05 07 2020

How to pay for the next crisis

“Survival of the fattest”. Sculpture by Jens Galschiøts in Ringkoebing, Denmark. “Survival of the fattest”. Sculpture by Jens Galschiøts in Ringkoebing, Denmark. https://www.visitringkoebing.dk/sevaerdigheder/kunstvaerker/survival-of-the-fattest

The economic crisis caused by the new corona virus has in the advanced economies been paid for in the same way as the 2007-2009 Great Financial Crisis: pumping money into the financial sector and increasing public expenditure. Result: more public debt to be paid back in the future, basically by common people. This cannot continue eternally. The next crisis has to be financed otherwise, shifting the burden to those who sit on the cash.

Very few economists are now questioning the need for governments to do something to sustain demand during an economic crisis, be that through increased public expenditures or tax breaks. Despite that a couple of decades ago there were very influential economists claiming that this would not work, because people are clever enough to anticipate that this largesse has to be paid back in the future and will therefore react by reducing their own demand correspondingly. Nobel prices in economics were even handed out for this nonsense (I shall return to that in another article).

But that was then. The shock from the 2007-2009 financial crisis caused a change in mood. There was suddenly a very broad support for increasing the public deficit to stimulate demand and avoid the economy spiralling down in a self-enforcing process. And this has been repeated during the corona crisis. So all the neoliberal hullabaloo about self-regulating capitalism was discretely put aside (unfortunately only to be dusted off and reused later, but that is another story).

But what about the soaring public debt?

The 2007-2009 economic crisis and the policy response to it caused the public debt in most advanced economies to increase to a high level, and in most of them it has stayed high since. Now comes the corona crisis on top of it. We don’t know yet how strong the impact will be, we don’t know if there will be a second wave of the virus, and so on, so here is a lot of uncertainty. The International Monetary Fund, IMF, has made projections for the coming years, which it has updated regularly. The latest is from 24 June 2020.

Bearing in mind the uncertainty, IMF expects that the public debt world wide will increase from around 83% of total production (GDP) in 2019 to 103% in 2021. For the US, the forecast is an increase from 113% to 143%, for the Euro-area from 84% to 103% and for Japan from 238% to 265%. This is mainly a developed country phenomenon, as the expected increase in public debt in the so-called “emerging” market economies (as China, India, Brazil, Russia etc.) is much lower. The same is the case for the developing countries – for these this is in many cases simply because they don’t have the option to increase the public expenditure to meet the corona crisis as they don’t have access to international capital markets. And they can’t just print money.

There is a lot of discussion regarding what a “too high level” of public debt is. As the interest rate on government bonds in many developed countries presently is so low (close to zero), it can be argued that this debt can simply be financed with long-term bonds and these can subsequently be rolled over later when needed. So what is the problem? Look at for how long Japan has been increasing its public debt to levels hitherto unheard of, and still they have no problems financing it at a ridiculously low interest rate of 0.033% on a 10-year government bond. Or what about the recent Austrian 100-year bond (in Euro) with a yield of 0.88%?

It is clear that this bonanza is limited to countries that don’t have problems emitting bonds in their own currency – basically in US dollar, Euro, Japanese Yen and British Pounds. For other countries, this is much more difficult. China has to pay an interest of around 3% on a 10-year government bond, while Brazil, India and Russia have to pay 6-6.5% and Turkey around 12%. Against this background it is not difficult to understand that these countries are reluctant to follow the lead of the advanced economies and just increase public expenditure and public debt with what it takes to counter the corona virus crisis.

Truth is, we don’t know what the consequences of the increasing public debt mountain are in the longer run. This is unknown territory.

So how to pay for the next economic crisis in a way that is not just piling up more public debt? In the short run, the most important is that the households can sustain their necessary consumption and that small enterprises don’t go bankrupt and close down. In the advanced economies one of the main expenditures for a household is housing, be that rent or mortgage. For the small enterprises rent is an important cash drain as is payment on loans. A temporal general debt moratorium on existing loans and a temporal waiving of rents is an obvious way of giving survival aid to households affected by unemployment or to small enterprises suffering under lack of demand. This would not be forgiving loans, but simply freezing pay-back for a period with no accumulation of interests. This would bring relief without just piling on more public debt.

Who would the losers be from such a scheme? Rents and debts constitute a long chain. The main strain on owners of e.g. a commercial centre or an apartment building who would not receive rents for a period is often servicing their debts, be that to the bank or via corporate bonds. In that case they would benefit from the moratorium themselves. The end of the chain s obviously the owners of capital, be that banks, capital funds, pensions funds or individual owners of shares and bonds. So the cost will be spread out on not only wealthy owners of capital but also on more humble wage earners who will see their future pension shrink or their savings losing value. But as the measure is temporal, the effect will not be devastating. And as the distribution of wealth is very unequal, the main burden will fall on those who are best able to shoulder it.

But what about the banks who’s main business is supposed to be lending out money? They will of course suffer from lost income for a period, but as the loans are not considered in default it will not affect their balance sheet. As a result of the interventions from the central banks, the advanced economies are awash with cash, so a cash-crunch is not an immediate threat either.

The main challenge is probably legal, and it is further complicated by cross-border loans. But in times of crisis, crisis measures are necessary.

Still, it is likely that more will be needed to stimulate demand to lessen the impact of the next economic crisis (whatever its origin). It is often presented as if during an economic crisis the most important is to increase the fiscal deficit so to sustain overall demand. But the way it is increased matters a lot, and some ways of stimulating the demand are less costly than others, meaning that the same effect can be obtained with a lower public budget deficit. And the distributive effect varies.

To sustain demand and hence production and employment, the effect of lowering taxes is very different from e.g. increasing infrastructure spending, improving public sector services or increasing transfers to low-income households. Lowering taxes in general increases the budget deficit, but the effect on overall demand is uncertain. If the tax on capital income is lowered, the effect during an economic crisis is negligible – the capital owners will just sit on their extra cash, waiting to see what happens. If it is for low-income households, it is likely to help sustain their consumption and will hence have a much stronger effect. If it is linked to behaviour, e.g. providing tax-breaks or subsidies for investments that are considered socially beneficial, it is likely to increase private investment with an amount that is considerably bigger than the cost to the public finances. It could e.g. be investments in renewable energy, energy saving, housing improvements, environmental improvements, or the like. The public expenditure will in this case mobilise private, otherwise paralysed funds. And if increased public expenditure implies bringing forward needed investments in public infrastructure, the increased public debt will be mirrored by a lower need for public investment in the future. To state it briefly: the way the measures to counter the crisis are put together has implications for their efficiency – and for the distribution of incomes.

After years of austerity in many European countries, the public coffers have suddenly been thrown wide open during the corona crisis. It has been amazing to see, how the politicians have tried to overbid each other in proposals for spending public funds. In some countries compensating private firms for not furloughing their workers, providing direct cash subsidies to households, approving rescue packages for selected big firms, stretching the period for unemployment benefits, etc. There has been no real discussion of what impact these measures would have, but rather pure horse-trading: if you give me this for my constituency, I will give you that for yours.

Before the next crisis is over us and the panic spreads again, there should be a real analysis and discussion of the options and their consequences. We can’t go on like this.


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Thorbjorn Waagstein

Thorbjørn Waagstein, Economist, PhD, since 1999 working as international Development Consultant in Latin America, Africa and Asia.

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