In Navigating the Economic Recovery, One Size Does Not Fit All

Different countries will need different responses to dealing with the global economic challenge, but risks of spiralling debt or inflation can be controlled with timely and specific decision-making on policy.

Expert comment Updated 15 September 2020 Published 8 June 2020 2 minute READ
Empty shelves and shop fittings, sheets of closing down posters lying on the shop floor. Photo by In Pictures Ltd./Corbis via Getty Images.

Empty shelves and shop fittings, sheets of closing down posters lying on the shop floor. Photo by In Pictures Ltd./Corbis via Getty Images.

Concerns are growing in some corners of financial markets about the longer-term consequences of government and central bank support packages - and two in particular are starting to gain more attention.

The first is that a huge injection of policy stimulus eventually leads to a pick-up in inflation. Concepts such as ‘helicopter money’ and ‘deficit monetisation’ have now entered the mainstream, invoking images of Weimar Germany post-World War One. The second is that the costs of providing fiscal support will lead to an unsustainable rise in debt.

These concerns are actually related, since one way of eroding debt burdens over time is through higher inflation. But both are overdone. If current policies remain in place, that makes the threat of higher inflation significant, either because aggregate demand rebounds and economies return to full employment, or because inflation expectations rise and the spectre of stagflation appears.

Generating inflation is difficult

But this point in time remains a long way off. Japan’s experience shows how difficult it can be to generate inflation in a world of flat Phillips’ Curves and where inflation expectations have become entrenched at low levels. And when the point does arrive, authorities can still withdraw support and tighten policy.

Central banks would be able to destroy the commercial bank reserves created as part of the latest round of asset purchases - so quantitative easing (QE) becomes quantitative tightening (QT) - and they can also raise interest rates or reserve requirements, while governments can tighten fiscal policy.

Admittedly, we could still end up with higher inflation if governments and central banks actively pursue this as a policy choice or if they make policy mistakes. And both of those are possible. Timing the withdrawal of policy stimulus is difficult as central banks may come under political pressure to maintain support - particularly in a world of higher public debt burdens - and once it is acknowledged that monetizing debt is acceptable in certain circumstances, it may be harder to change course.

But three points are worth bearing in mind. First, in any of these scenarios, the most likely outcome is a period of moderately higher inflation rather than rampant price increases. The hyper-inflation worries invoked by images of Weimar Germany tend only to come as the result of political and institutional breakdown.

Second, this is not an immediate threat as in most countries the disinflation pressures caused by the current downturn are likely to dominate for several years to come. And third, risks are spread unevenly across countries. It is easier to envisage a bout of inflation in the US or UK over the next decade or so than it is in the eurozone, where institutional structures and regional imbalances tend to embed disinflation.

In terms of the potential risk that support programmes lead to an unsustainable rise in debt burdens, there are two key aspects to this. The first is companies that are not viable take on too much debt from the bail-out measures, such as bank loans backed by government guarantees, or central bank purchases of corporate bonds.

Emergency support is propping up these firms for now, but there could be a painful period of adjustment once that is withdrawn. But this does not mean that the policy itself is wrong as, for every insolvent firm being propped up, several viable firms are likely to be saved. But we could see a rise in corporate defaults as support is scaled back.

Secondly, the fiscal cost of various support measures could lead to an unsustainable rise in public debt burdens. However, the past decade shows that governments issuing bonds in their own currencies can sustain relatively large public debt burdens without causing a meltdown in financial markets.

Admittedly, fiscal risks are greater in smaller emerging markets that still rely on dollar funding and in eurozone countries where national central banks cannot stand directly behind sovereign bond markets. But most governments - including the US, UK, Japan and China - are likely to absorb fiscal costs of the crisis without triggering a rise in borrowing costs that would cause debt burdens to spiral out of control.

Of course, none of this means the crisis will not incur real costs or require difficult choices to be made in the future. But events will play out in different ways in different countries, rather than the ‘one-size-fits-all’ framework dominating most current commentary. And a failure to respond to such a huge collapse in activity and output with substantial policy loosening would have resulted in even bigger economic, social and financial costs overall.