The coronavirus crisis has led to unprecedented declines in economic activity and increases in central bank balance sheets and government debt. With the recovery in risk assets, markets seem to be telling us the policy response has been proportionate to the problem. However, this “sea of stimulus” has caused many investors to worry about whether economies will drown in debt—even though it’s helping keep things afloat today. Is the concern over global economies’ ability to swim or sink merited? We believe the answer comes down to three key questions.
In this piece, we’ll explore the stimulus measures that governments and central banks have taken thus far and discuss how they might respond going forward—with insights for readers on what to watch as events unfold in 2020 and beyond.
Room to maneuver: Policymakers were not out of options
Going into 2020, concerns arose over whether countries like the U.S. had the fiscal and monetary capacity to provide economic stimulus in light of two challenges: the already large size of recurring government deficits and the already low policy rates set by central banks. With apparently little room to maneuver, what options were there to provide policy support if a shock occurred? At least temporarily, those concerns were unfounded. Fiscal and monetary policymakers showed they had the willingness and ability to do more.
Take a look at our map infographic, featuring a snapshot of four major economies’ monetary and fiscal policy positions.
Here are our key takeaways from the regional data:
- For monetary policy, central bank balance sheets have already begun to grow rapidly through asset purchases and credit support programs.
- For government debt levels, the debt burdens on the map reflect data as of the end of 2019, so they’re not updated to capture the coronavirus response.
- Some of the programs will affect the amount of debt issued, like payments to households, businesses, and local governments to provide economic relief.
- Other programs will not likely show up in debt statistics, like government guarantees of loans.
- Another noticeable insight on the map: Japan already had a very large central bank balance sheet and government debt load relative to its gross domestic product (GDP).
- That may give an indicator of at least how much more capacity other countries have to expand asset purchases or issue debt before pushing the limits.
Fiscal action: The bill will need to be paid, but not all at once
The fiscal outlook probably has investors worried as countries like the U.S. and Japan already were running deficits typically associated with recessions even during the economic expansion. It may be little consolation, but the U.S.’s debt-to-GDP ratio is still less than half that of Japan’s, showing that there may be quite a bit more debt capacity left in the U.S.
Regions that took measures presented them as temporary and targeted at dealing with the crisis. Instead of viewing the responses as a form of stimulus, it’s more accurate to think of them as a form of economic relief. This is important to keep in mind. Borrowing is a form of bringing future benefits into the present, which is exactly what relief is meant to do: take future economic activity or growth and shift it into the present to deal with an emergency situation. So what might happen next?
Providing more relief
It seems likely that countries might offer more relief, especially to help with the transition for many millions of people to get off unemployment benefits and back onto payrolls. It also seems likely that more relief might be needed for states and municipalities to deal with the economic hit to sales, income, and even property tax revenue. This means that, while budget deficits might be elevated for 2020 and possibly part of 2021, this does not mean the deficits must stay elevated indefinitely.
Focusing on the future
One way governments can deal with large debt levels is by trimming future spending or raising future revenue. Emergency spending programs should, by design, be temporary, but they often tend to become somewhat permanent. As a result, bending the spending curve can be politically difficult. A government can raise taxes to raise revenue, as the U.S. did coming out of World War II. In this example, the U.S.’s top marginal tax rates were very high relative to today’s standards—although few people or businesses actually paid those rates, thanks to a complex tax code containing all sorts of deductions, exemptions, and exclusions. Faster growth can also help expand a country’s tax base, something that regulatory policies could potentially enable (what those specific policies entail is open for debate). Given how slow—yet stable—economic growth was in the wake of the 2007–2008 financial crisis, policymakers may take regulatory or economic reform approach as a first-best option for trying to deal with debt incurred to provide relief.
We expect that, as these temporary spending programs sunset, a bending of the government spending curve can happen. The most likely solution to the government debt issue is a combination of bending the spending curve and raising revenue. This can play out over decades; debt does not have to be paid back immediately. During the 1950s and 1960s, that’s how the U.S. dealt with the debt it accumulated during World War II. Monetary policy can also play a role in dealing with accumulated debt, as we’ll discuss in the next section. However, just as an example, if interest rates on government debt stay less than the growth rate of government revenue—which is typically thought of as growing in line with nominal economic growth—a country can gradually shrink its debt relative to the overall economy. With interest rates around 1.5% on long-term debt and if nominal GDP grows around 4% (2% inflation plus 2% real growth), debt relative to GDP can shrink 2.5 percentage points per year.
Monetary action: Inflation takes more than money creation
Many investors seem to be worried about the bloated balance sheets of central banks. Central banks purchase assets by issuing reserves or currency—some refer to this act of expanding a balance sheet as a form of “money printing.” However, it’s not literally money printing, as printed bills and notes are used to satisfy the public’s demand for cash. The type of money printing that happens today is more like an accounting entry in electronic records:
- The central bank buys an asset and creates a bank deposit.
- A bank sets aside some of that deposit as reserves but can then lend out the rest.
- The loans become deposits at another bank.
- The deposits can serve as the basis for more loans.
That’s how the money creation process works. If there is too much money chasing too few goods, prices rise and those rising prices equate to inflation.
The inflationary effects of monetary policy depend on many steps taking place. Central bankers wanted to keep credit flowing to prevent temporary liquidity problems for households and businesses from morphing into solvency problems. Unlike the condition of banks during the run-up to the Great Financial Crisis, banks were much healthier in the run-up to the coronavirus crisis of 2020. That made it easier for central banks to help keep credit flowing, providing a type of “bridge loan” to their various economies, to help see households and businesses through the crisis.
Whether those bridge loans need to become a form of permanent financing remains to be seen. But as long as a second wave of shutdowns does not occur, the government can likely set these temporary and targeted programs to expire, with the assets acquired by the central banks naturally rolling off. In other words, central banks can gradually reverse the reserves created by money printing over time. Also, central banks can help control how quickly reserves become money, given their abilities to:
- Incentivize banks to lend more or less through interest on reserves
- Regulate banks’ abilities to lend
Monetary policy can interact with fiscal policy and help keep fiscal policy sustainable. Keeping interest rates low—sometimes referred to as “financial repression”—is one way to slow the growth of debt. Arguably, that approach helped the U.S. government fund its deficits in the post–financial crisis world. This also has helped Japan finance its government debt load since the 1990s.
Can the financial repression approach be useful now? One way to make it work: encourage high volumes of debt purchasing by two types of captive buyers:
- Interest-rate-insensitive buyers of debt, such as central banks
- Certain institutions—such as banks and insurance companies that governments can require to be captive debt buyers
This approach, however, does run the risk of “crowding out” those institutions’ abilities to invest in other types of assets that could help finance more productive activities. In this way, dealing with large levels of government debt can serve as a drag on growth. However, it could be a very subtle and small drag that plays out over decades.
Final thoughts on the sea of stimulus
Policymakers have tried to provide economic relief throughout the uncharted waters of a pandemic-induced global crisis, but that relief has caused worry among market participants. Is the worrying justified? Here’s our perspective on the sea of stimulus’ potential implications:
- On the monetary side of things, inflation does not have to accelerate, especially if business activity is quicker to come back than consumer activity. Based on early indicators we have so far, that seems like a good base-case scenario.
- The longer-term issue is on the fiscal side of things, which was already worrying coming into the coronavirus crisis. Even that could be manageable, though. Historically, four variables can combine over the long term to bend the debt curve:
- Financial repression (keeping rates artificially low)
- Growth-enhancing policies
- Future fiscal restraint (which seems unlikely)
- Higher taxes (which do seem likely)
In addition to watching higher-frequency economic data, such as continuing jobless claims, to gauge how the economic recovery is progressing, we recommend watching inflation breakevens—stemming from Treasury Inflation-Protected Securities—to see how markets are reacting to the data. Rising breakevens could indicate markets are shifting their worries about growth to worries about inflation.
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