The Increase in Government Indebtedness

The pandemic has flipped our daily life and our beliefs of reality from day to day, leaving us breathless, like a cold shower. The worst needs to come, when governments in a few years will have to deal with an indebtedness that has, in many developed countries, crossed the threshold of 100% debt-to-GDP ratio. The great amount of money that governments need to pool out to implement fiscal policy against the pandemic is like war, literally: according to The Economist, “public borrowing in the rich world is set to soar to levels last seen amid the rubble of smoke of 1945”[1] (The Economist, 25th April 2020). Our next year could be the beginning of a new Golden Age, if governments will be able to set agendas that would bring long-run economic growth.

In the last 40 years government in western countries liberalised their economy by decreasing the scope of government intervention in the market by, for example, deregulating it and removing subsidies. That caused an economic process called ‘financialization’ defined as “the increasing role of financial motives, financial markets, financial actors and financial institutions in the operation of the domestic and international economies”[2]. In the 1980s, there was a shift in the economic system: since the post-war, Keynesian economy prevailed over the rival economical ideology of neoliberalism, with economists like Friederich Haykes and Joseph Schumpeter . However, this equilibrium changed in the 1970's, when the market started to be liberalised: in August 1971 President Nixon signed the Smithsonian Agreement that replaced the Bretton Woods Agreement. The central banks were not required to exchange the US dollar with gold, making it a fiat money. Fiat money is a currency that is not backed by commodities such as gold and, therefore, it allows central banks to control the economy through interest rates deciding the amount of money needed to be printed. This led to a floating exchange rate, making it even more sensitive to the market fluctuations. Private institutions become more influential in domestic economies, as an increase in state debt is held by foreign companies, reducing the sovereignty of the debt by national agents. However, “external debt is much riskier than internal debt, which a state owes its own citizens in their own currency” [3]. With external debt, states need to repay the debt in different currencies, which are sensitive to currency fluctuations.

In the 1970s, OPEC imposed an embargo of oil exports on Western Countries. In 1979 “the US and Saudi Arabia negotiated the United States-Saudi Arabian Joint Commission on Economic Cooperation” [4], following the political escalation and the stagflation hitting the US. They agreed that oil should be traded in US dollars, enhancing the role of dollars as global currency, and creating a process of reinvestment in US companies called ‘petrodollars recycling process’. This caused a huge amount of US currency to be held by foreign companies and it intensified globalisation. Private institutions became predominant lenders to the government who could not rely on traditional tools such as taxes and levies to decrease the debt-to-GDP ratio.

External debts triggered in several countries a sovereign debt crisis, defined as “a situation in which a state is unable or unwilling to make instalments or interest payments on loans and bonds held by foreign creditors, so that debt servicing is either interrupted to varying degrees or even discontinued” [5]. This has been the case of the Latin American debt crisis of the 1980's as a consequences of US commercial banks buying a great amount of Latin States bonds in the 1970's, “amounting to 176 percent of their capital” [6]. When US decided to apply contractionary monetary policy to control inflation, commercial banks asked for a shorter repayment period and higher interest rates in return. Latin countries needed to ask the IMF for emergency funds to solve the sovereign debt crisis, leading to 10 years of recession.

Nowadays the situation is different. Last august Jay Powell, centrepiece of Federal Reserve Board (FED), an American institute that regulates monetary policy, stated that the Federal Reserve will be “more tolerant of temporary increases in inflation, cementing expectations that the US central bank will keep interest rates at ultra-low levels for years to come” [7]. Other central banks like the Bank of Japan (BoJ) for instance last summer, during the process of financing a $1.02tn monetary policy, decided to cap 10-year bond yield at about zero percent, sending “a strong signal that Japanese interest rates would not rise for the foreseeable future” [8]. The European Central Bank (ECB) on December has expanded its bond buying programme to €1.85tn and “extended it well into next year in response to a resurgence of corona-virus infections” [9]

In the graph above IS represents the good market equilibrium, whereas LM curve describes the money market equilibrium. According to the Zero Level Bound Rate, people will be relatively indifferent to the change of interest rates, because they are already to a level close to zero. A shift outward of the LM curve will not affect the market equilibrium, which remains at Y* level, whereas an increase in government spending will shift outward IS curve, leading to an higher GDP Y''. Therefore, monetary policies that are based on interest rate are less effective, whereas fiscal policy will increase economic output without triggering the crowding-out effect. Normally a government borrows a lot of money to implement its policy, it will cause an increase in interest rates and then a negative effect on private investors. This is not the case, because interests are at the minimum level.

When we think about debt we tend to be horrified and worried about the consequences in the future, however in my opinion that should not be the case, because money historically and anthropologically is a token for credit. Therefore, as Stephanie Kelton has said: “when a government spends without taxing, it doesn’t have to commit a sin. It could be filling a void”[10]

Jacopo Lussetti

References

[1]The Economist, 25th April 2020, After the disease, the debt

[2] Berghoff, Hartmut, and Laura Rischbieter. “Debt and Credit. From Post-War Reconstruction to the Age of Financialization.” Journal of Modern European History / Zeitschrift Für Moderne Europäische Geschichte / Revue D'histoire Européenne Contemporaine, vol. 15, no. 4, 2017, p. 499. JSTOR, www.jstor.org/stable/26266304. Accessed 4 Feb. 2021.

[3] Berghoff, Hartmut, and Laura Rischbieter. “Debt and Credit. From Post-War Reconstruction to the Age of Financialization.” Journal of Modern European History / Zeitschrift Für Moderne Europäische Geschichte / Revue D'histoire Européenne Contemporaine, vol. 15, no. 4, 2017, p. 497 . JSTOR, www.jstor.org/stable/26266304. Accessed 4 Feb. 2021. [3] Amadeo, Kimberly. “Will the Petrodollar Collapse?” The Balance, 22 Nov. 2020, www.thebalance.com/what-is-a-petrodollar-3306358.

[4] Amadeo, Kimberly. “Will the Petrodollar Collapse?” The Balance, 22 Nov. 2020, www.thebalance.com/what-is-a-petrodollar-3306358.

[5] Berghoff, Hartmut, and Laura Rischbieter. “Debt and Credit. From Post-War Reconstruction to the Age of Financialization.” Journal of Modern European History / Zeitschrift Für Moderne Europäische Geschichte / Revue D'histoire Européenne Contemporaine, vol. 15, no. 4, 2017, p. 491. JSTOR, www.jstor.org/stable/26266304. Accessed 4 Feb. 2021.

[6] Sims, Jocelyn. “Latin American Debt Crisis of the 1980s.” Federal Reserve History, www.federalreservehistory.org/essays/latin-american-debt-crisis.

[7] Arnold, Martin. “Fed to Tolerate Higher Inflation in Policy Shift.” Subscribe to Read | Financial Times, Financial Times, 27 Aug. 2020, www.ft.com/content/e1e59faa-5005-4e1c-9d54-b1a8d4de9586.

[8] Harding, Robin. “Bank of Japan Pledges $1tn in Coronavirus Loans.” Subscribe to Read | Financial Times, Financial Times, 16 June 2020, www.ft.com/content/5d8e5df2-dfb6-44f1-a434-ab8a745d37ba.

[9] Arnold, Martin. “ECB Details Bond-Buying Shift as It Holds Rates and Stimulus Steady.” Subscribe to Read | Financial Times, Financial Times, 21 Jan. 2021, www.ft.com/content/14821fa0-0e3e-4a95-8414-53a257ee9142.

[10] Greeley, Brendan. “Stephanie Kelton: 'They're Going to Have Massive Deficits. And It's Fine'.” Subscribe to Read | Financial Times, Financial Times, 17 Apr. 2020, www.ft.com/content/ea25934a-7b28-11ea-af44-daa3def9ae03.

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