Low Growth Threatens Public Debt Sustainability: A Sustainable Fiscal Stimulus Is Essential

As 2020 comes to a close, the world stands at an historic turning point. Can we build back better, or have economies run out of money?

There’s much to do. Casting backwards, the world has suffered decelerating growth and widening wealth disparities promoting social discontent; surveying the current landscape sees a world scarred by an unprecedented global pandemic, and envisioning the future confronts us with an existential climate crisis and an onslaught of digital technologies which stand to reshape our world.

As public borrowing surges…

With the welcome advent of effective COVID-19 vaccines, the policy focus is shifting from rescue (the need to support people’s livelihoods and keep businesses solvent during the global pandemic) to recovery. Further public spending will be necessary to build a post-COVID-19 economy that is inclusive, resilient and sustainable. This spending must boost productive capacity, secure sustainability and provide a short-term economic stimulus to offset the paradox of thrift caused by retrenched spending by nervous consumers and investors.

With public debt in many countries already pushed to historic highs, relative to output, there is understandable concern about our ability to pay for all this public investment. It should be no surprise, therefore, that the purveyors of fiscal austerity are once again setting out their stall. They must not be allowed to succeed. Their success would come at great cost to society

…historic underinvestment bites

Even before the pandemic, the global economy was in trouble. The first two decades of the millennium were marked, in the major economies, by a period of weak GDP growth and slow productivity growth. Inflation and nominal interest rates were historically depressed, and crucially, so too was the real rate of interest. Near zero real interest rates told of an underlying environment where desired investment was weak relative to desired savings. This has been put down to a number of factors, neatly described by Larry Summers under the heading ‘secular stagnation’.

In the aftermath of the great financial crash of 2008, many of us argued against the futility of seeking to prematurely balance public budgets. We reasoned that the early move to austerity in the EU and US, ostensibly to restore sustainability in the public finances, would be counterproductive and end badly. So it has.

The failure of public borrowing and investment to absorb the surplus of global desired saving sent interest rates plummeting. The zero bound on interest rates (below which money makes a better return stashed under the mattress) forced monetary policymakers to seek ever more experimental approaches to boost liquidity.  

This surplus of liquidity in turn inflated the price of assets held mostly by the wealthiest, thereby exacerbating inequality, over a period in which earnings growth for the majority stagnated. Years of underinvestment in key public services not only limited productive capacity, though inadequate and unreliable and unsustainable (carbon intensive) infrastructure, it also spawned popular discontent, nativism and political polarisation.

Should we worry about public debt?

But how do we square the urgent need for public investment with the need to contain the growing mountain of public debt?

Managing the public finances well reduces vulnerability to future debt crises and the threat of debt default and insolvency, especially if interest rates rise or growth disappoints. It also limits the requirement for future tax increases or spending cuts. So, it is understandable that the unprecedented government response to the global pandemic, and the need for public investment to boost productive capacity, has raised concerns about fiscal space.

But the risks from higher public debt do not currently outweigh the benefits. Investors have shown no signs of concern. The UK sold negative-yielding government bonds for the first time in 2020 and financial markets expect rates to remain below zero for the rest of the decade. This appetite for assets, regardless of low risk-adjusted returns, reflects a tower of desired saving which could more profitably be tapped for necessary investment. Moreover, in most advanced economies around a third of public debt is owed to the publicly owned central bank (this sums to £875 billion in the UK) and this can be rolled over indefinitely as the central bank creates new money.

There is plenty of time to worry about public debt vulnerability. If, eventually, underlying inflation revives and desired private net investment bids up interest rates, this will make debt repayment harder. But that is not where we are now. Indeed, that is where we want to be, having reversed the forces of secular stagnation. By then, policy will have done its job in stimulating growth and steering the economy out of a cyclical and secular slump driven by deficient net investment.

Growth is the key to debt sustainability

What matters most is growth. Low growth makes debt harder to handle, as anyone with a mortgage or credit card debt will attest. It undermines the denominator in debt/GDP and weakens the flow of net fiscal revenues necessary to meet interest payments and pay down debt. As the table below shows, growth offers the only secure avenue for bringing debt/GDP down again. By contrast, aiming to balance budgets prematurely, after such a traumatic economic shock, is likely to prove self-defeating.

Figure 1. Options for reducing the public debt/GDP ratio

There is no magic ceiling to public debt/GDP. Total government debt as a percentage of GDP in Japan was a sustainable 238% in 2019. What matters is not the level of public debt to GDP, but its quality in terms of generating sustainable investment and growth. It is the latter that secures prosperity and provides the foundations for public debt sustainability. This is why the latest IMF Fiscal Monitor for October 2020 suggests that an additional $1 in public borrowing, to invest in “job-rich, highly productive, and greener activities”, would generate an extra $2.7 of additional output.

Fiscal and monetary policy must work together to steer funds toward the growth of productive sectors, as the Chairman of the Federal Reserve in the US and the Governor of the Bank of England recently acknowledged. Leaving monetary policy alone to support global growth was the mistake made after the great financial crash of 2008. It must not be repeated.

In my next blog, I will discuss what form this fiscal expansion might profitably take, and what the supporting institutions and policy frameworks might look like. But for now, it is important to recognise that missing this opportunity to crowd in sustainable and resilient growth would be a mistake from which the world may never recover.