October 29, 2020 (MLN): The coronavirus (Covid-19) outbreak has prompted advanced economies to unveil extraordinary fiscal measures. So far, this year G20 countries have announced stimulus programmes worth around US$11trn (or nearly the size of the Japanese, German and French economies combined).
The Economist Intelligence Unit’s recent report on ‘A new era of slow growth, low inflation and high debt’ has examined and explained the impact of fiscal measures on public debt and future of global economy post-COVID-19.
According to the report, these fiscal measures have helped many companies to stay afloat, kept workers employed and stabilised financial markets. However, they will also push fiscal deficits to an average level of 17% of GDP across OECD countries. In turn, public-debt-to GDP ratios will rise to around 140% of GDP (or US$13,000 per head) across developed economies.
In the past, such high levels of indebtedness would have alarmed economists and prompted heated discussions about which country would be the first to experience a sovereign debt crisis.
However, this no longer appears to be the case. As per EIU, two factors explain this shift. First, instead of depleting their (already empty) coffers, governments have enlisted central banks to finance their spending spree: over the past few months, the central banks of the US, Japan, the eurozone and the UK have created US$3.7trn in new reserves of money to buy government and corporate bonds.
Second, low inflation means that sovereign debt will erode over time and, crucially, cost virtually nothing to service. As Olivier Blanchard, a former chief economist for the IMF puts it, at a zero-interest rate, it “does not matter whether you finance by money or finance by debt”. This was not a given. There were fears at the start of the pandemic that shortages of goods or supply-chain disruptions would prompt price spikes. However, inflation has remained subdued across major economies over the past few months.
The report stated that governments are too busy dealing with the pandemic to worry about fiscal deficits, but the debt pile-up will have to be tackled eventually. Once the pandemic is over, austerity will not be a credible option. Cutting expenses take up a huge amount of political capital, which will be in short supply once citizens start to scrutinise their governments’ response to the outbreak.
From the revenue side, tax increases are possible, but they will not be sizeable enough to narrow the fiscal shortfall meaningfully. Sovereign defaults do not appear to be a likely option, either, the report said.
Over time, if nominal growth remains higher than interest rates, the debt pileups will simply disappear; with interest rates at zero, and assuming that fiscal stimulus manages to boost growth, this does not look like a far-fetched assumption.
The governments of developed countries will hope that investors will continue to be willing to invest in their sovereign bonds: with debt-to-GDP ratios shooting up across all advanced economies, the point at which investors see sovereign debt as too risky could move up from 100% of GDP to, say, 200% of GDP. The situation appears unprecedented, but it is not. In the years that followed the second world war, the US public-debt-to-GDP ratio stood at 112%; that of the UK was more than twice that figure, at 259% of GDP.
As was the case 75 years ago, this situation creates opportunities to finance investment and research in an attempt to fuel the post-pandemic recovery and boost long-term growth prospects. However, this new normal also comes with risks. Generous furlough schemes and support measures will help to keep otherwise unprofitable companies alive, weighing on productivity and innovation and fuelling a rise in the number of “zombie” firms, the report assessed.
In addition, if inflation rises unexpectedly, central banks would have no choice but to hike interest rates to curb price growth. In turn, the cost of sovereign borrowing would spiral out of control.
One commonly accepted view is that there is a relationship between unemployment and inflation: when labour markets boom, inflation rises. If this theory holds true, governments will be in difficulty as soon as the economic picture starts to improve, and labour markets recover. However, this economic precept seems to have broken down after the 2009 global financial crisis. Since then, unemployment and inflation have not moved in sync.
Giving an example of Japan’s economy when equity and real estate bubbles burst in 1989, the report highlighted that its economy crashed abruptly before going through a “lost decade” of feeble growth between 1991 and 2001. The government tried to boost activity via fiscal stimulus programmes, which increased the debt-to-GDP ratio to around 240%. These measures failed, and subdued demand meant that inflation remained stubbornly low. The report raised a question i.e. ‘Will the pandemic turn us all Japanese?’
Coupled with a bleak demographic outlook, as per EIU’s report, these three characteristics—slow growth, low inflation and high debt—will become common features of advanced economies in the coming decades. The impact of such unprecedented conditions will be a game-changer for the global economy. The pandemic may not last once a vaccine is found. However, the post-coronavirus zombification of advanced economies appears to be here to stay.
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