private investors, etc.) willing to subscribe to the issue.
What are the limits to a government's capacity to take on debt?
In the past, we would have listed the following constraints:
- The cost of servicing the debt becomes too high. Even if we assume that generally governments never repay their debt (they just continuously refinance it), they have to pay interest on it. If the amounts to be paid in interest become too large, the government will have to cut back on other expenditure.
- Investor confidence. If investors see the government debt-to-GDP ratio deteriorate significantly, their confidence in the government's ability to meet its obligations will wane. They will then decide not to buy the bonds that the government issues or at least they will demand higher remuneration (i.e. a higher yield).
- The fact that private sector funds are limited. If the government makes a massive call on private sector funds, two things are likely to happen. Firstly, the law of supply and demand will cause the price of this funding to increase. In other words, interest rates will rise. It will then become increasingly difficult for the private sector to find financing (known as 'crowding out' when public sector spending squeezes the private sector). Given that private sector spending is generally more productive than government spending, economic growth will suffer.
- Inflation. An increase in government spending leads to an increase in demand in one form or another. If government spending is increased to compensate for weak private sector demand, there will be no inflationary impact. However, if government spending is increased without a major fall-off in private demand, inflation is likely to rise since, at least in the short term, supply will not be able to grow as fast as demand. This can be illustrated by a very simple example: imagine that a country manufactures 100,000 cars per year; 70% are sold to the private sector, 30% to the public sector. If private sector demand falls by 10% (- 7,000 cars) and public sector demand increases by just over 20% (+ 7,000 cars), total demand will still be 100,000 cars and, all other things being equal, there is no reason for the price of the cars to rise. If, on the other hand, public sector demand increases by 20% without a decrease in private sector demand, there will be a demand for 107,000 cars against a supply of 100,000 cars and a consequent increase in the price of the cars. For this reason, economists like Keynes only agreed to large budget deficits in periods of weak private demand (and hence lower economic activity), while insisting that periods of strong growth in economic activity should instead be used to rebalance the government's accounts.
Historically, these considerations resulted in a close correlation between high public debt and low growth. When there is too much public debt, taxation increases, interest rates rise and less money is available for the private sector.
While, in the past, these considerations were therefore likely to limit the government's ability to incur debt, some economists argue that they are no longer relevant today, or that there is a way around them. In this respect, we might acknowledge three characteristics about economists and their theories:
- Economics is not an exact science.
- Economists like theory and are often convinced that what works in theory will also work in practice. However, to quote the legendary American baseball player, Yogi Berra, known for his pithy aphorisms: “In theory, there is no difference between theory and practice. In practice there is.”
- Economists do not generally have the intellectual humility to question their theories when they don't work. (The behaviour of central banks in recent years is a good illustration of this point.)
We should keep in mind these characteristics when analysing the arguments now being put forward by those who, one way or another, are trying to make people believe that billions of spending and ever-increasing public debts are not important. These arguments are largely based on the fact that interest rates today are near zero or even negative. This means that the cost of government financing is currently zero or even negative, and the cost of servicing the debt is low. Why shouldn’t governments take advantage of this to increase their spending? (Theories such as modern monetary theory (MMT) argue that, as long as there is no inflation, the government can spend as much as it wants because, unlike other economic agents, it has the power to create the money it needs. In this respect, MMT is one of the theories which try to make people believe that it is possible to create more wealth simply by creating more money – theories which have hitherto tended to be associated with certain Latin American countries.)
It could be argued that although interest rates are currently low, there is no certainty that they will remain so. If they were to rise, and public debt has meanwhile risen sharply, the cost of servicing that debt would become prohibitive. Also, someone will still have to be found to buy all those bonds that the government wants to issue. After all, private sector funds are limited and buying government bonds that do not provide any return is not a very attractive proposition for most investors.
Enter the central banks...
During the 1970s, the realisation that public spending financed by the central banks printing money fuelled ‘hidden’ inflation — which eroded household purchasing power and ruined the competitiveness of businesses — led to the central banks becoming independent. Since elected politicians like spending to secure their re-election, the central bank’s independence from the government constitutes a credible commitment to stability: as the central bank is not affected by election schedules, it is better able to keep to a pre-determined objective of price stability. The government thus delegates its monetary authority to a 'conservative central bank' that is in a better position to limit inflation (harmful to the economy as a whole) as much as possible.
Things have changed a lot since the 1970s. Today, central banks have found a new enemy: deflation. They are trying everything they can to create inflation. But they are forgetting that mild deflation is the hallmark of a functioning market economy. In such an economy, declining prices are the result of an increase in productivity and a healthy competition. They then reflect an increase in the quantity and/or the quality of the goods and services produced and in the purchasing power of households. Cars were initially only available to the very wealthy because they cost so much to produce. The same is true for televisions and mobile phones. Deflation only becomes a problem when there is too much debt or when there is a sharp fall in aggregate demand. This usually happens when people lose faith in the future. Such a loss of faith is often linked to the bursting of a speculative bubble (in real estate, in equities, …), bubble that is often the result of an irresponsible monetary policy. The idea that deflation is bad is in large part a consequence of studying the Great Depression of the 1930s which followed the stock market crash of 1929.
Inflation on the other hand has the capacity to destroy an economy. It penalises the values that should be the basis of the economy: work, savings, frugality. Why work hard today if the proceeds from that work do not allow you to live comfortably tomorrow? Why save if your savings don't even allow you to buy a home? Why not simply go into debt in a currency that is bound to decrease in value? The basis of our entire society is to a certain degree a bet on the future made possible by capital. Investment, innovation, credit: everything is projected towards tomorrow. Inflation breaks this spiral. With good reason, almost all languages have an expression equivalent to 'time is money'. But with inflation and negative (real) interest rates, time becomes a waste of money.
The principle of the central banks’ independence led (among other things) to a rule that, until recently, was considered sacrosanct: a ban on monetising debt (debt monetisation is the financing of government spending by the central bank. Note that until now, central banks have always defended themselves against the accusation of monetising debt. They say that the bonds they are buying under their quantitative easing programmes will eventually be resold to the private sector.). However, like central bank independence, this rule is increasingly being called into question and it would seem that there is no longer any real brake on the government's capacity to be able to borrow and spend:
- The central banks make sure that interest rates cannot rise (e.g. the Bank of Japan 'anchored' the 10-year rate at 0% in 2016).
- Governments don’t need to raise funds from the private sector since they are financed directly by the central banks.
- The private sector need not fear higher taxes.
Thus we find ourselves in a situation where consenting central banks seem to be able to remove the two brakes on increased public spending: a possible rise in interest rates and limited private sector savings. The remedy is so simple that one wonders why it wasn't applied sooner. And why not go further? Households not consuming enough? Let’s send them a cheque. A business has a problem? Ditto. Unions demanding wage increases? Let’s raise wages. The result of all this is to increase the public debt that the government will have to finance by issuing bonds, but this is not a serious problem because the central bank will buy the bonds with the money it creates out of thin air. Advocates of these theories will respond by saying that governments know how to make well-considered decisions and that the public expenditure financed in this way will be 'smart' spending, such as investments in infrastructure that will bear fruit and somehow be self-financing. No harm in dreaming...
In theory, this could work. In practice, the recent examples of Zimbabwe and Venezuela, and Germany in the 1920s, show that printing money to finance public expenditure has disastrous consequences.
Before coming to these consequences, we should bear in mind that for all this to work even in theory, interest rates will have to be kept very low. This too will have negative consequences.
As mentioned in my previous article, prices have a very important role to play in the smooth functioning of an economy, starting with the most important price, the price of money, i.e. the interest rate. A market economy needs a hurdle rate in order to function properly. While it is easy to see the theoretical positive impacts of near-zero interest rates (especially in highly indebted economies), it is more difficult to see the negative impacts. These may include an increase in social inequalities, problems for insurance companies and pension funds, and the maintenance of unprofitable 'zombie' companies which prevents the process of 'constructive destruction' and hinders the productive investment of profitable companies and hence growth. Zero interest rates can also be considered as a tax on savings: whereas in the past the government would have paid 3% interest on a bond and taken back part of this 3% through a withholding tax (albeit leaving something of a return for the saver), today, quite simply, it no longer pays anything.
Why does the financing of public spending by central banks generally have disastrous consequences?
First, because it has an inflationary impact. The government injects demand into the economy through a budget deficit. If it finances this deficit by issuing a bond sold to the private sector, it absorbs part of the disposable money in the system, which is then no longer available to finance investments. The surplus demand injected by the government is therefore partly offset by a potential demand that will not ultimately be generated in the private sector. If, on the other hand, the government's deficit is directly financed by the central bank, there will be no such restraining effect and, sooner or later, the impact will be inflationary. In theory, one could of course argue that the government could always back-track and reduce its spending. In practice, it is very difficult politically to cut public spending.
Secondly, financing public spending by printing money (physical or digital) is the best way to destroy confidence in the currency. When this happens, rising inflation will turn into galloping inflation. Confidence in paper money is a fragile thing. In theory, it's hard to imagine a loss of confidence in the currencies of industrialised countries. In practice, common sense says that, sooner or later, an asset whose supply increases massively will lose its value. And you only have to look at rising prices for property and art, or football transfer fees, to see that the value of money is constantly shrinking.
The value of money is constantly shrinking. Guy Wagner, Managing Director of BLI - Banque de Luxembourg Investments
By implicitly devaluing their currency, monetary authorities are doing much more than just harming the economy. A strong currency is a sign of confidence in the future. It assumes that savings made today can be used later. History shows that there is a close relationship between a devaluation of money and a devaluation of social values and social disorder. Back in 1921, Keynes wrote: “By a continuing process of inflation, Governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method, they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some (…). Those to whom the system brings windfalls (…) become ‘profiteers’ who are the object of the hatred (…). The process of wealth-getting degenerates into a gamble and a lottery (…). Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”
The rise of populism shows that this is already happening.
It’s one thing to criticise theories but it’s another to try to be constructive. How on earth can we get out of this mire? With public authorities taking increasingly desperate measures, how can we avoid lurching from one crisis to the next? The first thing we can do is realise that the fundamental problem currently weakening the global economy and the financial system is over-indebtedness. This is even more serious if we take into account the demographic profile of the industrialised countries (and increasingly also of some developing countries) and the unfunded promises that go with it. The second thing to realise is that it is quite simply inconceivable that this problem can be solved by fiscal austerity measures or tax increases. Yet, to enable the economy to get back on a fundamentally sound footing, the problem of over-indebtedness must be resolved once and for all.
The most agreeable way of doing this is through growth. Taking a particular debt-to-GDP (or debt-to-national income) ratio, if the denominator increases faster than the numerator, the problem would gradually be solved. However, at the present time, it is very difficult to see where such an acceleration of economic activity would come from. On the contrary, over-indebtedness and demographics act as structural brakes on growth.
On the contrary, over-indebtedness and demographics act as structural brakes on growth.Guy Wagner, Managing Director of BLI - Banque de Luxembourg Investments
A second way is to create inflation. Inflation is the friend of the debtor and the enemy of the creditor. Through inflation, the authorities manage to lower the real cost of debt. Going back to the debt-to-GDP ratio, the denominator will increase. It will increase not because of real growth, based on productivity gains and an increase in the goods and services produced, but because of a rise in the price of these goods and services, just as a company can increase its revenues by increasing sales or raising prices. As noted above, inflation would nevertheless engender other risks, especially as the authorities would have to prevent the hike in interest rates that would normally accompany a rise in inflation.
There is a third way: the cancellation (or, to use a euphemism, restructuring) of debt. Why not finally lance the boil? Why, as the central banks implicitly do, actually do the opposite and encourage economic agents to go even further into debt?
If a debt is cancelled, there will obviously be a loser: the creditor. However, an interesting idea has recently emerged concerning the public debt held by the central banks: why don't they simply cancel this debt? Since the government and central bank both belong to the public sector (in the US, the Federal Reserve's profits go to the Treasury), such a cancellation would not result in any loss to the private sector. The loss will be borne by the central bank, whose equity will become significantly negative, but in the end, who cares? (Others propose that the central bank should agree to exchange the government bonds it holds for perpetual non-interest-bearing bonds. By having these bonds on the asset side of its balance sheet, it would avoid having to show negative equity, even though in reality these bonds would obviously be worthless. This would allow the central bank to 'save face' but would have the disadvantage of not officially reducing the level of public debt.)
Could this work?
Some deplore the idea as a monetary magic trick that could destroy confidence in money. Others will say that it could work provided:
- it is made clear that this is an extraordinary operation that will never be repeated
- safeguards are put in place to prevent the public debt from rising again (forcing governments to balance their books, including a 'debt brake' written into law, and above all ruling out any idea of central banks financing public spending, etc.).
There would also be some practical questions: would central banks only cancel the public debt they currently hold or would they first buy back from the private sector some or all of the public debt it holds and then cancel it? The reduction in public debt would then be even greater. The Bank of Japan currently holds more than 40% of Japanese government bonds; for other countries this percentage is much lower. Also, the fact remains that the problem of over-indebtedness in the private sector would still not be solved.
In the meantime, and to answer the question that is the title of this article, there is no magic money tree (MMT) and no miracle solution. There is a price to pay and many will pay it even if the connection is not as visible as it is when there is a tax increase:
- savers who don't get any interest on their savings and see the purchasing power of their savings decline
- a majority of the population who will gradually have less and less access to certain goods and services. At present, this primarily concerns property, but in the future could relate to other goods and services
- society as a whole through lower economic dynamism, an increase in social inequalities, a loss of a sense of personal responsibility and, finally, a loss of individual freedom.
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