The COVID-19 crisis is causing enormous dislocations in the world economy, in a very short time: the wave of support policies (especially expansive monetary policies) has stabilized production activities and main services, but inevitably inflates an already significant public debt. The governments of nearly all states are now being challenged to make difficult decisions to address this issue.
Public support and strong currency injections from major central banks have caused public debt to rise in the developed world: a necessary evil to tackle the Covid crisis. But what will governments do now?
The problem of public debt: an endemic situation or Covid crisis?
In developed economies, public debt was at record levels even before the pandemic. The huge amount of fiscal spending so far (and probably destined to grow) could push public debt up to 20% of GDP and beyond in many countries.
According to some experts, the increase in public debt is simply a natural by-product of economic stagnation, a situation due to the inflationary and oversupply economic model. With this in mind, when the private sector does not spend enough (a situation that the Covid crisis is likely to exacerbate) the government is forced to spend to avoid a depression.
According to other analysts and economic historians, the economic model based on public debt that has been seen in recent decades has run out of resources and the world is now stuck in the debt trap.
Evaluation of historical debt relief models
It is never desirable to reach extreme levels of public debt (a prospect amply corroborated by history), but it is equally true that in serious and unforeseen situations such as the Covid crisis, governments are undoubtedly called to intervene.
To understand the paths that developed economies could follow, we can analyze four models of the past:
- the United Kingdom after the Napoleonic wars
- the Weimar Republic in Germany after the First World War
- the path followed by the United States, the United Kingdom and other Western economies after World War II
- Japan after 1990
At the moment, it is difficult to think of a long period of fiscal adjustments. We can therefore safely rule out the possibility of a fiscal tightening such as that implemented by Britain in the 19th century to recover from record levels of debt.
Instead, Germany’s economic model in the years following the First World War led to a period of vicious hyperinflation, a clear example of the risks involved when a country monetizes its debt by having public spending financed by the central bank. This scenario could be current if an extreme version of modern monetary theory were misused, but it seems unlikely that any country will actually follow this path in the near future.
There are thus two paths to debt reduction.
Covid crisis and public debt: post World War II economic model or post-1990 Japan formula?
On the one hand the formula adopted after World War II, based on strong economic growth, inflation and financial repression (very low interest rates). But in the current period there are no signs of strong growth, at least not like the growth expected after a world conflict, so the scenario is reduced to a mixture of financial repression and increased inflation. The second path is instead that taken by Japan after 1990: weak growth, unfavorable demographics, increase in debt, very low rates and deflation.
Understanding which path the world will take is arguably the biggest challenge facing financial markets today. At first glance, I believe that some variant of the post-war formula with higher inflation is more likely than the post-1990 Japan model and deflation, also considering that Japan was an isolated case in the economic history but also that populism and rising deglobalization also point towards the first path.
The missing piece of the puzzle
We are also beginning to see concrete signs of the change necessary to sustain the rise in inflation: among others, the recent move by the Federal Reserve towards an average inflation target is another important step in this direction.
However, we have not yet reached the crossroads. The final piece of the puzzle is a credible commitment to raise inflation expectations. This could lead to the abandonment of the anti-inflation regime which, aided by demographics and globalization, has supported the low-inflation era of the past three to four decades.
But without the restarting of production, trade and international exchanges, without an increase in wages and growth in employment (antithetical objectives according to the models of the classical economy), all of this can only crash in the face of a very strong crisis.