If COVID-19 Doesn't Kill Us, Will Inflation or the National Debt?

CC license by Chinmaya S Padmanabha

High servicing costs, crisis and collapse, and runaway inflation are all dangers in the coming years. They can be avoided—if Washington partisanship, gridlock, and radicalism don't hinder the proper response.

Governments around the world are running unprecedented peacetime deficits to battle the novel coronavirus and the economic effects of the social distancing measures that battle requires. The United States’ debt-to-GDP ratio at the end of last year stood at 106%. With an estimated current deficit of 12.3% of GDP, that ratio will end the year above the previous record of 119% reached in 1946. The heavy debts incurred during WWII did not prevent economic growth in the US in the years thereafter. Can such a feat be repeated?

There are three dangers that can emerge from heavy debt burdens: high servicing costs that strangle the economy, debt crisis and economic collapse, and inflation. Economies may experience one or more of these in succession or even all at once. Avoiding them will require heavy and potentially permanent government and central bank intervention into the economy. Failure to intervene or implementing the wrong kind of intervention at the wrong time could precipitate one or more of the three calamities.

High servicing costs 
Heavy national debt burdens can “crowd out” private investment (by diverting investment to government bonds) and raising costs so high it is difficult for businesses to turn a profit and for consumers to have disposable income for consumption. The long-term solution to this problem is to pay down the debts, but by limiting growth, the high costs make this difficult by reducing the amount of money available to pay those debts. The short-term solution is central bank intervention to keep interest rates low. Central banks throughout the rich world have been doing this for more than a decade. As a result, debt service costs remain at historic lows and are likely to continue to do so. This means debt service costs will remain low. Central bank debt purchases also mean private investors will have plenty of cash leftover to invest in other assets, so crowding out is unlikely.

Debt crisis and economic collapse
In some ways, debt crises are the result of the opposite scenario to stagnation. Instead of investors piling into government debt, they run from it. When no one is willing to buy debt, those wishing to borrow must offer more money in return, in the form of higher interest rates. Those high interest rates can then lead to stagnation as described above or even recession. If GDP shrinks, debt-to-GDP ratios climb, raising costs and interest rates further. A country can find itself in a “debt spiral”: rising debts lead to higher costs and higher taxes; higher taxes lead to a shrinking economy and rising unemployment; the shrinking economy and rising unemployment lead to falling tax revenues, greater debts, and higher taxes; and so on. A country trapped in a debt spiral may have no choice but to default on its debt.

Luckily, two things will likely prevent this from happening to the United States. First, the global economic crisis caused by the spread of the coronavirus means investors are seeking “safe” assets like government bonds, especially those of apparently creditworthy countries like the US and Germany. Second, as detailed above, the US’s central bank, the Federal Reserve, can buy up US government debt to keep it cheap. This can stave off a debt spiral. Japan’s debt exceeds 200% of GDP and it has yet to experience such a crisis (though, worryingly, its economy has stagnated for two decades even as its debt burden rises).

The final danger is runaway inflation. This may seem an odd concern at a time when inflation has remained low, often too low, year after year. The world economy has been battling a lack of demand for goods and services. Inflation is caused by the opposite: excessive demand for (or insufficient supply of) goods and services. The short-term solutions to the first two dangers can go too far, however. An overstimulated economy produces inflation—especially when supplychains have been disrupted, which may lead to shortages.

So far, deficit spending in the US has not led to any noticeable ill effects and the interventions noted above, and the dollar's status as the world's reserve currency, mean such effects will remain unlikely in the short term. Free money means a kind of fantasy world in which, initially at least, hard choices can simply be avoided. When enough people see borrowing as cost-free, it will become even harder to rein in spending or increase taxes (a feat American governments have struggled with at the best of times). Inflation will not occur unless the deficit spending ends up with consumers, but it may do just that. An example could be through borrowing to finance healthcare and education, which would free up disposable income to spend elsewhere. Another would be an earned-income tax credit increase, which has support on both the left and right.

Since the 1980s, central banks throughout the rich world have been given the independence and mandate to hold inflation down, usually to around 2% per year. That independence and mandate have been attacked from both the left and right over the years, however. When banks, corporations, individuals, and the government itself all stand to benefit from low interest rates, it may become increasingly difficult for a central bank to raise them. Even without changing the law that protects the Fed's independence, a president can bring significant influence to bear on the bank through the appointment process. The Fed’s continued ability to prevent inflation is thus not guaranteed.

A precisely calibrated response
The US government and Federal Reserve must walk a very fine line in the coming years. Both must do whatever it takes to support the economy during the coronavirus crisis. Thereafter, continued monetary support should be combined with a credible plan to bring the budget deficit to zero and reduce the national debt. That plan also needs to include ways to stimulate growth and demand over the long term without deficit spending or massive Federal Reserve interventions. This would mean investments in infrastructure, education, and research, and measures to reduce the cost of living for all Americans, focusing on housing, education, and healthcare, as well as further increases to the retirement age. It is possible to come out of this crisis in a strong position, but given Washington partisanship and gridlock, a descent into any of the above scenarios appears just as likely.


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