– April 10, 2020

In response to the coronavirus crisis, governments across the western world have been increasing spending to provide relief for those who have been fired or whose businesses have temporarily closed. Deficits will probably follow in the future. However, even in the absence of such relief efforts, there would have been deficits. This should be worrisome to the point of terrifying. Not because deficits in times of crisis are ill-advised, but because these deficits will take place at the tail end of a long string of deficits that already increased the public debt to unsustainable levels. 

Before the 1970s, budget surpluses were the norm. Deficits were temporary affairs with a clear understanding that they were the results of temporary shocks. Subsequent surpluses had (and were) used to amortize public debts racked up in exceptional periods such as natural disasters and wars. As such variations in the public debt would thus occur but they occur around a certain long-term level (and thus exhibit no trend over time). 

This is why, when we look at countries like Canada, the United Kingdom and the United States over the long run before the 1970s, we see no discernible change in net public debt. The United Kingdom is a particularly fascinating example as it managed to reach levels of public debt during the French Wars that exceeded 200% of GDP. By 1914, it was back down to roughly 30% of GDP. Thus, great spikes occurring at the time of wars were followed, once things returned to normal, by public debts rapidly reverting to historical levels (relative to GDP). 

The great advantage from this long-term is that it smooths tax rates. In essence, the idea was to set tax rates so as to provide revenues at least equal to the normal expenses, the interest on the existing debt, and the interest on the loans which results from unexpected loans that had to be raised. Doing so meant that one would avoid increasing taxes or decreasing spending on public goods during an adverse shock. In other words, the cost of government was minimized by staying steady on spending and taxing patterns in the face of temporary shocks. This helped provide some macroeconomic stability (at the very least, it minimized potentially procyclical government policies). 

There were two corollary advantages from such an approach to public finance. First, as long as creditors understood that public debt burdens would revert to lower levels once things normalized, loans could be extended at relatively low rates. Thus, the cost of the public debt was relatively low itself. Second, consistently keeping to the tendency to revert to lower levels meant that if there was a cascade of temporary shocks, there was greater resilience. This resilience is what allowed economies to adjust easily to shocks. 

However, since the 1970s, these advantages have been squandered away. Public debts in most western countries have increased to high levels relative to GDP, in spite of the fact that these were years of decent economic growth. Consequently, capacity to keep things as close to normal as possible in times of crisis, such as the one we are facing now, through borrowing is considerably reduced.

This is particularly important because the broad economic cost of the public debt tends to increase faster than the public debt itself. This can be seen in the work of Reinhart et al. who point out that the cost of public debt when it exceeds 90% of GDP tends to increase disproportionately—which translates into considerably slower growth rates. The idea of a “magic” threshold has been debated and I admit to be agnostic on who is correct. 

However, one more widely accepted finding is that, once a shock hits an economy, the cost to the public is greater for economies with high initial levels of debt. As such, there is ground to believe that economies with more indebted governments are more fragile to shocks. This fragility translates into long-term costs in the form of slower economic growth. For hard-hit countries like Italy, France and Spain, where public debt burdens are exceptionally high by western standards and where growth has been slow in the last decade, this is a daunting prospect. 

Indeed, the “second wave” to fear is not a resurgence of the coronavirus once the curve has been flattened but rather a second wave of economic contractions due to fiscal crises in large western economies such as Spain, Italy and France. 

The precariousness of the situation cannot be understated. True, it could be that these governments will manage to turn things around. They could also fail to do so. One thing is certain: the current fragility is unacceptable. Thus, there is one certain lesson: there is a need to return to older, proven, public finance traditions that make deficits the exception rather than the norm.

Vincent Geloso

Vincent Geloso, senior fellow at AIER, is an assistant professor of economics at King’s University College. He obtained a PhD in Economic History from the London School of Economics.

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