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The long run costs of Covid-19

April 22, 2020

Hopefully, probably, one day, the new coronavirus will have disappeared. It will leave behind a huge bill. Beyond a terrifying number of casualties and immeasurable suffering, public debts will have increased by amounts that resemble what happens in war times. Many countries that had allowed their debts to reach large levels before Covid-19, will be facing a huge challenge. How will they handle it?


Large debts are a burden. Taxes must be raised to serve interest and reimburse the debt. Italy, Portugal and Greece spend 3% of GDP or more just to pay interest. These are resources that could be put to a better use, like public spending on productive or socially desirable objectives. Alternatively, taxation could be lower, which would free resources for taxpayers. Large debts are also dangerous. The lenders keep worrying whether they will ever be paid back. They stay put and, then all of a sudden, they panic as a herd when a few of them are seen selling their stakes. The storm does not break out in blue skies.


None of these observations suggest that governments should refrain from stepping up and responding to the Covid-19 epidemic without counting. Even from the narrow indebtedness viewpoint, the best that can be done is to reduce the depth of the recession and ensure a vigorous recovery afterwards. However, it is not too soon to start thinking about how to deal with the legacy debts.


In fact, this question matters for the way governments intervene during the crisis. It is crucial that the expenditures set in motion be strictly temporary. For example, enacting partial unemployment benefits is a perfect response today but should not become a permanent fixture, otherwise it will lead to opportunistic behavior that stands to be quite costly. Another example concerns big corporations like airlines that naturally face such extreme hardship that they have to be rescued. The rescues must not only be explicitly exceptional but also unappealing in normal times. Indeed, some governments provide support by becoming shareholders – in which case there should be a deadline for the state to sell its shares – and/or by forbidding the distribution of bonuses to managers and dividends to shareholders. Much the same concerns commercial banks that are asked to lend to risky customers.


But the most daunting challenge will come later. Public debts will have to be rolled back after the dust – the virus, really – settles. Many people will have a simple solution: tax the rich, who presumably have an easy time as they are locked down in comfortable solutions and do not need to worry for their survival about lost incomes. That will have to be part of any solution but the bad news is that there not enough rich people to make a significant impact. Going down the income scale would provide significant resources but it would require taxing the middle classes, a move that can bring any government down. This could be a good test of solidarity but paying higher taxes is less popular than applauding hospital staff in the evening. Much the same applies to taxing firms. Some firms, big and small, are greatly benefitting from the epidemic so it would make sense to impose a one-off tax on their extra profits in 2020. Beyond that, most firms, big and small, will need to restore their financial wealth after the crisis so taxing them will be counter-productive.


Cutting public expenditures down is another way to go. However, there will strong public demand for significantly more spending on health, for good reasons. Furthermore, one lesson from the lockdown is that better educated people are more prone to working at home and to abide by the regulations. Logically, spending on education should also increase. In theory, the other public expenditures should be reduced to more than make up for these increases. Most governments will struggle to achieve such goals.


Most likely, therefore taxation will be, at best, a small part of the solution and expenditures are unlikely to contribute much, if any. An implication is that the debts will not be rolled back any time soon. The experience with wars, when huge budget deficits are needed to sustain defense efforts, is that it takes decades, not years to bring debts down.


One strategy often adopted is to let inflation rise. A sudden burst in inflation, as in Austria, Hungary and Germany after World War 1, and in Hungary and Greece after World War 2, immediately erases the values of debts, public and private. These bursts are highly disruptive, however, and most unlikely to be tolerated in the developed countries. To seriously dent existing debts, moderate inflation would have to be sustained over many years but it will not not work if interest rates rise in proportion. In that case, the higher borrowing costs offset the benefit of debt erosion. Yet, this approach has been adopted in many countries after World War 2, and it succeeded because of financial repression, which limited interest rate increases and often mandated commercial banks to acquire Treasury bonds. Financial repression was eased up in the 1970s and 1980s. Since then, while highly regulated, the financial markets operate freely in a large number of countries, which has led to financial globalization. Reversing this evolution and re-establishing some form of financial repression will certainly become an active policy issue. As long as interest rates are nil or even negative, there is little point in capping them. This would change if inflation were to be allowed to rise, see below. But there are other ways of repressing the financial markets, in particular in order to prevent financial crises. In mid-March, some European countries – Belgium, France, Greece, Italy and Spain – already moved to forbid some speculative trades.


Backed by financial repression, moderate inflation – around, say, 5% – is a great way of erasing the debt progressively. If maintained for a couple of decades, the job is done, which widely occurred in the 1960s and 1970s. The inflation tax is barely felt by those who pay for it, mainly savers and employees whose wages are not properly indexed. Many countries around the world have brought inflation down in the 1980s. This was achieved by making central banks, which ultimately determine the inflation rate, independent from governments since governments rarely fail to succumb to the inflation tax. Raising inflation would require either removing the independence of central banks or passing legislation that require them to deliver moderate inflation. This would be highly controversial because the experience with subservient central banks has not been a happy one. However, mounting concerns with large debts could lead policymakers to forget old lessons.


Finally, the simplest solution to large public indebtedness is to eliminate the debt, partially or totally. This is called a default or, more gently, debt structuring. Governments have that power to renege on their financial commitments without going to jail like plain people or without being pushed in bankruptcy liquidation like plain businesses. In reality, it is not that simple, however. Lenders – households or investors who hold government bonds – obviously hate this form of holdup. Defaulting governments are then unable to borrow, even though the experience is that this pariah status does not last very long, as the example of serial defaulter Argentina illustrates. Such a brute force solution could be attractive when everything else has failed.


The Eurozone has a special problem. Countries like Japan and the US harbor very large public debts and yet no one worries. The reason is that no one doubts that their central banks will always do whatever it takes to support the debts. Within the Eurozone, there is no such standing assurance, even though several countries’ public debts are in the danger zone and more will get there. The ECB is limited in its moves by disagreements among member countries. As a result, the countries with very large debts are in the danger zone and could remain there for years to come. Given the sheer size of Italy’s public debt, a panic in the markets could bring the euro to its end.


One solution is to partly mutualize the public debts. Thus, some Italian bonds, along all other bonds, would become Eurobonds guaranteed jointly by all member countries. These bonds would be correctly seen by the financial markets as perfectly safe. The remaining Italian debt would be smaller than the current (and the future) one and therefore away from the danger zone. Many variants of this solution have been advanced over many years but strongly rejected by the lower-debt countries, which are loathe to ask their taxpayers to guarantee foreign debts.


Other proposed solutions would make it possible for the ECB to acquire parts of the national public debts and keep them forever. In effect, this would extinguish these debts since the interest paid by national governments would be redistributed to the same governments as part of the ECB’s profits. National taxpayers would not be on the block and the remaining debts would be safely way from the danger zone. Some fear – the same who cried wolf when the ECB started to inject massive amounts of cash in 2015 – that it would create runaway inflation, but this is wrong. It simply did not happen and will not.


In the end, the public debt problem will become a painful thorn. No solution is easy and most are painful. And yet, something will have to be done if we want to avoid highly disruptive financial crises.

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