The New Economic Paradigm
Once upon a time Governments balanced budgets or else borrowed in the financial markets to make up any shortfall. Interest would be paid on any borrowings so it was considered appropriate that a State would keep it’s borrowing at such a level that the overall interest burden as a share of GDP would not rise beyond a certain point. A Government could, of course, allow inflation to rise and this reduced the share of debt as a % of GDP without actually having to pay it back but it created an uncertainty premium going forward.
Borrowings in foreign currency could not be inflated away and could only be repaid by earning an export surplus with which to pay the interest and capital. It could be said that as a general rule Governments should never borrow in foreign currency unless the money is ring fenced for a specific project which will earn the foreign currency with which to repay it. However, the world does not always follow such logic such that at any given time there are numerous countries with foreign debt repayment problems.
The role of Central Banks is to keep the currency stable. Thus, Central Banks were kept independent of Government. We are now in a new era where Central Banks are buying up Government debt as it is issued. Normally this would be the function of investment funds and the capital markets. It would appear that as the debt issuance has grown these don’t have the appetite to absorb all of it so the Central Banks have stepped in. What this means, in effect, is that Governments are printing money and Central Banks are no longer independent.
Does this matter? Well it depends!
Were the current situation to become normalised it is likely that the publics would lose faith in the currencies and inflation would take off leading to devaluations. This would be not dissimilar to the situation in Latin America in the 1980’s. However, during an emergency Governments can take one-off measures that don’t cause the publics to lose confidence. This would appear to apply to the current Covid 19 crisis.
The most common cause in the 20th century for Government’s to exceed normal spending limits and resort to financial engineering was during war. During war Government’s had no option but to spend whatever was required but there was no corresponding increase in revenue. Thus, during World War 1 Britain’s Government spending leapt from about 10% of GDP in peacetime to 70% of GDP in wartime without any corresponding increase in revenues. During World War 2 the corresponding figures were from 25% of GDP to 70%.
In the case of Britain during World War 1 there were two types of borrowing, that in Sterling and that in foreign currency, principally US Dollars. In the case of the former the UK issued debt in the London capital markets. In the case of the latter during the first two years of the War (1914–16) Britain was able to obtain dollars by selling its extensive holdings in the US in railways and other industries. During the latter years of the war Britain had to borrow in dollars from the US capital markets.
When the War ended the Bank of England (the Central Bank) bought up and retired a significant amount of the Sterling debt outstanding. This was effectively the same policy of quantitative easing we see today. It wasn’t inflationary back then because the public understood it to be a one-off. In the case of the dollar denominated debt Britain along with France, who had a similar burden, decided that Germany would pay. This then became the infamous reparations denounced by the economist John Maynard Keynes in ‘The Economic Consequences of the Peace’ as unpayable and which were a significant contributory factor to subsequent events.
The current operations of Central Banks in the advanced countries appear to have created a new paradigm about what is and is not possible for Governments. However, if countries don’t return to standard thinking as soon as practicable they run the risk of inflation and devaluation. The underlying truths of economics are always unchanged; that a country’s place in the international system depends on what it makes and sells internationally and that depends, in turn, on long term investment in science, manufacturing and education. Financial engineering can only be used to avert short-term crises but cannot make a country competitive in the long term.