There have been a very tense debate among economists, notably in France where I am currently staying, over debt sustainability as a consequence of the surge in public spending to face the coronavirus crisis. Some economists, mostly from the right-wing, are already calling for public expenditure cuts while others, mostly from the left-wing, are supporting the idea of debt cancellation. I think that in both cases the debate is largely ill-founded.
In period of crisis, it is normal that governments use fiscal policy as a weapon of choice to fight the coronavirus, protect people’s life and save businesses. As it was the case in any previous crisis, for economic and social reasons, there is not alternative but to socialize debt. By doing so, the ultimate goal is to prevent private sector debt from growing more than necessary in the short term, which would weight on the path of the economic recovery, and it does not matter if it means that public debt is doomed to increase by 30% or even 50%.
There are two main reasons justifying state intervention in the current situation. First, by avoiding an accumulation of private debt, it increases household disposable income that will be desperately needed to stimulate the recovery and it reduces the risk of bankruptcies. Secondly, almost all the new coronavirus government debt will be absorbed by central banks and it will virtually cost nothing to governments. This is how it will work for the Eurozone: Governments will pay interests on coronavirus debt to the ECB, thus increasing its profits, which are almost totally redistributed to governments and represent therefore a source of fiscal revenue. Put another way, interest rate on coronavirus debt will be basically equal to zero.
The major mistake made by those calling for budgetary consolidation or debt cancellation is they ignore the changing role of central banks and the duration of QE, including its reinvestment strategy. Since 2007, central banks are not only focusing on maintaining price stability, but also on maintaining financial stability and supporting the State’s financing needs as long as the crisis lasts. As a consequence of the massive liquidity injections made through asset purchase programs (also called QE), they have become market markers on the sovereign debt market. Basically, they provide liquidity and fix the price. In the Eurozone, the ECB is expected to buy at least €115bn per month on average of public and private debt until the end of the year. The total amount of asset purchases for 2020 is already standing at €1.1trn, surpassing the previous record of 2016 at €900bn, and could be increased further next week by the ECB at €1.5trn.
This brings me to my next point: The risk of another sovereign debt crisis in developed countries is close to zero. We are not getting out from expansionist monetary policy anytime soon. In the euro area, the economic damage resulting from the pandemic and the deterioration in inflation outlook will push the ECB to continue or even increase its QE in 2021, and potentially beyond. Given its unlimited firepower and recent indications from Governing Council members of long term deviation from capital keys, the ECB can stem any lasting increase in interest rates in the Eurozone. In addition, after years of conflict between governments and the central bank, they are finally working together to ensure that economic activity can restart as quickly as possible. This new cooperation will undoubtedly continue and deepen in the post-covid area. It will then make it easier to cope with new challenges, especially related to climate change, and make sure that the level of public debt never really become an issue.
We observe the same situation in the United States. Since 2010, the Federal Reserve can purchase up to 70% of Treasury debt outstanding, and it has done so with almost all the bond issuance since the outbreak in order to carry out its latest round of QE to fight the pandemic. Considering the economic situation and the long term scars of the crisis, monetary policy normalisation is unlikely in the near- and medium-term. It’s quite the opposite. The Federal Reserve is certainly six to twelve months away from implementing a new form of unconventional monetary policy, in this case formal Yield Curve Control (YCC). When the economic recovery will materialize, the Federal Reserve will likely want to run the economy hot, and YCC will help preventing yields from rising too quickly. In the past two weeks, three Fed officials, including Vice Chairman Richard Clarida, gave hints of serious talks among the FOMC about targeting specific yields on Treasury securities as a way of ensuring that borrowing costs remain low. In 2010, in the midst of the global financial crisis, the Fed staff presented three options to the FOMC for YCC (see here, it is worth a read):
1) Policy signaling approach which is a form of yield caps on maturities during the period over which the FOMC expects to keep interest rates near zero;
2) Incremental approach which consists in preventing front-end yields (i.e. up to two years) from rising too fast. This is the option favored by Clarida in his latest speech;
3) Long-term approach which would consists in targeting a long-term Treasury yield.
In the eurozone, formal YCC might not be legal, is not needed at the moment, and would certainly raise major political discontent. But what is clear is that we have definitively entered into a new period of economic history where central banks on both sides of the Atlantic are market makers and thus will do whatever it takes to avoid a sovereign debt crisis. This time is truly different.