Public Debt Isn't the Problem, Soaring Deficits Are

Governments are borrowing like never before to shield their economies from the pandemic.

Given how cheap it is to do so, thanks to central banks maintaining negative and low interest rates and buying up bonds en masse, this hasn’t been a problem. But debt and deficits are set to remain elevated for years to come. This will complicate policy makers’ ability to balance growth and deficits in the future, raising the risks of a boom-bust cycle followed by years of government austerity and market stress. The only way to ensure a lasting pandemic recovery and avoid a financial crash is to adopt a long-term vision for sustainable growth.

Global GDP fell by more than 4% last year, compared with a 0.1% decline during the global financial crisis. The euro area alone suffered an unprecedented 7% shock in 2020, versus a 4.5% decline in 2009. Meanwhile, government borrowing in the developed world has jumped by a record 60% in the past year — almost double the pace that preceded the euro sovereign debt crises a decade ago. 

This central bank-funded fiscal action has allowed countries to prop up the balance sheets of entire economic sectors, from hospitality to aviation and from households to local governments. The result is that debt in both the euro zone and the U.S. has now eclipsed the size of their economies.

This is not presently a reason for market concern, thanks to the extraordinary measures taken by the U.S. Federal Reserve and the European Central Bank to absorb new government issuance and keep bond yields — and thus the cost of debt as a share of GDP — historically low. But the question is: What happens to market confidence and borrowing costs in the future?

While the effects of Covid on growth tend to be seen as mostly cyclical and transitory, the effects on debt and future borrowing needs are structural and long term. From the starting position of record-high borrowing volumes and record-low borrowing costs, it follows that the direction for both cyclical and structural forces is toward higher future borrowing costs as market equilibrium rates adjust.

This has indeed been the case. Just look at the past year’s steepening of benchmark government yield curves and the recent rapid rise in bond yields, despite unchanged policy rates and with central bank quantitative easing extending the maturity of government debt piles. U.K. Chancellor of the Exchequer Rishi Sunak has already expressed concern about higher borrowing costs.

The pandemic has also aggravated chronic fiscal vulnerabilities. In the euro area, government financing needs — the sum of fiscal deficits and maturing debt — are projected to remain sizable over the next two years, at near 20% of GDP, and stay higher than pre-crisis levels thereafter. Even in the event of a swift recovery and unchanged policy rates, debt ratios are projected to continue to rise well into the middle of this decade and remain well above pre-Covid levels into the 2030s.

For markets, it is fear of uncontrolled debt growth where crises are born.

The role of central banks as financial cycle regulators during the pandemic remains critical and will prevent liquidity gaps in debt markets over the short term. But the ECB’s assurances on Thursday that it will intervene to prevent a near-term tightening of financial conditions is neither a commitment to targeting lower future bond yields nor to buying infinite amounts of government debt for the rest of the decade.

This still leaves markets to ponder the long-term legacy of Covid, via the interconnected parts of debt, the recovery, inflation and fiscal versus monetary policy choices.

This matters especially in the euro zone where, after Covid, fiscal stress is no longer a “peripheral” problem: Higher debt has left three of its four largest borrowers — France, Italy and Spain — much more vulnerable to a rise in borrowing costs and another growth shock. Without a closer European Union, these stresses are not within the power of the ECB to forestall or underwrite indefinitely.

Nor will the Fed be able to guarantee a cheap cost of debt if markets decide that large U.S. fiscal deficits, the rocket fuel of $1.5 trillion in consumer savings, and the Fed’s “average inflation” framework will succeed in reflating U.S. growth. Arguably, markets do not need to see sustained inflation volatility to price deflation out of bond market valuations and raise borrowing costs.

Similar to where we were after the global financial crisis, Europe and the U.S. are facing a new era of worrisome debt growth and structural disrepair. Governments need to plan now for how to tackle the twin challenges of debt and growth sustainability after Covid-19.

This first means sustaining fiscal lifelines to avoid deeper Covid scarring on the economy. But it also means transitioning away from one-off programs focused on propping up demand and toward targeted supply-side measures focused on rebuilding growth. These measures should include incentivizing long-term business investment, upskilling workers, rebuilding domestic supply chains and international markets, and developing green markets, industries and jobs.

Raising our economies’ growth potential is critical for long-term debt sustainability, as higher potential growth would secure a low-inflation recovery, extend central bank support for low borrowing costs and reduce future borrowing needs. All three levers would support market confidence in high public debt sustainability and a long-lasting post-Covid rebound. The alternative would be a new financial crisis and a lost decade for growth.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Lena Komileva is managing partner and chief economist at G+ Economics, an international market research and economic intelligence consultancy based in London.

©2021 Bloomberg L.P.

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