Covid-19 Response: Don’t Lose Sleep Over Mounting Government Debt
The blow-out in fiscal deficits around the world triggered by the Covid-19 pandemic is leading many to ask: how are we going to pay for all of this? Aren’t we imposing a huge debt burden on future generations? Surely a day of fiscal reckoning will come. That is the wrong way to look at things: government debt issued in domestic currency never actually has to be repaid.
From a macroeconomic policy perspective, the size of the budget deficit should be driven by how far from full employment the economy is and how much inflationary or deflationary pressure there is, not concerns about how much debt the government is accumulating. The deficit and associated level of government debt should be a policy instrument, not a target.
We are used to talking about government finances as if the government were like a household and had to ‘finance’ its deficit by issuing bonds, ‘borrowing’ the very money that it creates. This is an artifact of the separation of monetary from fiscal policy.
Adjusting The Prism On Deficits
When the government spends to buy goods and services, hire people or make transfers it injects purchasing power or ‘money’ into the economy and when it taxes it withdraws it. The budget balance represents the net spending power the government either injects into the economy when it runs a deficit or withdraws from it when it runs a surplus.
Depending on how much quantitative easing the central bank does, the money so created can take the form of either government bonds or central bank reserves. The two are just alternate forms of liabilities of the consolidated government (the government including the central bank). Private sector entities hold those liabilities as assets or financial wealth.
The national accounting identity shows that, for the world as a whole, as sure as water flows downhill, when there is an excess of private sector savings over investment there must be a corresponding excess of government spending over revenue. Think of the corresponding bonds the government issues as being the asset it supplies to satisfy the private sector’s appetite for extra savings.
Deficits, far from being a burden on our grandchildren, help households transfer purchasing power into the future.
It is the damage to the productive capacity of the economy wrought by recessions that is the burden on future generations.
Inflation, Down The Road?
Central bank reserves are different from government bonds in one crucial respect: while a government bond typically has a maturity date, making it look like it has to be repaid, central bank reserves never have to be repaid, in the same way that the government never has to repay a dollar bill.
In principle, as quantitative easing shows, the government, via the central bank, can always convert bonds into reserves, rendering moot with the tap of a keystroke the notion that it needs to repay its debt. In practice, society generally curbs the government’s ability to do this—in the case of the euro, in an extreme way—but that is a constraint to be loosened when it makes sense to do so, not a God-given fact.
If they never have to repay their debt, does that mean governments can run budget deficits and print money willy-nilly?
Absolutely not: there is no fiscal free lunch when it comes to real resources. The government still faces the constraint that, if it creates too much purchasing power relative to the economy’s capacity to produce, it will cause high inflation as “too much money chases too few goods.” To curb that impulse is why the innovation of an independent central bank evolved in the first place.
The money that governments around the world are creating now runs no risk of causing inflation any time soon. Output has collapsed due to the pandemic-induced shutdown and much of the fiscal red ink is being split to buoy private sector incomes.
In the U.S., in thirteen weeks the equivalent of 27.8% of February’s work-force has filed unemployment claims and another 3.8% has dropped out of the work-force, not to mention millions of idle workers who are benefiting from the Paycheck Protection Program. If and when households start to unleash their spending power, there will be plenty of spare labor to accommodate the demand without the economy hitting up against inflationary resource constraints.
But what will happen if, once the dust settles on this horrendous period, the private sector purchasing power associated with the elevated stock of government debt threatens to cause inflation because it starts to overwhelm the capacity of economies to produce? From the current vantage point, in the U.S., the euro area, Japan and other developed economies that would be a nice problem to have.
Then, policymakers will have to rein in the inflationary aggregate demand via some combination of central banks raising interest rates and doing quantitative tightening and by governments cutting spending and raising taxes. Any such tax hikes will be to help drain purchasing power from an economy having too much of it, not to raise the money to finance spending or pay off government debt.
It is possible that, in the future, some governments will have to run budget surpluses as part of an overall macroeconomic policy mix aimed at reining in demand in an overheating economy. This will be because there will be too much spending power in the economy, not because the government needs to repay its debt.
Paul Sheard is a Senior Fellow at Harvard Kennedy School and formerly held chief economist positions at leading institutions in New York and Tokyo.
The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.
Note: This column was amended to include the latest unemployment update in the U.S.