A view of the east steps of the United States Capitol Building.
A personal view from Ian Steward, Deloitte’s Chief Economist in the UK.
Governments around the world have responded to the pandemic by borrowing, and spending, on a vast scale, equivalent to 12% of world GDP. Twelve years ago, in the financial crisis, monetary policy did the heavy lifting in supporting growth. Now, with interest rates near zero, the burden has fallen on fiscal policy.
The level of government debt fluctuates over time, with war and recession driving it higher, and faster growth taking it down. Four decades of expansion after the Second World War shrank UK public sector debt from a wartime peak of 250% of GDP to 30% by the mid-1990s, close to the lowest-ever level. Since then it has risen inexorably, to 40% on the eve of the financial crisis and 75% in its wake, 103% today and, on IMF forecasts, a likely 115% in 2023.
This is an historic shift, one which takes debt to levels that have only ever been seen in the wake of the Napoleonic War and the First and Second World Wars.
The surge in public debt in the financial crisis led, as growth came back, to programmes of tax rises and spending cuts across the West as governments sought to reduce borrowing. A broad coalition of mainstream political parties and international institutions including the IMF and the European Commission favoured curbing levels of debt.
The concern was that high debt levels would make countries more vulnerable to future shocks and make it harder for governments to counter them. Shortly before becoming chancellor of the exchequer, George Osborne remarked that “while private sector debt was the cause of this crisis, public sector debt is likely to be the cause of the next one”. The widely held view was, as Mr Osborne subsequently put it, “the time to repair the roof was when the sun is shining”.
In the US Harvard economists Carmen Reinhart and Kenneth Rogoff warned that debt-to-GDP in excess of 90% would pose a significant obstacle to longer-term growth. They argued that high and rising debt levels could cause investors to take fright, and demand higher interest rates for holding government debt, which would push up borrowing costs and lead to painful budget cuts. Their research was widely cited by politicians in the West at the time.
Since then public sector austerity has, in many countries, only slowed the rate of growth of public debt, rather than reduced it. Yet there has been no backlash in public debt markets. On the contrary, weak economic activity and low inflation have increased the allure of government bonds to investors, driving interest rates on them even lower. In the UK, the willingness of financial markets to finance government borrowing, weak growth and fatigue with austerity slowed the process of debt reduction. Indeed, the government proclaimed the end of austerity three years ago despite the fact that the UK is continuing to run a budget deficit.
So the pandemic arrived into a world of already elevated government borrowing, where traditional rules of balancing the books held less sway. The pandemic has dealt a further blow to such notions. High levels of public borrowing are here for some time to come.
The zeitgeist on public debt has been transformed. In an inversion of its advice a decade ago, the IMF has been joined by leading central banks in urging governments not to tighten fiscal policy and prematurely cut off the recovery, while the European Commission is embarking on an unprecedented programme of joint-EU debt issuance. There are no signs that voters are keen on either spending cuts or tax hikes to rein in the deficit.
So why, as countries exceed the 90% marker set out by Reinhart and Rogoff, are policymakers not talking about austerity?
Debt financing costs have fallen still further, making it much easier for governments to finance borrowing. The UK government currently pays interest of 0.2% to borrow for ten years, less than a quarter the rate at the start of the year. As a result, the UK’s overall debt financing costs are lower now than they were with far lower debt levels a year ago.
In a perilous world, the safety offered by government bonds is more attractive than ever. Quantitative easing programmes have made central banks big buyers of government debt, further fuelling demand and driving down interest rates.
As the economy recovers, and the growth rate outstrips the low interest rate on this debt, the ratio of debt-to-GDP should begin to unwind organically. Even if interest rates do rise, the average maturity of UK government debt is 15 years, meaning the overall financing costs are unlikely to
In the higher interest rate era of the 1970–90s, it was thought that high levels of public borrowing and spending might “crowd out” private-sector borrowing and activity. Today, with activity vastly below normal levels, the problem is of excess capacity and insufficient demand. With the private sector unable to do so, the government becomes, in Keynesian terms, the borrower and spender of last resort.
This story is playing out in the US election, where investors appear to see the benefits of greater fiscal stimulus under a Joe Biden administration more than outweighing any negative effects from higher taxes or greater regulation.
Biden is the strong favourite to win Tuesday’s US presidential election. The electoral model run by Nate Silver, the US pollster, puts the probability of a Biden win at 89%. The Economist’s model assumes an even higher probability, of 96%. The New York Times estimates that even if the polls were as wrong as they were in 2016, Biden would still win by a wide margin.
However, it is quite likely that a clear victor will not emerge on election night, and, possibly for weeks or, indeed, months. Trump has questioned the validity of postal votes and suggested he might refuse to concede defeat. This could lead to days or weeks of uncertainty and legal battles in the case of a close outcome.
As president, Biden would have discretion over trade matters, foreign policy and regulation, areas in which he could reverse many of Mr Trump’s policies. But to pass tax and spending legislation, Mr Biden would need the Democrats to take control of the Senate. With a Biden win seen by many as a foregone conclusion, the Senate battle is likely to be a major focus on election night. Most forecasters expect the Democrats to take the Senate, though this is likely to be a closer fight than for the presidency.
A Biden administration is committed to raise income and capital tax rates on higher earners and partially reverse Trump’s corporate tax cuts. A Democrat president and Senate would probably increase public spending significantly, with a pandemic recovery package and a programme of green infrastructure, healthcare, education and R&D expenditure. Other Biden policies would strengthen the position of workers, including a higher federal minimum wage and paid family and medical leave. Our reading is that investors tend to see the beneficial effect of greater fiscal stimulus on the economy under a Biden administration outweighing the drag from higher taxes and increased regulation.
The IMF has observed that the current backdrop of cheap money and insufficient demand creates the perfect environment for greater public investment. The fastest returns come, according to the IMF, from smaller or modular projects like infrastructure maintenance or renewable energy installations that are labour-intensive and can be rolled out quickly. The biggest projects operate with longer leads and carry the risk of cost overruns and delays.
None of this is to say that the limits to public borrowing have been removed. If the economy fails to recover to pre-pandemic rates of growth, the government could be faced with a permanent imbalance between the burden of public debt and the economy’s ability to finance it. The picture could worsen further if inflation were to rise markedly, driving investors to demand higher yields on government debt. Past debt crises have come out of the blue, as bond markets can quickly change their minds about fundamentals.
But, for now, borrowing and spending is the only game in town. The UK’s new lockdown has already triggered the extension of the furlough scheme. More spending is sure to follow, as it will if Biden wins the presidency and secures the US senate. The attitude of policymakers has changed. The balance of opinion has shifted to maintaining fiscal support, until the recovery is secure, something which is looking ever more distant. We are in an age of bigger, more activist government.