LONDON (Reuters Breakingviews) - Not that long ago, most economists condemned anything more than modest government borrowing in normal times. They mostly did not trust governments, and they had theories to show that official debts would squeeze out private investment, spur inflation and depress economic sentiment. Now, deficits are A-OK – and that’s mostly good.
The old thinking is not dead. It is an appealing intuition that the government is a sort of big national family which should not spend more than it takes in. Angela Merkel, the German chancellor, characterized that as the wisdom of a “Swabian housewife”.
This has led the euro zone to limit deficits of member governments to 3% of gross domestic product in normal times, and inspired Germany’s so-called “debt brake”, which prohibits further borrowing when the annual deficit reaches 0.35% of GDP, with some wiggle room for economic conditions.
A few, mostly German, politicians still think that large government deficits are simply a bad idea. Some well-known economists agree. For example, Christina Romer, former chair of the U.S. Council of Economic Advisers, said recently that sustained large fiscal deficits are “not a recipe for being a strong, healthy superpower economy,” according to Bloomberg.
For the most part, though, judgements are changing. The facts simply don’t match the old theories.
Consider the Group of Seven leading developed economies, the United States, Japan, Germany, France, the UK, Italy and Canada. In 2007, their average fiscal deficit was 1.5% of GDP, according to International Monetary Fund data. Canada and Germany ran surpluses. Then came the global financial crisis. The countries’ average deficit rose above 7% over the following three years, and did not fall below 3% again until 2015.
The borrowing binge did not obviously cut into growth. It’s true that the average annual growth in GDP per person in the G7 countries shifted downward. Between 2001 and 2007, the average annual increase was 1.4%. Between 2014 and 2019, the average rise in GDP per person has been 1%. However, the numbers in the earlier period were inflated by unsustainable financial activity, and the more recent outcomes have been depressed by trade wars and slowing overall growth in developing countries.
As for inflation, the G7 annual average peaked at 2.9% right as the global financial crisis hit in 2008. After falling to 0.3% the next year, it rose all the way to 2.6% in 2011 – and then dropped back. The IMF forecasts a 2019 average price increase of 1.4%. No one really understands what does cause inflation, but fiscal deficits don’t seem to be on the list.
Deficit-haters can always find arguments for their thesis. Borrowing that seems harmless now may be storing up long-term trouble. Or perhaps the mid-crisis deficits were a special case. This year’s large U.S. fiscal deficit, 5.6% of GDP or over $1 trillion by the IMF’s count, could trigger the long-expected bad effects.
The theoretical battle will rage, but a practical worry has helped tip the balance of thinking. Central banks currently have little room to cut interest rates to respond to a recession. They could resort to putting new money into the financial markets by buying bonds and other assets, but that technique has not proved very effective. So fiscal expansion looks more alluring.
The change should be welcomed on theoretical grounds, too. Governments are actually not like large households. They are the ultimate monetary authority, responsible for ensuring that enough money is circulating to keep the economy going. They subcontract most actual money-creation work to banks, but when private lenders fall short, governments can and should lean in.
Loans to government, like all loans, basically create new money, so fiscal deficits are unlikely to take money away from private investments as the old theory assumed. And any politically competent government that sells its debt domestically can support a high ratio of outstanding debt to GDP. Finally, deficit spending which activates otherwise unused economic potential will push up output rather than stoking inflation.
Voters and politicians can be even more enthusiastic than economists about a more relaxed approach to fiscal deficits. Additional government spending could help pay for helpful infrastructure, alleviate poverty and create more and better jobs. It could even delay the next recession, and limit its depth. No wonder that even German resistance seems to be softening.
U.S. President Donald Trump is already trying higher deficits and the UK under Prime Minister Boris Johnson is likely to follow his example. Italy and Japan would be good candidates, too, although their high existing debt burden scares deficit-friendly economists. Although in theory governments can create money without borrowing, even proponents of Modern Monetary Theory, which is the most pro-deficit approach around, are reluctant to propose that.
However, there is a risk. While fiscal deficits are often good in moderation, they can become dangerous. Unchecked money-creation does eventually create runaway inflation – think Argentina and Zimbabwe. After four decades of disinflation in developed economies, that sort of destabilising inflationary momentum is hard to imagine. However, politicians desperate to win elections – and lacking any fiscal conscience to hold them back – are the one group which might just manage that feat.
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