From The Economist, April 23rd, 2020
In “how to pay for the war”, a pamphlet published in 1940, John Maynard Keynes looked back on the way that the British government had, in the late 1910s, tried to pay off enormous quantities of debt with a combination of higher taxes and inflation. Wages had not kept up with inflation, meaning “that consumers’ incomes pass[ed] into the hands of the capitalist class”. Meanwhile the rich, as bondholders, had benefited from interest on the loans.
This time, Keynes argued, it would be better to take money from the workers directly by forcing them to lend to the government while the war was on and there was little to spend money on anyway. Later the government could pay the workers back the money they had lent it with interest, using the proceeds of a substantial wealth tax. “I have endeavoured”, Keynes wrote, “to snatch from the exigency of war positive social improvements.”
Like a war, the fight against covid-19 has seen governments, particularly those in the rich world, rack up debts so large that the way in which they are paid off could have a long-lasting effect on their economies, and significantly affect the distribution of wealth. There are deep differences between today’s circumstances and those which Keynes surveyed, perhaps foremost among which is that advanced economies now routinely shoulder a level of debt that Keynes would have seen as an unmanageable burden (see chart 1). But those dealing with the aftermath of this year’s remarkable borrowing should still heed his example in looking for the right way to distribute the pain as they do so.
Debt before dishonour
The numbers involved are enormous. Advanced economies will run an average deficit this year of 11% of GDP, according to the IMF, even if the second half of the year sees no more lockdowns and a gradual recovery. Rich-world public debt could run to $66trn, which might be 122% of GDP by year’s end.
Governments wishing to see such debt burdens diminish must tread one of three broadly defined paths. First, they can pay back the borrowing using taxation. Second, they can decide not to pay, or agree with creditors to pay less than they owe. Third, they can wait it out, rolling over their debts while hoping that they shrink relative to the economy over time.
The likely constraint on paying off debt with future tax revenues is politics. Such a strategy requires some mix of raising taxes—which upsets quite a few people—and cutting spending on other things—which also upsets quite a few people, including some who will not have liked the tax increases either. Nevertheless, after the global financial crisis of 2007-09, which increased debt levels by about a third in advanced economies, many countries chose to reduce public spending as a share of the economy. Between 2010 and 2019 America and the euro zone cut their public-spending-to-gdp ratios by about 3.5 percentage points. Britain’s fell by 6 percentage points. Taxation, meanwhile, rose by between 1 and 2 percentage points of gdp.
Public appetite for paying off pandemic debts through a return to such austerity seems likely to be scant. The emotional, as opposed to economic, logic of austerity—people had spent too much, and must rein themselves in—does not apply. What is more, post-covid publics are likely to want more spent on their health, not less. More than half of Britons supported tax increases that would pay for more spending on the National Health Service even before the pandemic struck. Ageing populations are also increasing the demand for public spending, as are investments needed to tackle climate change.
The second option—defaulting or restructuring debts—may be forced on to emerging economies which lack any other way out. If it is, that will cause significant suffering. In advanced economies, though, such things have been increasingly rare since Keynes’s day, and look unlikely to make a comeback. A modern economy integrated into global financial markets has a huge problem if capital markets lock it out as a bad risk.
That said, there may be more than one way to default. Kenneth Rogoff of Harvard University argues that promises to increase health-care and pension spending in coming decades should also be viewed as government debt of a sort, and that this sort of debt is easier to back out of than obligations to bondholders. It is hard to ascertain whether the “default” risk in these debts—ie, the risk that politicians cut health-care and pension spending, reneging on their promises to ageing populations—is rising. Unlike bonds they are not traded on financial markets that provide signals of such things. But it almost surely is, especially in countries, like Italy, where pension spending is already enormous.
Rich-country politicians unwilling to shift away from spending and towards taxing, or to risk finding out how terrible a default would be, are likely to choose to grow their way out of hock. The secret to this is ensuring that the economy’s combined level of real economic growth and inflation stays handily above the interest rate the government pays on its debt. That allows the debt-to-gdp ratio to shrink over time.
In a much-noted speech in 2019 which called for a “richer discussion” about the costs of debt, Olivier Blanchard of the Peterson Institute for International Economics, a think-tank, argued that such a strategy was more plausible than many might think. In the United States, he pointed out, nominal growth rates higher than interest rates are the historical norm.
Many rich-world governments pursued this sort of strategy after the second world war with some success. At its wartime height, America’s public debt was 112% of GDP, Britain’s 259%. By 1980 America’s debt-to-gdp ratio had fallen to 26% and Britain’s to 43%. Achieving those results involved both a high tolerance for inflation and an ability to stop interest rates from following it upwards. The second of these feats was achieved by means of a regulatory system which, by depriving citizens of better investment options, forced them in effect to lend to governments at low interest rates. By the 1970s economists were calling this “financial repression”.
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Greece and the Euro 