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Budget Deficits Still Matter

Several of the world’s most indebted countries seem to think they can grow their way out of any amount of debt. Good luck.
November 12, 2020
Budget Deficits Still Matter
Jerome H. Powell, Chairman, Board of Governors of the Federal Reserve System during the Senate's Committee on Banking, Housing, and Urban Affairs hearing examining the quarterly CARES Act report to Congress on September 24, 2020 in Washington, DC. The Coronavirus Aid, Relief, and Economic Security Act, also known as the CARES Act, is a $2.2 trillion economic stimulus bill passed in response to the economic fallout of the COVID-19 pandemic in the United States. (Photo by Toni L. Sandys-Pool/Getty Images)

In the last few years, economists and policymakers around the world have been seduced by the fantasy that budget deficits are harmless as long as interest rates remain low. The outsized budget deficits that government are now incurring as they battle the coronavirus pandemic will test the theory, and the results are likely to be painful for policymakers and citizens alike.

In the wake of the COVID-19 pandemic, a number of major countries, including Brazil, Italy, and Spain, now find themselves on unsustainable debt paths. They will all soon learn the hard way the imprudence of embracing debt without any plan to repay, especially if those countries are forced by their debt burdens to resort to debt restructuring or inflation.

Those who argue that budget austerity is obsolete point to the strong likelihood that world interest rates will remain at historic lows, as Federal Reserve Chairman Jerome Powell keeps on suggesting. That makes it likely that growth rates in most countries will soon exceed the real interest rate at which their governments can borrow, which in turn will have the effect of reducing public-debt-to-GDP ratios. In short, these heavily indebted governments are hoping they can grow their way out of debt.

The key point that these budget deficit doves tend to overlook is that in the post COVID-19 world, primary budget deficits (i.e. budget deficits excluding interest payments) will be the dominant factor in determining a country’s public debt dynamics. If the primary budget deficit is sufficiently high, the public-debt ratio will continue to rise even if the country’s economic growth rate were to exceed the real rate at which the government can borrow. There is such a thing as more debt than growth and low interest rates alone can solve—and it’s not that uncommon.

A simple arithmetic example may illustrate the point. Take a country with a public-debt-to-GDP ratio of 100 percent. If that country had a growth rate that exceeded its interest rate by 2 percent, its public-debt-to-GDP ratio would, in effect, shrink by 2 percentage points. However, if that country also had a primary budget deficit of 10 percent of GDP, it would find that its public-debt-to-GDP ratio would have risen by 8 percentage points, even though interest rates were low.

For heavily indebted countries like Brazil, Italy, and Spain, this is more than a mere theoretical exercise. All of these countries went into the pandemic with record high public-debt-to-GDP ratios. They all have also seen these ratios balloon amid the worst economic recession in 90 years as their primary budget deficits have swollen to about of 10 percent of GDP.

These countries are left with few options to improve their budget balances and stabilize their public-debt ratios. Any attempt at belt-tightening when their economies are still weak would risk deepening the recession, which would  hardly reduce their debt-to-GDP ratio. Italy and Spain, being bound to the Euro, are especially vulnerable since they are unable to resort to interest rate cuts or currency depreciation to offset the negative impact of austerity on aggregate demand.

History is littered with examples of countries that have been forced to resort to debt restructuring or hyper-inflation to reduce their real debt burdens. When that eventually occurs in the cases of countries like Brazil, Italy, and Spain, it will become plain for all to see the folly and costliness of pretending budget deficits don’t matter.

It’s worth noting that the United States ended the last fiscal year with a budget deficit of about 15 percent of GDP and a public-debt-to-GDP ratio of close to 130 percent. One can only hope that policymakers in Washington will learn from the experiences of Brazil, Italy, and Spain, and that it isn’t already too late for them to bring our public finances under some sort of control to avoid another inflationary episode at home.

Desmond Lachman

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund's Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.