Can policymakers reduce the debt burden without strangling economic growth?

John Maynard Keynes once remarked that “there is no more subtle and sure way to overthrow the existing base of society than to debauch money.” As the specter of higher inflation appears to become more than transient, policymakers should be wary.

Keynes first made this observation in the context of the high indebtedness of European governments after World War I. It has always been tempting for governments to erode the value of their loans through inflation, rather than swallowing the bitter medicine of cutting spending or raising taxes. The British economist noted that inflation represents a form of arbitrary confiscation by governments of the wealth of their citizens. Indeed, high inflation reduces the real purchasing power of both wage earners and those with significant savings. However, it can also enrich those who hold large assets, who see the value of those assets soar. Throughout human history, the rapid increase in inequality has tended to lead to conflict.

Since the global financial crisis of 2008, central banks around the world have engaged in quantitative easing and extremely low interest rates in an attempt to stimulate economic growth. At the same time, wealth and income inequalities have increased. Monetary and fiscal incentives in response to the COVID-19 pandemic have added fuel to the fire. However, recent policy measures have only exacerbated pre-existing trends. Combined with technological advances resulting in industrial automation and outsourcing, increasingly regressive tax policies and less rigorous antitrust enforcement due to the inclination towards free market ideology in the 1980s resulted in huge increases wealth for some, while the wages of many ordinary workers in developed countries The West has stagnated. Meanwhile, market-oriented reforms in China have helped lift millions out of abject poverty, but, even there, slowing growth and sharply rising wealth disparities have recently exacerbated tensions. social.

Of course, Keynes himself spoke out against overly strict monetary policies during the interwar period, also arguing that in the face of economic stagnation, governments needed to increase spending to “pump” the economy. Certainly, thanks to rapid and large-scale monetary actions under Ben Bernanke, the US Federal Reserve Avoided even more catastrophic global economic turmoil in 2008. However, with the political deadlock preventing the use of fiscal levers, the US recovery has become too dependent on an accommodating monetary policy.

COVID-19 has forced governments to trigger massive fiscal stimulus in addition to unprecedented monetary measures from central banks. However, unlike the global financial crisis, which affected consumer demand, the pandemic had a major impact on the supply of goods and services. Stimulating demand through flexible fiscal and monetary policies at a time when global supply chains have been disrupted is likely to simply fuel price inflation, as more money drives out a tight supply of goods. As economies emerge from the pandemic, policymakers are now caught in an impossible impasse.

Prolonged accommodative monetary policies encouraged massive borrowing. The U.S. government’s debt-to-GDP ratio reached an all-time high of 136% in mid-2021. Tightening monetary policy will inevitably lead to lower asset prices, especially fixed income securities such as government debt. Since US Treasuries are the main asset used as collateral in financial markets, this could lead to a cascade of deleveraging that would precipitate a collapse of activity in the real economy. It would further increase debt servicing costs for the U.S. government, and while America is in the privileged position of being able to simply print more dollars to meet its obligations, it would likely trigger an inflationary spiral as well.

Policymakers will need to walk a tightrope to reduce the debt burden without stifling economic growth.

In the deleveraging phase of the credit cycle, policymakers can follow four paths. First, they can reduce expenses. The problem is, when aggregate consumption and investment fall, it can weigh more heavily on economic activity and make it even more difficult to service loans. Second, they can be lacking. In the case of the US government, a default would lead to global financial chaos that would inevitably hurt the United States itself. Third, they can continue to redistribute wealth by raising taxes. Although like the first two options, raising taxes just to pay off debt would precipitate a drop in economic activity, taxation is not always a zero-sum game. Where excess savings are accumulated or used for unproductive purposes, raising taxes to invest in infrastructure, scientific research, and education could actually increase long-term economic growth. Fourth, they can print more money. However, as the experience of hyperinflation in Germany in the 1920s showed, it can be very destabilizing and have catastrophic social and political repercussions.

American policymakers face tough decisions. A key consideration will be the role of the dollar. The dollar-centric global monetary system that has persisted since the 1940s has inflated international demand for dollars, preventing the U.S. currency from depreciating in response to higher relative productivity gains in other countries. This has singularly contributed to an erosion of American industrial competitiveness and undermined economic vitality. Given the global dependence on the dollar, the changes will be complicated. Nonetheless, any serious attempt to address contemporary economic and financial challenges must face the long overdue reforms of our global monetary system.

James Fok is the author of the forthcoming book, Financial cold war, published by Wiley.

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