Paying for the coronavirus will have to be like a war debt – spread over generations
The macroeconomic shock caused to the global economy by the COVID-19 pandemic is arguably unprecedented in modern times. The financial response from the governments of major economies has been substantial.
The Center for Strategic and International Studies estimates that the G20 had rolled out US$7trillion (£6.2trillion) in direct spending, tax relief and loans by the end of May. This represents more than 10% of their combined GDP for 2019, with an average of more than 12% among advanced economies. This exceeds the fiscal support measures taken by governments during the great financial crisis of 2007-09, as shown in the map below.
COVID-19 Tax Interventions vs Great Financial Crisis
Still, economists agree that the 2020 interventions were both necessary and timely. More may also be needed. In many industrialized economies, governments have focused on job support and subsidized loans to businesses of all sizes. Some countries like Germany are now announcing major investments in green infrastructure and consumer incentives like reduced VAT and subsidies for electric and hybrid vehicles.
Debt and more debt
In the UK, the Office for Budget Responsibility (OBR) currently estimates that the total impact on government borrowing will be £132.5bn in 2020-21. This will widen the deficit to over 15% of GDP, from less than 2% in 2018-19.
Even that depends on the end of the lockdowns and the resumption of economic activity. Otherwise, the deficits could exceed those observed in wartime, when they peaked in the regions of 25 to 30% of GDP.
Many wonder how the additional debt will be paid off. For the UK, even in the OBR’s most optimistic scenario that economic activity recovers rapidly within three months of a three-month lockdown, the debt-to-GDP ratio peaks at 110% and falls back to 95 % in 2021. If the recovery is much slower, most governments will indeed face very high debt-to-GDP ratios.
As during the Great Financial Crisis, central banks play an important role in the public debt market with significant quantitative easing (QE) programs. QE involves central banks creating new money to buy assets – mostly government debt in the form of sovereign bonds, and sometimes also commercial debt.
On March 19, the Bank of England announced that it would increase its holdings of UK government bonds (gilts) and some corporate bonds by £200 billion to £645 billion. The ECB announced a €750bn (£668bn) program around the same time, then expanded it on June 4 to €1.35trillion. The Fed’s new QE commitment is open-ended, with more than US$1.5 trillion in assets purchased since the crisis began.
It is important to note that QE programs do not directly fund public spending. Money created by central banks is used to buy government debt from investment funds that bought it from the government. Central banks are supporting demand for this debt to ensure that the cost of government borrowing remains low. This potentially avoids messy situations where investors become more reluctant to buy the debt because they believe the country in question has become a bigger credit risk.
QE also supports economic recovery through other channels. First, when central banks pump new money into government and corporate debt, it encourages investors to redirect their money into relatively similar assets like stocks or different corporate debt.
This is called the portfolio rebalancing effect, and it brings benefits. For example, if additional demand causes the price of certain stocks or corporate debt to rise, the cost of borrowing for the companies in question will decrease. This lowers the cost of borrowing across the economy.
Second, buying government debt from banks gives them more money to potentially lend. This is reversed when the QE program ends. Third, asset purchases create stability. During the Great Financial Crisis, one of the biggest impacts of QE was to signal to financial markets that central banks were serious about supporting economic recovery with loose monetary policy that kept interest rates low.
Risks and consequences
The key question of QE is whether giving governments leeway to borrow, while easing monetary policy, will have unintended consequences. After the 2007-09 crisis, there were fears that QE would drive up asset prices and cause people to take excessive risks. There is evidence that this happened.
This time around, we have already seen stock markets soar. The S&P 500 is up 43% since mid-March. Related to this are concerns that the unwinding of a very large QE program at the end of the crisis could destabilize markets – note that QE injections following the previous crisis never been completely reversed.
Another concern is that QE may be insufficient to stimulate demand in the economy after a crisis as deep as that caused by COVID-19. Some economists, such as Jordi Gali, Refet Gürkaynak and Deborah Lucas, argue for a so-called “helicopter airdrop” of cash to support fiscal policy.
What they mean is that central banks give new money directly to their governments that would never need to be repaid – this is called direct monetary financing. This would eliminate the need for these governments to issue additional debt in the markets.
It is probably too early to resort to such financing, without seeing the duration of the crisis and the effectiveness of QE in supporting governments in debt financing. In the meantime, more could be done to spread the debt burden across generations.
For example, governments could issue debts with very long maturities like 50 or 100 years, or even debts that never mature – so-called perpetual debts or consolations – as is common in wartime finance. British Chancellor Rishi Sunak is currently being urged by many in his party to think along these lines.
It is also important to realize that direct monetary financing is not a free lunch.
Unfortunately, there is no magic money tree in economics. Ultimately, current government spending is a claim on real resources that must be financed either directly by future taxes and growth, or by lower future spending, or by future inflation (which is a tax on money and creditors).
The crisis will, however, mark a change in the relationship between governments and central banks. Blurring the lines between the two, even through QE, forces them to coordinate their actions much more closely. In the post-COVID era, the notion that central banks are independent of governments is bound to be toned down somewhat.