Dealing With Pandemic Debt Will Mean Breaking Some Taboos

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(Bloomberg Opinion) -- Defeating the coronavirus could result in public debt approaching that of the two world wars and certainly comparable to the financial crisis. At the same time, the traditional routes out of that debt hole are closed off. A different strategy is required now.

The robust economic growth that powered the Western world after World War II is now highly unlikely. But battered societies won’t tolerate the austerity measures they accepted after the financial crisis, despite protests to the contrary from the Bank of England and the European Central Bank that new measures don’t amount to debt monetization. And yet today’s crisis calls for questioning old taboos.

The U.K. government’s present rescue measures involve subsidies for employment, financial support for the unemployed and self-employed, and loan guarantees and other funds for business. By mid-April, various government pledges amounted to 6% of gross domestic product, while the U.S. package was already around 9% of GDP. The cost to governments could far exceed these figures depending on how long the pandemic rescue lasts, how many of the guarantees are called upon because of defaults, how much revenue is lost from recession, and the scale of any necessary further government assistance.

Even when shops, restaurants, offices and factories are allowed to reopen and hire staff, business will be slow as apprehension about social mixing and fears for the future diminish consumer demand. Continued support — buttressed by government debt — will be needed for the unemployed and to keep ailing firms going. We may also need a big injection of demand like that provided by the 2009 coordinated, fiscal expansion and later the Chinese investment boom.

Meanwhile, those companies that survive the lockdown will be loaded with debt and will want to improve their balance sheets rather than invest. This could lead to what has been called a balance-sheet recession — a phenomenon first recognized in Japan, which seemed to be trapped in an endless process of stagnation and deflation as a result of corporate debt accumulated in the financial crisis of 1989 to 1990.

Prime Minister Shinzo Abe sought to break out of the cycle by using highly expansionary fiscal and monetary policy. That combination — now referred to as Abenomics — could yet be called upon in Western countries as other means of escape prove elusive. Postwar debt — rising to 250% of GDP for the U.K. following World War II — ceased to be an issue because strong economic growth brought down the debt-to-GDP ratio. Global conditions make a comparable growth spurt unlikely.

Japan’s high debt-to-GDP ratio (234%) is sustainable in part because the borrowings are financed primarily by patriotic domestic savers. But public debt in the West is now largely financed by market borrowing and depends on the “kindness of strangers.”

The attention of these strangers will inevitably be drawn to countries with levels of debt that are already high and could soon seem unsustainable, even with the cost of borrowing at an all-time low. Not all countries are in the same position. The U.S. can borrow in its own currency from creditors, the most important of which, China, has a strong self-interest in maintaining the value of the dollar. And the U.K., with debt at 86% of GDP, is in a slightly stronger position than members of the euro zone because it can, if necessary, let its currency devalue. Greece already has a debt ratio of 188%, while Italy is at 133%, France 99% and Spain 96%.

Japan pioneered quantitative easing, even before Abe, with large-scale purchases of government bonds by the central bank with the aim of driving down bond yields. The Japanese central bank finances government deficits directly by buying up new debt, with no expectation that it will be repaid. Japan’s strong overall economic performance and dedicated armies of savers mean this unorthodox system works. But will it travel?

Some fear that the use of QE by the ECB in particular, but also by other central banks, already amounts to monetization since they suspect that the QE will never be reversed by the sale of bonds back into the market. Although this deliberate blurring of the line between monetary and fiscal policy isn’t to be taken lightly, the two traditional arguments against monetization — that it will lead to hyperinflation and that it raises the risk of “moral hazard” — no longer seem relevant to today’s monetary environment. Japan (and now other countries) are more worried about deflation than inflation. And moral hazard is more easily navigated in a crisis, since electorates can tell the difference between the world finding its way out of a global rut, and individual governments which are just repeatedly careless with money.

The BOE and ECB governors continue to insist that monetization of debt even in today’s circumstances would be a breach of monetary orthodoxy and a dangerous precedent. Yet for different reasons both may have little choice but to follow Japan’s example.

The euro zone is in a particularly weak position, as it shoulders the burden of some already vulnerable economies and lacks a binding federal government to make fiscal union work alongside monetary union. It is difficult to imagine that its weaker economies will now submit to the euro-zone disciplines imposed on Greece while remaining under democratic governments. Patience has worn thin across Europe, with populist movements winning significant electoral support.

Meanwhile, in the U.K., Boris Johnson had already recognized — before coronavirus but after a decade of austerity — that voters were asking the Groucho Marx question, “What has the next generation ever done for me?” He sought to break the cycle of Labour governments borrowing to spend and Conservative governments cutting spending to reduce debt. Instead, his Conservative government promised to reverse the austerity imposed by its predecessors. Johnson may yet find Abenomics a perfect way to keep his word.

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

Vince Cable is a former U.K. secretary of state for business and was leader of the Liberal Democrats from 2017 to 2019. He was previously chief economist at Royal Dutch Shell. He is currently a visiting professor at the London School of Economics. His next book, "Politicians and the Politics of Economics," will be published later this year.

©2020 Bloomberg L.P.

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