Debt, inflation, and public expenditures

Facts demand revision of priors. But with economic orthodoxy, those facts are confined to happenings in developed economies.

Accordingly, when developing countries face an external shock induced economic downturn, it calls for austerity and fiscal consolidation. However, when developed economies face crises, conventional wisdoms which are preached with the greatest ideological fervour to developing economies slowly get shelved and priors get revised. The ideologues lead the chorus by starting to sing a new tune.

Just one example is this turn of events,

A decade after the last global downturn, the economics establishment’s U-turn on austerity is complete. In 2010 the IMF praised Britain’s tough deficit-reduction plan. Now it recommends a big fiscal expansion to cope with the coronavirus pandemic. Politicians were once fond of citing research co-authored by Kenneth Rogoff, an economist, to warn that public debt exceeding 90% of a country’s GDP would crimp growth. Today Mr Rogoff advises spending more.

The global financial crisis and its aftermath has led to a revision of several narratives. Faced with the brunt of savings glut and cross-border capital flows, and its distortions, capital account liberalisation gave way to capital flows management. Faced with liquidity squeezes within the financial markets, central bank balance sheet expansion and direct purchases of even corporate securities have been embraced as quantitative easing. Faced with anaemic nominal growth, a higher inflation band became the new norm. Faced with the Chinese manufacturing onslaught, industrial policy and protectionist barriers became the respectable.

Now, faced with a pandemic which has brought economies to a standstill, forcing governments into extraordinary stimulus programs, questions are being asked about the orthodoxy on debts, deficits, and deficit financing. Even things like nationalisation of private assets (by public equity infusions), as is happening in Germany, or wage subsidies, as is happening across Europe, become part of the toolbox to combat the Covid 19 shock. Nothing becomes off the table to "do whatever it takes".

Even quasi-nationalisation, by way of loans with warrants to take equity stakes, is being proposed - this and this (Larry Kudlow).

The Economist, a flag-bearer of free-market capitalism, leads with a briefing which is atleast ambivalent, even welcoming, about all these things hitherto considered evils.

Even economists with reputations as fiscal hawks tend to support today’s emergency spending, and some want it enlarged.

The infamous Rogoff-Reinhart hypothesis that growth declines below the debt-to-GDP threshold of 90 per cent has now been conveniently cast aside without even a mention. The Economist article now points to the post-war precedent how growth and inflation denuded high debt debt levels,

Many rich-world governments pursued this sort of strategy after the second world war with some success. At its wartime height, America’s public debt was 112% of GDP, Britain’s 259%. By 1980 America’s debt-to-GDP ratio had fallen to 26% and Britain’s to 43%. Achieving those results involved both a high tolerance for inflation and an ability to stop interest rates from following it upwards. The second of these feats was achieved by means of a regulatory system which, by depriving citizens of better investment options, forced them in effect to lend to governments at low interest rates. By the 1970s economists were calling this “financial repression”. In a paper published in 2015, Carmen Reinhart of Harvard University and Belen Sbrancia of the imf calculated that France, Italy, Japan, Britain and America spent at least half of that period in so-called “liquidation” years in which interest rates adjusted for inflation were negative. They estimated that the average annual “liquidation tax” to governments resulting from real interest kept low by inflation and financial repression ranged from 1.9% of GDP in America to 7.2% in Japan. To attempt such repression today, though, would require redeploying tools used by post-war governments—tools such as capital controls, fixed exchange rates, rationed bank lending and caps on interest rates.

The IMF too is approving, highlighting also the current low interest rates,

Vitor Gaspar, a senior official at the IMF, says the fund expects a combination of low rates and rebounding growth to see debt burdens stabilise or decline in the “vast majority” of countries in 2021. And bond-buying by central banks takes much of the worry out of some of the debt.

Sample this trajectory of post-war debt-reduction in UK

In the context of high debt burdens, Stephen Roach writes approvingly for a dose of inflation,

For the indebted US economy, an inflation-driven rise in interest rates would slow growth. Public debt is headed to about 120 per cent of gross domestic product by 2025, up from 79 per cent in 2019 and well above the post-second world war record of 106 per cent. History suggests that inflation may be the only way out. After the second world war, the US escaped from its public debts by reflation. Public debt fell by 0.9 percentage points a year from 1947 to 1957, while nominal gross domestic product, helped by accelerating inflation, rose 7 per cent annually. The ratio of debt to GDP soon plunged to 47 per cent. Today, a comparable debt shrinkage would occur if inflation moved back to 5 per cent. With rock-bottom interest rates, open-ended quantitative easing and a massive debt overhang, inflation may be the only way forward for the US and other indebted western economies.

Noah Smith advocates a higher 4% inflation target for the US to erode the debt burden,

... there’s another way that the government can shrink the mountain of debt weighing down the U.S. economy: inflation. Because most interest payments are fixed in nominal terms, inflation makes existing debt less important in real terms. Raising the long-term inflation target from the current 2% to a still-modest 4% would substantially increase the rate at which debt effectively vanishes.
The U.S. has used inflation this way before.

Economists Joshua Aizenman and Nancy Marion wrote: The average inflation rate over this period [from 1946 to 1955] was 4.2%...inflation reduced the 1946 [federal] debt/GDP ratio by almost 40% within a decade.

A decade of 4% inflation today would do the same for total debt, not just government debt.

In the context of India, Sajjid Chinoy makes the point about the importance of nominal GDP growth rate,

India comes into COVID-19 with a debt/GDP of about 70 per cent, a primary deficit across the Centre and states of about 2.5 per cent of GDP (including the Centre’s extra-budgetary resources) — based on the Revised Estimates for 2019-20 — a weighted average sovereign borrowing cost of about 7.5 per cent (on the stock of debt) and an estimated pre-COVID nominal GDP growth of 7.5 per cent in 2019-20. In other words, the favourable gap between growth and borrowing costs had closed... even under relatively benign scenarios (nominal GDP growth of 4 per cent and a fiscal expansion of 3 per cent of GDP this year) India’s debt/GDP will balloon towards 80 per cent by the end of the year. But India will not be alone. Public debt is expected to balloon all over the world... In turn, the subsequent trajectory depends overwhelmingly on medium-term growth. Consider this: Even if this year’s combined fiscal deficit widens by 6 per cent of GDP (but the primary deficit is then consolidated back to 2 per cent of GDP in 3 years) as long as nominal GDP is 10 per cent in the medium term (which corresponds to real GDP growth of 7 per cent), debt/GDP gets on to a constantly declining path after the third year. This suggests a bigger fiscal intervention is sustainable but only if medium-term growth prospects are lifted in tandem. In contrast, if this year’s deficit widens by “just” 3 per cent of GDP but if medium-term nominal GDP growth settles at 8 per cent (that is, real GDP growth of 5 per cent), debt/GDP rises relentlessly for the next decade towards 90 per cent of GDP. This suggests even a relatively-conservative fiscal response this year becomes unsustainable if medium-term growth prospects are diminished. Small changes in medium-term growth have large implications for fiscal sustainability.

The main takeaway: How much fiscal space India has to respond in the crisis year will depend crucially on what potential growth is likely to be in the coming years. The more that India’s policy response can preserve, protect and boost medium-term growth — both through the nature of the policy intervention this year and the accompanying reforms — the larger the fiscal response India can mount. Put more starkly, the fiscal debate between “need” and “affordability” is endogenous. The medium-term sustainability of any fiscal package this year will depend on the nature of growth-enhancing interventions and reforms that accompany it.

The fundamental idea is simple. It is true that any debt is a borrowing from the future. But it is also true that the life-cycle of capital investments go a long time into the future. Besides, capital investments also strengthens the foundation on which future growth is built. And this is especially so for countries like India which are chronically deficient in capital assets like physical infrastructure. Therefore, if right kind of such investments are made, even by borrowing, the nominal rate of economic growth is most likely to be much higher than the borrowing cost. This is the basis for borrowing to invest in infrastructure. 

In a speech in 2019, Olivier Blanchard struck a contrarian note to argue that debt was alright as long as the nominal growth rates were higher than the interest rates, and this was the historic norm in countries like the US. This new found acceptance of debt in developed economies should be instructive for India as it stands at the margins of 'high' debt.

India has several things going for it. It is the second most populous country with a very youthful population and with several other cultural, historical, and political advantages. It has a fairly diversified industrial base. While it faces a daunting human resource development challenge, the sheer size of the country, the low base for growth, and being primarily reliant on domestic consumption for growth, means that with modest efforts India stands on fairly strong footing for sustained real GDP growth rates in the 5% range for the coming few decades. More reforms and better policies, episodes of which will most likely happen, will further boost growth.

In the circumstances, a temporary spike in the flow and stock of debt while a matter of concern should not be seen as a disastrous outcome in itself. In fact, as Sajjid Chinoy writes, if it is necessary to preserve future growth prospects, such a spike is a desirable thing.

The challenge for India is not about announcements or policies. Both can be perfect, and it would count for pretty much nothing without effective implementation is a failure. That, unfortunately, depends on state capacity, an issue which gets limited attention in public debates.

Update 1 (22.06.2020)

Gavyn Davies is sanguine about the rising debt burdens in developed economies.

Even more notable has been the unanimity among macroeconomists that massive fiscal and monetary stimulus is the appropriate response to a “wartime” economic emergency. Almost no one seriously disputes that policy should be doing “whatever it takes” to overcome the shock from the virus. This agreement reflects a key conclusion from public finance theory: that higher government debt is the correct shock absorber for the private sector in the face of unpredictable, temporary economic crises. It avoids the distortions that would follow the big variations in marginal tax rates that would otherwise be needed to finance a surge in public spending over a short period. The chorus of approval from the macroeconomics profession has helped fiscal and monetary policymakers introduce massive stimulus packages almost instantly, in contrast to the much slower response to earlier recessions, including the 2008 financial crisis...

Most New Keynesian economists, including Paul Krugman and Lawrence Summers, believe high debt levels will not in themselves be a problem for advanced economies. They even suggest further rises in debt would be desirable, as that would help reverse the trend towards secular stagnation in Europe and the US. A key reason for their optimism is that the annual cost of servicing the debt will be clearly below the nominal growth rate in the economy and the central banks seem set to keep it there. If the interest rate keeps below the growth rate, the debt/gross domestic product ratio will eventually stabilise, provided governments’ non-interest — or “primary” — budget balance remains stable. Assuming the high public debt strategy succeeds, real bond yields will probably rise gradually towards more normal levels. In addition, equities will respond positively to improved growth prospects as inflation returns to the 2 per cent central banks’ targets. Debt could be managed without a crisis.