(July 9): The speed and magnitude of the globally synchronised deterioration in public finances is among the many unprecedented developments over the past six months. It has been a more sudden and pronounced shock than the global financial crisis a decade ago, and will have a lasting fiscal impact even if the economic recovery eventually recoups most of the lost income.
Recessions take a toll on public finances, since one of the primary objectives of fiscal policy in all but the lowest-income countries is to smooth the tops and bottoms of economic cycles.
Crises are apt to take a much greater toll, however, as they can engender more fundamental questions about the size of government and role of the state. Understandably, governments worldwide responded quickly to the Covid-19 crisis, putting aside financial considerations. The question is what will happen afterward.
The starting position for global public finances entering the current crisis was much weaker than prior to the 2008 crisis. The sum of world fiscal balances in 2019 was a deficit eight times larger than 2007 in nominal terms, at US$2.8 trillion ($3.8 trillion), and five times higher as a share of the gross domestic product (GDP), at 3.3%. Global government debt last year was US$68 trillion, compared with US$34 trillion in 2007.
On the face of it, these numbers suggest that as the world entered the current crisis, government finances had not fully recovered from the last one. This partly reflected overt policy choices. As the then–managing director of the International Monetary Fund (IMF) Christine Lagarde noted in her 2017 “A time to repair the roof” speech, despite better than expected growth at the time, there was an appeal among policymakers to “...sit back, enjoy the progress, and wait for the next big crisis before making big changes”.
Changes will indeed need to be big given this year’s transformation of public finances. Fitch Ratings forecasts global fiscal balances will sum to a deficit of US$9.7 trillion this year (12% of GDP) and debt will reach US$76 trillion (95% of GDP). A unique feature of the current fiscal response is the massive surge in government spending (see chart), which is concentrated in the advanced economies.
Normally, the directional change in nominal government spending matches that of nominal GDP growth, but nominal GDP is forecast to contract by nearly 6% in 2020 while spending will increase by about US$3 trillion.
Even if recessions in the advanced economies prove short, fiscal deficits will linger, as they have after past recessions. In none of the eight US recessions since 1960 did the fiscal deficit peak during the recession. Instead, deficits peaked an average of four quarters after the recession ended, meaning fiscal recoveries lag behind economic recoveries.
Moreover, every US recession since 1980 (with the exception of the 2001 recession) has resulted in a ratcheting up of government debt so that the average debt and GDP ratio during the next expansionary period was higher than the preceding one.
While there will be a fiscal runoff as some Covid-19 policies expire, there may be limited appetite for a complete unwind of the current expansion, especially if the primary rationale put forward for consolidation is to reduce government debt.
Just as large deficits are now accepted across most of the political spectrum for programmes to support households, employment retention and corporates in distress — in contrast to the range of views on support for the financial sector in 2009 — it could be argued in the years ahead that the resulting increase in government debt is also a price worth paying.
As a truly exogenous shock, the pandemic is rightly viewed as being “nobody’s fault” — a point in favour of collective burden-sharing, including a sharing over time, which is the essence of a debt–financed policy response.
In addition, the argument made by Christine Lagarde noted above, that it is prudent to create fiscal space during economic upswings to ensure sufficient policy headroom for dealing with downturns, will be openly questioned, if not discredited. There is little evidence that the policy responses of governments in advanced economies have been constrained by their relative starting fiscal positions.
In the Eurozone, for example, some fiscal rules have been temporarily suspended, new region-wide support programmes announced, and bond markets have acquiesced as they have elsewhere in light of more central bank intervention. Neither the supposed institutional nor market constraints on fiscal policy have been binding.
A final consideration for the fiscal outlook is a possibility that the debate that predated the Covid–19 crisis on closer coordination between fiscal and monetary policies may be increasingly tilted to one side. Without a rise in inflation or financial market dislocation, a larger fiscal role supported by central bank accommodation to address other policy priorities — like a “green new deal”, for example — becomes a higher probability. Closer policy coordination is explicitly linked with increased government spending and higher debt.
It is too soon to conclude definitively that the current global recession and public spending related to Covid–19 will result in a lasting increase in government debt, but the balance of risks points in that direction. Past post–recession trends, the depth of the current fiscal deterioration and some of the pre–Covid–19 policy debates together imply government debt is likely to remain high through the medium term.
James McCormack is the global head of sovereign ratings at Fitch.
