Government in an age of debt
Bond market vigilantes may have disappeared, but fiscal policy choices remain important
Welcome to small world, a new series of notes on the global economy from a small advanced economy perspective. Read to the end of the note for the chart of the week, and a selection of developments from around small economies.
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Government in an age of debt
The world entered the Covid-19 crisis with government debt levels near all-time highs, at 89% of GDP in Q1 2020. On top of this, the IMF and OECD forecast a jump in public debt of 15% of GDP or more across advanced economies by 2021 as governments run substantial fiscal deficits in response to the collapse in economic activity.
Across the OECD, the average fiscal deficit in 2020 is forecast to be between 11% and 13% of GDP under different scenarios, up from 3% of GDP in 2019.
The case for fiscal deficits
This fiscal response is appropriate given the scale of the shock. In its latest Economic Outlook, the OECD continued to recommend aggressive fiscal policy action to respond to the steep contraction in global economic activity.
It is clearly too early to start reducing this debt load. Short-term attempts at fiscal consolidation would be self-defeating as fiscal tightening would deepen the sharp recession.
And the structurally lower interest rates, reinforced by aggressive monetary policy action in response to Covid-19, increase the carrying capacity for government debt. 10-year bond rates are below 1% in most advanced economies, and below zero in many small economies (Switzerland, the Netherlands, Denmark). Indeed, Austria recently issued another tranche of 100-year government bonds at a remarkable 0.88% yield.
Given the need for structural transformation of economies (green, digital, infrastructure), the attractions of deficit-financed spending are obvious.
Indeed, there has been a pronounced shift in the centre of gravity in the global fiscal policy debate over the past several years. Even short of accepting MMT (modern monetary theory), the consensus is now much more relaxed about public debt accumulation.
But there is a risk that a view that ‘deficits don’t matter’ gets taken too far, driven by the experiences and perspectives of large countries like the US and Japan.
The small economy experience
It is instructive that small advanced economies, from Singapore to the Nordics, run more disciplined fiscal policy approaches than larger economies. Public debt levels are markedly lower in small economies than in large economies despite relatively high levels of government spending.
Small economies have provided substantial amounts of fiscal stimulus over the past several months, supported by a strong fiscal starting position. But from Ireland to New Zealand, small economies are also starting to think through medium-term options for debt reduction – recognising limits to debt accumulation.
This reflects systematic differences between small economies and large economies like the US and Japan. Small economies are more exposed to economic shocks that can cause fiscal positions to unwind quickly, and so act in a more cautious manner. High public debt levels can create significant economic exposures.
The historical record also suggests that ‘growing your way’ out of debt (when nominal GDP growth is higher than the borrowing cost) is more of an option for economies like the US. Although this relationship has held recently for small economies, there are risks in relying on it over longer periods.
And financial repression (imposing losses on creditors) is more challenging to execute for small economies.
But as importantly, small economies place less emphasis on aggregate fiscal policy to generate strong economic and social outcomes. For example, the strong record of small advanced economies on employment generation and inclusive growth is primarily due to sustained investment in education and skills, high quality labour market policy, and social insurance - and not primarily to fiscal policy.
Deficits are not the answer to everything
Fiscal stimulus is a valuable element of economic policy, particularly in times of crisis, but it is not the main game for most small economies. Indeed, there is no obvious relationship between high public debt levels and sustained economic and social performance.
Although the consensus around fiscal policy has clearly changed in a low interest rate world, the small economy experience shows that context matters. Some economies face tighter fiscal constraints than others, and different economies will strike the balance in different places. There are risks in applying universal policy approaches.
And, as discussed in my last note, those economies that will do best in terms of the Covid-19 recovery are those that position themselves for a new world, not just those that grow their public sector balance sheet by the most. The quality and composition of the fiscal spending matters, particularly given the already record levels of public debt.
Fiscal stimulus will be an essential part of the policy response to Covid-19, but it should increasingly be seen as a support to policies that strengthen economic potential – from investing in training and innovation or in green infrastructure – rather than an end in itself.
Much higher levels of public debt will be a central feature of the new normal, and it is important that governments manage this in a disciplined way. Bond market vigilantes may have disappeared, but that does not mean that governments should completely relax about public debt accumulation.
Government budget constraints have been relaxed not eliminated, and hard choices will be required over time. In this area, as elsewhere, there is much to take from the small economy policy model.
Chart of the week
Small advanced economy out-performance continued into Q2: the GDP contraction for the group in the year to Q2 (9.3%) was much less pronounced than for most large advanced economies.
Around the world
‘Only two issues in the United States are truly bipartisan: a caution about China and devotion to Ireland’. The strength of Irish soft power has been on show as PM Johnson introduced legislation in the UK to break international law. Small countries need friends, and Ireland has proven adept at making them: it turns out that the special relationship is stronger with Ireland than it is with the UK.
Not a V-shaped recovery profile. New Zealand’s Pre-Election Economic & Fiscal Update forecast a less marked GDP shock in 2020 than previously expected, but a less rapid recovery process: it will take until the end of 2022 before GDP returns to Q4 2019 levels. Refer here for summary charts.
Sweden and Israel show that performance in controlling Covid-19 can change over time. Sweden now has new cases below the Nordic average, while Israel is having to lock down again after a surge in cases. And many other small economies are experiencing a second wave. But Finland’s national preparedness has positioned it well to manage the crisis; including the use of Covid-19 sniffing dogs at Helsinki airport…
Employment data out over the last week in Singapore and Hong Kong underlines the economic contraction underway, with employment growth in reverse (-6% and -3% respectively). But while Singapore has been rolling out aggressive fiscal stimulus and other measures, Hong Kong is acting in a more conservative manner.
A new Clingendael survey of 23,000 Dutch people found high levels of support for greater cooperation with France and Germany, and that an increasing share saw the US as a potential threat (at only slightly lower levels than Russia and China). Even in an historically Atlanticist, small open economy, new geopolitical realities are causing a rethink.
And as the 75th General Assembly of the United Nations convenes (virtually) this week, with warnings exchanged between the big powers, small states are emphasising the importance of a rules based global system. Singapore’s PM Lee said in his address that the system had ‘given small states like Singapore a voice, and a stake in the global commons’.
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