This opinion piece by Professor Peter Robertson and Rod Tyers, from UWA's Business School, is reprinted with the permission of The Australian Financial Review newspaper. It was published on Wednesday 1 April 2020.
The unprecedented nature of the pandemic and economic relief package has drawn comparison with wartime periods. The metaphor is apt. It covers not only the diversion of the labour force and the loss of production – then to war activities and now to staying at home – but also the debt needed to finance it.
The government spending announcements so far add up to over $214 billion, or 11 percent, of Australia’s GDP (not including underwritten private debt). While referred to as “stimulus packages”, they are not stimulus in the traditional sense but emergency funding to ensure the best chance of a bounce back at the other side of the crisis – in today’s case the turning of the epi-curve.
Yet how these costs will be covered should legitimately concern us, the more so in the light of fanciful speculation that the emergency funding can be attained for free – that the government can simply pay by printing extra money.
Money for nothing seems like a fairytale and it is.
The emergency funding means, fundamentally, that the government is now spending more than it is earning through tax revenues. Assuming that the government isnot going to cut back substantially in other areas, such as health, defence, education or welfare, the spending will result in a bigger government budget deficit. The debt shows up on the government’s balance sheet and is funded either by borrowing from the private sector or from the central bank. The ultimate question is not which of these institutions does the financing but the means of repayment.
There are several alternatives and governments are likely to rely to some extent on all of them.
First, the government can increase taxes in the future. An extra GST, an extra Medicare levy, an increase in income tax and more effective resource rent tax are all on the cards. It’s likely that, once the health crisis is over, we will see tax increases that reduce the level of outstanding sovereign debt. A more hopeful scenario is that resurgent economic growth delivers the extra revenue without the need to actually increase tax rates.
Either way, in a time of concern about intergenerational inequity, this represents the passing of the burden to future generations in the most explicit way possible. Tax increases are politically unpopular and, if the economy fails to bounce back, new taxes would potentially draw the recession out. It is more likely that the government will face pressure to extend tax breaks rather than increase taxes.A large monetary expansion will make money so abundant relative to goods that high rates of inflation could return.
A second alternative is to “monetise” it – to have the Reserve Bank of Australia, our central bank, acquire most of its debt using newly printed money and then hold it on what would become a bloated balance sheet.
Sadly, proponents of “modern monetary theory” notwithstanding, this is not a freebie. Since the GFC, private wealth managers and financial institutions have sought to hold additional money, either to maintain liquid proportions as the growth of financial wealth has outpaced GDP or out of pessimism about risks associated with future economic performance. The last decade has therefore seen expansionary monetary policy to meet this demand throughout the OECD, which would otherwise have caused employment-sapping deflation. Failure to meet the target inflation range of 2 to 3 per cent per year, despite this expansion, has thus far constrained inflation expectations.
While it is hardly a time to be more optimistic, the pandemic has changed relative optimism about the future. Failing a complete economic and political disaster, longer-term returns should become attractive relative to cash or more liquid assets. In this environment, a large monetary expansion will make money so abundant relative to goods that high rates of inflation could return. The extensive temporary shutdowns of many industries and services will add to this pressure by creating goods shortages that persist due to the temporary loss of capacity and expertise. This parallels the behaviour observed in the 70s, when monetary expansions in response to supply side cost increases kicked off the stagflation of that period.
Heavily indebted governments might not mind the resulting erosion of their real debt obligations and central banks may not resist it, having struggled against deflationary pressure for a decade. Yet this will erode the real incomes of people who are in weaker wage bargaining positions: people whose wages are fixed in nominal terms, workers who are not unionised or whose salaries are not indexed, not to mention the private holders of the sovereign debt. They all bear the future “inflation tax”.
If the RBA does not accommodate the new inflation, monetary tightening during the recovery will see moderated but higher inflation combined with higher interest rates. These would burden new borrowers, like younger homebuyers, and retard investment more generally.
So monetising the deficit means the government obtains real purchasing power in the short run. Yet the rising inflation and interest rates would impair any recovery on the other side. The advantage over increased taxes is that this is not “in the face” of voters and so it is popular with democratic governments. The more obscure costs, however, can be strongly regressive. Moreover, rising interest rates make the servicing of the increased sovereign debt more expensive, requiring more fiscal stringency than might be desired if the recovery is delicate.
A final option is to service but not repay the debt, and thereby pass it on to future generations. This is not as selfish as it sounds if we think of the pandemic as a once in a hundred-year event. A return to fiscal stringency would nonetheless be required.
Emergency funding is surely a good thing in the potentially appalling circumstances currently faced, but it doesn’t come free. It is likely that the resulting debt will be repaid over time via higher prices, higher interest rates and higher taxes. Each means of paying the debt is as real as the other, but they each place a burden on different parts of society. Benjamin Franklin’s adage “nothing is certain, except death and taxes” seems like a good description of both battle fronts of the COVID-19 pandemic.