October 12, 2020, will go down in German financial history. For the first time, new public debt increased at a rate of more than €10,000 ($11,900) per second, faster than during the 2007-09 global financial crisis, when a huge volume of net borrowing was needed. This headlong acceleration of debt, in Germany and in countries around the world, is the price being paid to stave off the economic consequences of COVID-19.
In the German Bundestag, the fiscal consequences of the pandemic have become a central concern, with Germany’s massive €1.3 trillion rescue/stimulus package fueling an already long-standing debate about the country’s debt sustainability. The key question is whether, and for how long, government and society can continue to shoulder the growing burden.
Detailed assessments offer reason to hope that Germany is well prepared. We have followed the path of sustainability, adhering to the rules of the Stability and Growth Pact of the Maastricht Treaty and reducing our debt to less than 60% of GDP before the COVID-19 pandemic hit. These consolidation measures over the past 12 years have given Germany some financial leeway that can now be used in the crisis. The Harvard University economist Kenneth Rogoff, a former chief economist of the International Monetary Fund, has long argued that Germany’s strong balance sheet gives it the capacity to react forcefully in a deep crisis.
In other countries this is not true, at least not to the same extent. In countries where insufficient progress had been made in lowering the government’s debt ratio, the additional pandemic-related debts have imposed a particularly heavy burden. In more and more countries, debt has now outstripped annual GDP, which has considerably reduced the chances of the governments “outgrowing” their debts.
There can be no disputing that an exogenous shock like the COVID-19 pandemic justifies a rise in public spending, as well as reinforced financial solidarity across borders – the raison d’être of the €750 billion European recovery fund, called Next Generation EU, established in 2020. Deficit spending is the order of the day, and none of it can happen without additional debt. But ifs and buts persist, as well they should. After all, even in a crisis as grave as the COVID-19 pandemic, money is not a panacea, and borrowing makes sense only if it is carried out prudently and reasonably. Otherwise, states will lose their financial flexibility in the longer term.
But the issue goes beyond preserving fiscal space. States with spiraling debt run the risk of massive ruptures in their social fabric. Most creditors are affluent individuals and entities whose wealth is increased by public borrowing. The rich grow richer, and the poor lose opportunities to share in prosperity. Widening the gulf between the haves and the have-nots in this way poses a huge threat to social cohesion and risks creating a political powder keg.
Against this backdrop, central banks’ role should not be immune from criticism. Central banks’ increasing purchases of sovereign bonds on the secondary market are swelling the money supply and increasing the risk of inflation.
Traditional advocates of budgetary austerity are not the only ones who recognize the dangers. Even Larry Summers and Olivier Blanchard, staunch champions of credit-financed stimulus spending in the past, are also warning against the potential consequences of growing public debt. It all comes down to the dose. And in the eyes of Summers, a former US Treasury Secretary under President Bill Clinton, and Blanchard, a former chief economist of the IMF, the dose has now been increased to the point that it could harm the patient.
Summers and Blanchard deserve a hearing for their warnings – particularly in Europe, where, even more than in the United States, debt-financed fiscal policies have received monetary backing. With the European Central Bank running the printing press overtime, the monetary base in the eurozone rose from almost €1 trillion in 2009 to nearly €5 trillion at the end of 2020. It will be €6 trillion in June 2021, and further increases have already been agreed. When the money supply multiplies like that without corresponding adequate growth in the volume of goods and services, an increase in the inflation expectations of businesses and households is inevitable. This does not necessarily mean that inflation will actually occur, but, if it does, currency devaluation becomes virtually impossible to stop.
There are already signs of galloping inflation, though not in the case of consumer goods, where annual price growth remains within the ECB target of “below, but close to, 2%.” Prices for real estate, equities, and art, on the other hand, are already rising at a double-digit quarterly pace in Germany. The overall asset price index rose by 6.3% last year. A considerable portion of the monetary excess created by the ECB is evidently being invested in the financial markets or in housing and is feeding speculative bubbles – with all of the aforementioned dangers to social cohesion and political stability that such speculation entails.
Not least for this reason, the German government is keeping a close eye on price trends outside the sphere of consumer goods. In November 2020, the government agreed to a proposal by ECB President Christine Lagarde to include owner occupiers’ housing costs in the Harmonized Index of Consumer Prices. This is a first small step toward enlarging the base of assessment for calculating inflation so that signs of trouble can be detected sooner.
TIGHTEN WITH CARE
Knowing about inflationary dangers, however, will not suffice. The threat of a loss of purchasing power through monetization of government debt requires concrete action. For this reason, several months ago, I initiated a cross-party discussion group to examine monetary policy and its risks and explore the scope that exists for a return to normalcy.
All stakeholders are aware of the dilemma facing the ECB. Applying the monetary brake too vigorously would send interest rates soaring and threaten the stability of the countries with the highest debt ratios. That cannot be anyone’s aim. If the interest-rate turnaround takes too long, however, the risk of inflation is liable to be accompanied by a “zombification” of the economy: the money glut fuels moral hazard, which prevents essential structural adjustments in enterprises and leads to a loss of competitiveness.
So, what is to be done? In the first instance, the fight against the pandemic will continue to govern our actions. That is the purpose of Next Generation EU. And it is gratifying that initial signs of improvement are already visible.
The prospect of recovery makes it all the more urgent to have a firm vision of how the burden of public debt can be reduced once the coronavirus has been vanquished. Otherwise, COVID-19 could be followed by a “debt pandemic,” with dire economic consequences for Europe. Countries like the US and China are already ahead of the demographically aging Europe in terms of productivity and workload. This competitive disadvantage would widen if EU countries were to jeopardize their financial flexibility through excessive debt.
For this reason, every country must work on itself and strive to maintain budgetary discipline. Financial solidarity is, and will remain, a key condition for sustainable investments in education, research, and innovation, without which our prosperity cannot be safeguarded. But one thing is clear: Left to their own devices, members of a confederation of states like the eurozone are too easily tempted to incur debts at the expense of the community. Balanced budgets are almost unattainable in high-debt countries without external pressure.
I have often spoken about that kind of moral hazard with Mario Draghi, now Italy’s prime minister. We have always agreed that, given the structure of the Economic and Monetary Union, maintaining competitiveness and a sustainable fiscal policy are the responsibility of member states.
THE FULL HAMILTON
I very much hope that Draghi can now put this principle into practice in Italy. The outcome is important not only for his country, but for the entire EU. Otherwise, we will need a European institution that not only monitors compliance with the Union’s jointly agreed budgetary rules, but has the power to enforce them. This would require amendments to the EU treaties, of course, but even without them the European Commission is assuming a more prominent role than ever in shaping the direction of European fiscal policy.
A promising approach that the EU could adopt to take political control of the debt problem stems from the German Council of Economic Experts: the European Redemption Pact, an initiative that is already ten years old. Back then, the Council proposed a debt redemption pact for the eurozone modeled on Alexander Hamilton’s historic sinking fund, established in 1792 for the then-infant US.
The sinking fund enabled Hamilton, the first US Secretary of the Treasury, to reduce the former colonies’ huge public debts after the War of Independence, thereby eliminating the threat of state bankruptcy. All 13 US states were required to deposit good collateral, practice budgetary discipline, and reduce their debts. Persistent deficit sinners were put into structured insolvency to prevent moral hazard at the expense of the more frugal states. That external constraint on fiscal policy – and not the mutualization of individual states’ debts, which is occasionally recommended for the EU – was the crux of the oft-cited “Hamiltonian moment.”
Hamilton’s plan worked. It is a good example of how crises can also present opportunities. The secret is to recognize them and grasp them boldly. I am confident that Europe is now ready to do that.