The unbearable lightness of the government debt
A proverb says that you live and learn. The last two decades with their crises have, indeed, taught many lessons in the field of economics both in Europe in general and Latvia in particular, highlighting the past mistakes especially clearly. Recognising and understanding the mistakes, however, is just the first step. Realising what should be done differently to avoid repetition is much more important.
One of the main lessons from these crisis years seems to have been the recognition of the importance of an active fiscal policy. In the period prior to the 2008–2009 global financial crisis, the commonly accepted paradigm was that the role of fiscal policy is primarily to keep the government debt at a level that raises no solvency concerns, that does not throw financial markets into panic and send the interest rates soaring. Macroeconomic stability was the sole responsibility of the monetary policy: it had to strike a balance between stimulating economic growth and preventing economic overheating.
Therefore, according to this paradigm, shortly after 2009 when the economic situation had stabilised, the fiscal policy in Europe was geared towards a sharp reduction of government deficits and debt stabilisation . According to this prevailing paradigm, such a policy was the recipe for economic recovery and return to pre-crisis levels. That, however, never happened. The European economies recovered much more slowly, growth was more moderate, and, to a large extent, this was also the reason for constant undershooting of the ECB's inflation target since the end of the global financial crisis.
This bitter experience inevitably led to a review of the practical application of economic policy tools, including a review of the role of fiscal policy, especially in a context where the monetary policy options for providing further economic stimulus are severely constrained.
The lesson learned was that in times of an economic turmoil and crisis, strong and timely support is needed from both the monetary and fiscal sides. Moreover, it is equally important not to withdraw this support too quickly before the economy has fully recovered. We were able to observe this new principle in action very recently, with governments responding to address the economic fallout from the Covid pandemic – significant fiscal support measures were implemented almost everywhere in Europe. This support will also not be withdrawn at the first signs of economic normalisation. As we know, the European Commission has allowed EU governments flexibility to depart from the provisions of the Stability and Growth Pact for balanced budgetary policies at least until the end of 2022.
The previous crisis taught us that the monetary policy stimulus also should not be withdrawn prematurely. Therefore, the reviewed ECB's monetary policy strategy inter alia includes a commitment to maintain the interest rates at their present or lower levels until we see a clear and sustainable return of inflation to the level of at least 2%. It offers extra opportunities and will support the euro area economies, and, as an additional secondary effect, it will also significantly facilitate government borrowing and the sustainability of the existing sovereign debt. These are major changes compared to the period up to now.
However, how far can national governments go with this "unlimited" fiscal support without risking new problems in the future? And what will happen when the economies return to a post-Covid balance? These are not just rhetorical questions. The responses will largely determine the actual budgeting process, with governments seeking a balance between the need to support the economies and to limit the growth of government debt. Latvia will be no exception. Potential courses of action could be subdivided into three groups.
1. "Grab all you can" or "Low interest environment stimulates more borrowing"
As already noted in my previous article, apart from the size of the debt and the borrowing rates, the sustainability of government debt and its servicing capability are also dependent on the growth rate of the economy generating additional resources that can be partly used to repay the government debt. Consequently, the lower the interest rates and the faster the country's economic growth, the easier it is to sustain the debt, and, in theory, it means the ability of living with a higher level of sovereign debt.
As we know, due to the Eurosystem's monetary policy over the past decade, interest rates have fallen to their historical lows. This has also significantly reduced the government spending on debt servicing, as shown in Chart 1. In some countries (including Latvia), buyers of government securities are at times even willing to pay for the privilege to lend money to the government (i.e. to get back less money than actually lent). At such favourable conditions, borrowing more seems logical and justified, doesn't it?
Undeniably, the current conditions are very favourable for borrowers. But it should be recalled why the interest rates are so low at the moment. Making the lives of national governments easier is not the primary objective of these low rates. Interest rates are low, because economic growth is also weak, lending development is relatively sluggish, and investment does not support economic growth as much as would be necessary for sustainable development. In this respect, high demand for government securities is not all good news at all, as it signals quite a considerable degree of risk aversion on behalf of investors who are reluctant to invest in the private sector, which is riskier, but necessary to ensure future growth. Consequently, low interest rates alone do not guarantee a carefree life in the future if economic growth remains equally low. Therefore, even if borrowing conditions are favourable today, the money borrowed must be invested in priorities that will secure economic growth also in the future, rather than simply being wasted.
Moreover, interest rates are not going to stay low forever. Sooner or later they are bound to recover. And if, at the current rates, virtually any debt seems easily sustainable in the long term, then at higher rates the surging debt servicing costs can become a serious burden on public finances. This is the exact recipe for a sovereign debt crisis – when the conditions are favourable, borrowing spins out of control based on an assumption that the favourable conditions will last. However, when the circumstances do change and the riding on a wave of easy money ends, it could be quite unpleasant to be caught swimming naked.
2. "What is permitted to Jupiter is not permitted to an ox" or "While the debt is low, more borrowing raises no concerns"
Latvia's sovereign debt was slightly above 40% of GDP at the end of 2020. Although this year's sizeable government deficit will also increase the total indebtedness considerably, potentially approaching already 50% of GDP at the end of 2022, it will still remain below the 60% of GDP limit set in the Stability and Growth Pact and considerably lower than the euro area average approaching 100%. Latvia is currently in a relatively good place. But does that mean that we can afford to borrow and spend more than other euro area countries?
Risks associated with repayment and sustainability of sovereign debt are currently lower in Latvia as compared to many other euro area countries. But it is equally clear that sustainability risks are growing with every instance of a considerable increase in sovereign debt. Where exactly is the borderline for safe additional borrowing, beyond which the risks significantly intensify (and the government debt servicing costs also grow accordingly)? No one can know it in advance, and very often a high level of government debt may go unnoticed as a downward factor affecting economic growth for a long time and only emerge as a serious problem in a crisis.
Arranging all EU countries according to the size of their debt and looking at their economic growth rates prior to and after the global financial crisis (Chart 2), it is quite obvious that the countries with the level of debt below 60% of GDP demonstrate stronger economic growth in the long-term than those exceeding the limit. The picture is particularly gloomy in the time period since the 2008 financial crisis, as highly indebted countries have failed to achieve any significant economic growth over more than a decade. Consequently, there is a vicious circle where the high indebtedness is a headwind to economic growth, while the weakness of the economic growth does not allow for a considerable reduction of the government debt. Breaking the circle is very complicated; therefore, it should rather be avoided.
Moreover, a swift advancement towards the limit up to which the debt is sustainable in the long-term, would also mean entirely depleting the reserve buffer that may be required to overcome any future crisis. According to our own experience so far (see links uz Ievas rakstu), during major economic turmoils, government debt can grow by as much as 30% of GDP in a couple of years. Even in a less drastic scenario and assuming that the Latvian economy will never again be hit by the same magnitude turbulences than those in 2008–2009, government support measures to prevent a deep economic slump may be required, potentially resulting in the government debt rising by some 10% of GDP in a couple of years. Consequently, this would be the absolute minimum of a safety cushion left untouched during normal crisis-free circumstances, to fall back on, as needed, to stabilise the economy in any future crisis.
3. "Much ado about nothing" or "Government debt as an exaggerated problem"
In an attempt to stimulate economic activity, along with setting historically low policy rates, all major central banks of the world have also been actively purchasing government debt securities. The ECB and the other euro area central banks are no exception. As illustrated by Chart 3, the amount of euro area government debt securities purchased by the Eurosystem (on the secondary market) has grown significantly since 2015, and in 2020, for example, the Eurosystem's purchases were almost equivalent to the amount of change in the government debt securities outstanding. Thus, at least technically, the Eurosystem’s purchases almost fully financed the increase in all government deficits related to the Covid-19 crisis in the euro area.
This tendency has breathed new life into the theory believing that the government debt is no serious problem at all, as long as the central bank is ready to finance the government spending in this way. At the end of the day, if national governments and central banks are part of the public sector, then central bank purchases of government securities are like the public sector's funding to itself. Consequently, as long as central banks hold the purchased government securities on their balance sheets, governments have no need to worry about the repayment of this particular chunk of their debt. If the government securities purchased by the euro area central banks currently amount to around 20% of GDP, the "risky" bar for the government debt is automatically raised by the same amount, and "80% is the new 60%".
Although this theory is often referred to as "the modern monetary theory", the idea of the central bank funding the government without resorting to market-based financing is actually not new at all. Unfortunately, its implementation has almost always ended in hyperinflation. The "modern" aspect here is likely to be linked to the observation that inflation has not increased significantly over the most recent years, even though central banks have purchased significant amounts of government securities. Hence, there may be some hope "that this time will be different".
However, the fact that we do not see any negative consequences for such practices in the short-term does not prove their non-existence or that they will never materialise.
The current monetary accommodation measures are essentially unique in recent history, and their long-term side-effects have not yet been fully realised.
Moreover, hyperinflation is not the only potential negative side-effect. The continued reliance on central bank funding provided on favourable conditions leads to a weakening of the fiscal discipline (see confirmation also in our Working Paper), resulting in an unjustified raising of government spending and public investment pushing the private sector out of the market. In addition, too much central bank dominance in purchases of government securities in the financial market creates lasting price distortions; as almost all other assets are priced on the basis of government securities, this poses a potential threat of various asset price bubbles and general financial instability.
Therefore, similar to the idea of radioactive toothpastes and other consumer items, which briefly seemed to be quite brilliant and without any serious side effects to some minds, but did not gain wide acceptance (for currently obvious reasons), the "modern" theory that central bank funding to governments could be the magic wand helping to solve all problems is and will remain only a theoretical concept advocated by individual economics professors, without practical feasibility in a foreseeable future.
To sum up, the role of fiscal policy as an economic stabiliser has increased significantly in recent years, especially in a context of crisis and low growth, when standard monetary policy instruments become less effective. However, this does not mean that the level of government debt has become irrelevant. In any potential future crisis, it will continue to grow, probably even to a larger extent and faster than before. But this also means that in the years of a normal development, the government debt must be compressed at a faster pace than before, in order to enable a maximum quick both fiscal and monetary policy response if necessary. Moreover, government spending is also important. No country has been able to print its way out of debt cleanly and painlessly, whereas to grow out of debt is possible, indeed. Therefore, we should be prepared for the next crisis already now.
Discussion about this particular issue and other government debt-related topics will continue at this year's economic conference organised by Latvijas Banka.
Unlike in Latvia, where external sources for funding the government debt were rapidly depleted due to the global crisis and consequently there were practically no alternatives to taking a course towards a swift fiscal adjustment, Europe in general (except for individual countries) knew nothing of such funding problem.