The May 4 issue of the London “Economist” headlined that ‘Governments are living in a fiscal fantasyland’. It focussed on the four biggest economies – the US, China, EU and Japan – although many smaller ones would also illustrate its proposition, that each was losing control of its fiscal position with rising government debt.
Each is a bit different, even if the rise is happening to all of them. Suppose the US Congress would resolve the current dispute over the debt ceiling. Even so ‘America’s budget deficit is set to balloon as its population ages, the cost of handouts swells and the government’s interest bill rises.’ The Economist forecasts that ‘deficits could reach around 7% of GDP a year by the end of this decade—shortfalls America has not seen outside of wars and economic slumps.’ Public debt will rise.
Discussions tend to present public deficits and debt from the government’s view. But any debt is being held by somebody as an asset. It happens that in China and Japan much of the population sits on a large body of savings, presumably for their retirement. Will they continue to lend their savings to the government? (A lot more holders of the US and EU debt are not citizens so we are less sure why they are investing in US government debt.) But when lenders reach retirement, they will start unwinding their savings. Who will make up the gap?
One possibility is that interest rates will rise so the retired live on the return from their savings. Though that may sound an excellent solution, higher interest rates choke off investment and raise government outlays. It is such concerns which worry the Economist especially, it says, because governments need to spend more on green technologies and the military. The magazine almost argues for higher (or new) taxes.
A word about the Chinese situation. Its books report low central government debt but that is because they do not include $23trn of local government debt. I don’t know the details of the degree to which the central government underwrites local government debt. But even suppose it doesn’t. If a local government defaults, the individuals who have lent to it through a bank would lose all their savings. There would be immediate local political turmoil which would spread as investors withdraw their savings from sound banks. My guess is central government would have to guarantee their savings (the implicit assumption here is that the army could not maintain law and order). That is why we think of the Chinese government being responsible for all the local government debt which means its total public debts are more than 120% of GDP; the IMF thinks they will rise to nearly 150% by 2027.
What I do not know, and neither does anyone else, is what the ultimate outcome will be. I would not rule out high interest rates and inflation or there may be a financial crash which wipes out masses of savings. Pretending something won’t happen is, so the Economist argues, fiscal fantasyland.
While the magazine focussed on those four largest economies, rising public debt is happening elsewhere. Should New Zealand join the fantasyland? Recently the government has been borrowing heavily to fund the war against Covid. That has been winding down and the government has been trying to control its deficit and debt levels. (The Prime Minister specifically mentioned this objective but I want to see the budget projections before I am convinced.)
However, there is some kind of intention there. But there are political pressures to abandon the strategy. Why not allow debt levels to rise, even when there is no real crisis? All the bullies in the (fantasy) playground are misbehaving, why should not the rest of us?
We need a serious discussion on this – one which does not skip the knotty bits of the argument. Earlier I said that I did not know how the rising government debt levels will play out. Sorry. But whatever the outcome, it will be chaotic; whatever we do, we cannot entirely avoid the chaos.
We have one clue from the 2008 Global Financial Crisis, when we avoided some severe difficulties which other economies did not. I attribute that to the Ministers of Finance who preceded the GFC, especially Labour’s Michael Cullen (but I do not forget the National Ministers of Finance of the 1990s). Cullen was under pressure to spend more generously and give big tax cuts but he built up financial buffers. When National came to power the economy was well placed to handle the GFC. (Its MoF, Bill English was one of National’s 1990s’ MoFs).
My position is that of a fiscal conservative, cautious because the downswing following a crisis is much more painful that the bubble and froth of the upswing, in which everybody parties with expectation that they will not suffer during the downswing (which cannot be true for everyone).
That does not mean I am committed to the current debt targets. I argued that our target should be about 20 percentage points lower than countries in similar circumstances to New Zealand because the New Zealand economy is so exposed by its private sector’s foreign borrowing for housing. (It’s a bit like China having to make an allowance for its local government borrowing.)
Hence my willingness to rethink the debt target but in a cautious, rational way, rather than joining fantasyland. I am talking here about, say shifts of 5 percentage points, a small relaxation which the countries we admire are also doing.
When fantasyland collapses it will be the smaller economies which will suffer most – unless they take precautions.
PS I have not grumbled about the exact target. A debt-to-GDP ratio is a mathematical nonsense because it relates a stock (debt) to a flow (income). It makes more sense to measure the flow of debt serving to GDP with the advice to borrow more when interest rates are low and less when they are high. But keep a watch for low interest rates increasing in the future.