Sunday 7 March 2021

How to dispose of Corona debt

 Published on 4th March 2021 in German at MakronomMagazin

https://makronom.de/wie-sich-die-corona-schulden-entsorgen-lassen-38585

 The EU states could deal with public debt, which rose sharply in the Corona crisis, in various ways. How promising are the individual options? An analysis by Helmut Reisen.

Like other pandemics before it, the current Corona pandemic will eventually end - either "medically" or "socially". The medical end occurs when the number of people who fall ill drops sharply. The social end takes place mainly in people's minds. It occurs when the fear of the disease decreases, people no longer want to accept the restrictions - and learn to live with the disease.

The same applies to the economic policy course, which will have to deal with the aftermath of the crisis. In Germany, the public dispute about the Corona pandemic has been very poisoned for quite some time, and unfortunately this increasingly applies to economic policy debates as well. Thus, in the meantime, it seems that even invective with ad hominem attacks in the ostensibly serious daily press regarding the financing of the pandemic measures is acceptable. This article is intended to help keep a cool head in the debate by outlining the various options for dealing with the national debt.

Historical lessons

The social and economic consequences of the virus have acted as an exogenous shock on public debt. The pandemic will leave behind high public debt/GDP ratios. There is ample historical evidence to learn from: The last 150 years have provided us with enough illustrative material on how advanced nations have dealt with debt. The Great Depression of 1929-33, the world wars of the 20th century and the world financial crisis of 2007-09 were also exogenous shocks that resulted in high government debt ratios in advanced countries. The Federal Reserve's Volcker monetary shock inflated emerging market sovereign debt in the 1980s via the dollar, commodity prices and interest rates. High public debt was also endogenous in these countries, for example as a result of balance sheet currency mismatches or loss-making state-owned enterprises.

Three notable periods of public debt relief can be identified, in the decades before World War I and in the period from the end of World War II to the beginning of the 1970s. The mean value of government debt often reached around 150% of GDP before being reduced to a value of around 40%. What were the main drivers of this erosion?

  • A recent study by Eichengreen et al. describes three successful episodes of debt consolidation before World War I: Great Britain after the Napoleonic Wars, the United States in the last third of the 19th century and France in the decades before 1913. The Napoleonic Wars, the Franco-Prussian War and the US Civil War were the three most expensive military conflicts of the 19th century, resulting in debt-financed war spending. Debt relief after these wars was carried out in all three states primarily through primary surpluses in view of positive interest rate-growth differentials (interest rates were higher than growth).
  • After the Second World War, debt ratios in the developed economies fell rapidly. They reached the pre-World War I level in the 1960s. However, this was primarily caused not by budget surpluses but by the rapid expansion of nominal GDP. The post-war boom had various labels: Erhard's "economic miracle years" in Germany, "Les Trente Glorieuses" in France, "Il Boom Economico" in Italy. In the case of Germany, the debt cancellations of 1948 and 1953 by the Allied victorious powers also depressed the debt ratio.
  • Towards the end of the 20th century, public debt ratios in the poorest countries fell rapidly and initially remained at a fairly low level. The main reason for this was the HIPC initiative of the Bretton Woods sisters in 1996 in favour of mostly African low-income countries. These had not benefited from the Brady Plan of 1989, which had mainly provided debt relief to Latin American emerging countries.

Today, after a year of the Covid pandemic, the Maastricht criterion of a 60% ceiling for the debt-to-GDP ratio is being blatantly missed, especially in Latin Europe. How can the highly indebted EU states get off their Covid debt? And: does that even make sense with the current interest "costs", which are close to or occasionally below zero?

Debt dynamics

Public debt as a percentage of GDP only declines if nominal GDP growth exceeds interest and is not compensated by the interest-adjusted budget deficit (primary deficit). In the (first) Covid year 2020, the public debt ratio skyrocketed despite massive EU support, especially in Latin Europe, which suffered additionally from the loss of tourism.

The purchase of government bonds by the ECB and the national central banks is thus broadly equivalent to debt relief for the state

In 2020, the ratio of growth to interest rates was naturally unfavourable due to the covid recession. But if the euro countries recover economically in the current year, this relationship will be reversed. On the one hand, market interest rates are currently still negative or very low, on the other hand, governments de facto no longer have to pay interest on their outstanding bonds held by the Eurosystem: The government pays interest to the central bank, which now holds the bonds, but the central bank usually returns this interest income to the government. So the purchase of government bonds by the ECB and the national central banks is broadly equivalent to debt relief for the government.

Debt relief

Led by Thomas Piketty, over 100 economists have proposed debt relief. They argue that this would allow governments to issue new debt unencumbered by old debt to finance major projects. In doing so, the signatories also refer to the London Debt Agreement of 1953, a radical plan to cancel half of Germany's foreign debt and create generous repayment terms for the remaining debt. The agreement boosted Germany's economic growth by creating fiscal space for public investment, lowering borrowing costs and stabilising inflation.

However, the idea that a selective default on the debt held by the ECB would be without consequences is unrealistic. Such a decision would at least have the effect of closing the umbrella offered by the ECB today and increasing the cost of re-leveraging or refinancing the remaining debt. Debt relief limited to individual countries is also ruled out because of the immediate contagion effects. Finally, from a purely accounting point of view, the benefit of repudiation would be zero in the short term: after all, the debt repurchased by the ECB was acquired by the central banks of the Eurosystem, which on-lend the proceeds accruing to it to their finance ministers.

Inflation

As long as the ECB sticks to the inflation target of 2% (and does not allow medium-term overshoots), it must reduce base money M0 if it misses the target. The ECB sells either government bonds or its own interest-bearing bonds, thus taking back the seigniorage it granted the government when it bought the bonds.

It would be different if the ECB allowed more inflation in the future, i.e. did not counteract it when inflation was above 2%. Then it would not have to sell the bonds (or issue its own bonds). In this case, higher inflation would reduce the real value of government debt that is not on the central bank's balance sheet and that has been issued at very low interest rates in recent years. Governments would win first, while private bondholders would have to "pay" for the higher inflation. Nominal interest rates would rise, lowering the price of the long-term government bonds that these investors bought at negative or zero interest rates. The inflationary surprise loss would subsequently make government bond financing more difficult and more expensive. In addition, tax revenues could fall in real terms when inflation is high as a result of the so-called Tanzi effect.

Financial repression

Carmen Reinhart and BĂ©len Sbrancia have shown in a widely acclaimed study how governments could get rid of their debt burdens by means of financial repression. Financial repression, like a tax on bondholders and savers through negative or below-market real interest rates, reduces government debt. It is most successful in liquidating debt when accompanied by moderate inflation.

After World War II, capital controls and regulatory restrictions created compulsory buyers of government debt and limited the erosion of the tax base. From 1945 to 1980, interest rates in advanced countries were negative about half the time - so savers paid on top when they lent money to the government. Britain and the United States liquidated debts averaging 3 to 4% of GDP annually as a result. In Australia and Italy, where inflation was particularly high, liquidation rates averaged more than 5%. Average annual savings in interest expenditure for a sample of twelve countries range from about 1% to 5% of GDP for the entire period 1945-80.

However, the fiscal yield of financial repression will be lower today in the Eurozone than it was then. Even Greece was able to sell an eight times oversubscribed ten-year government bond to investors at 0.8% just a few weeks ago. In addition, 80% of Greek government debt is held by public creditors such as the Euro Stability Fund (ESM). As part of the Pandemic Emergency Purchase Programme (PEPP), the ECB is also buying Greek government bonds, despite the securities being classified as non-investment grade.

Austerity

The key determinant of future debt stability is the ratio of interest rates to growth, more specifically the average cost of debt minus nominal GDP growth. This interest-growth differential is the black box of debt dynamics: countries where nominal GDP grows at a rate identical to the average cost of debt can stabilise the debt-to-GDP ratio by maintaining a balanced primary budget. States whose GDP in nominal local currency grows faster than the average cost of debt can stabilise debt by running a primary budget deficit (the size of this debt-stabilising primary balance or DSPB is determined by the level of debt relative to GDP in the previous year and the difference between interest and growth). In contrast, countries that pay more on their debt than nominal GDP grows must run primary surpluses to stabilise the debt-to-GDP ratio.

The interest rate-growth differential is the ´black box´ of debt dynamics

Using a historical database of average effective government borrowing costs for 55 countries over a period of up to 200 years, Paolo Mauro and Jing Zhou documented in an IMF study that negative interest rate-growth differentials occurred more frequently in both advanced and emerging market economies and often persist over long historical periods. In such periods, the debt ratio erodes with comparatively little fiscal discipline.

At the IMF, such a result cannot simply be left standing. Therefore, Mauro and Zhou point to the low information content of average interest costs: the default history of sovereigns shows that after longer periods of low differentials based on average effective interest rates, marginal borrowing costs can suddenly and sharply increase and countries can be excluded from the financial markets in the short term.  And even if interest rates are quite low, this does not mean that there is a fiscal free lunch in dynamically efficient countries, as Ricardo Reis, currently much respected among "fiscal hawks", argues. The label "dynamic efficiency" does not apply to Germany, as the Federal Republic saves too much at the expense of current generations and produces high current account surpluses.

The Maastricht criterion has lost all credibility and thus binding after the Covid pandemic

The following table gives an impression of the scope of the task: The "debt ratio stable primary budget position" (DSPB) reflects the calculations of the rating agency S&P for the necessary primary budget of the countries to avoid a further increase in the respective debt ratios until 2023.* In Belgium, France, Italy and Spain, the primary balance would have to increase by more than 10 percentage points of GDP compared to the negative balance of 2020 in order to consolidate the budget in this way. The interest-adjusted primary budget will have to come down from the negative balance of 2020 at the latest after the end of the pandemic. In principle, this can only be done by increasing tax revenues or cutting spending, whereby an increase in tax rates can be just as counterproductive in fiscal terms as spending cuts are harmful in terms of growth policy, even if the EU's reconstruction fund, financed for the first time by common European bonds, will cushion some hardships.

The shortcoming of such calculations of debt dynamics is, among other things, that a higher debt ratio requires a lower primary surplus; therefore, according to S&P, Greece would manage with less austerity. The last column therefore shows my calculations of how many years it would take to squeeze government debt back below the Maastricht criterion of 60% at S&P's projected interest rate differentials to growth. In some cases, it would take several generations.

Parameters of debt dynamics in some EU countries (2020)

Country

DEBT RATIO (IN % OF GDP)

PRIMARY BUDGET (IN % OF GDP)

DSPB* 2023

YEARS TO MAASTRICHT**

Greece

205.6

-7.1

-0.3

30

Italy

155.8

-7.6

6.2

96

Portugal

143.2

-4.2

0.9

32

Spain

117.1

-9.9

6.5

22

France

113.9

-8.5

5.6

24

Belgium

113.8

-8.8

7.4

53

Median Eurozone

86.1

-6.7

4.6

13

Memo: Germany

66.6

-5.6

4.0

4

*Debt ratio stable primary budgetary position (DSPB) until 2023. R=(D/Y)/0.6. **"Years to Maastricht" calculated from J=-(ln R/(g-i,%)). Sources : own calculations; S&P Global (2021), Sizing Sovereign Debt and the Great Fiscal Unwind

Because of many uncertainties, precise figures are less important here than the message: the Maastricht criterion has, in my view, lost all credibility and thus commitment after the Covid pandemic.

Perpetual debt

Among others, George Soros or Guy Verhoefstadt have recently called for the issuance of perpetual bonds, also called consols or perpetuals. These have an infinite maturity and pay an annual coupon. Their principal is never repaid. The main argument for issuing perpetual bonds is that the EU should take advantage of the low interest rate environment to lock in low interest rates through perpetual bonds. Perpetual bonds are also not subject to refinancing risk as they never need to be rolled over.

Would perpetual bonds be a low-cost repository solution? Given today's very low yields, it may be worthwhile for issuers to take on long-term debt at favourable conditions. But financial mathematicians are rather unimpressed . With a positive yield, a perpetual bond is a comparatively expensive source of funding compared to issuing ten-year bonds, which currently trade at rates below 0%. The yield is the average interest rate over all coupon terms, weighted by the present value of each interest coupon. However, it is difficult to make this calculation for a perpetual bond because we cannot observe interest rates to infinity. The ECB yield curve stops at 30 years because there are few bonds with a maturity longer than 30 years.

Yield curve of Eurosystem government bonds


Source: ECB

The well-rated Republic of Austria (S&P rating: AA+) is a pioneer in Euroland for government bonds with extremely long maturities. It issued a 100-year bond with a coupon of 2.1% in 2017 and increased it to six billion euros in 2019. Currently, the yield is just below one per cent.  The 51-year bond with a coupon of 0.5% of the less well-rated France (S&P: AA) currently yields similarly high. The question is above all who will want to invest in such long-dated bonds when yields rise at the long end.

There is no such thing as a 'jack of all trades', but any variant will produce winners and losers, whether they are governments, their taxpayers or bondholders.

Currently, there is a high demand for these ultra-long maturity bonds, so their monetisation by the Eurosystem is not necessary. Why? Institutional investors or endowment funds usually use long-dated bonds to extend the maturity of their bond portfolios. The addition on their asset side helps them to reflect the maturity structure of their obligations (liabilities). Austria, like many other developed countries, is considered low-risk, so investing in the 100-year bond will at least give investors a positive long-term return - in contrast, many shorter-dated government bonds in Europe currently have negative returns.  Bonds with ultra-long durations also benefit from "positive convexity": if investors own long-dated bonds with low coupons (low payouts), their purchase price increases more when yields fall. Conversely, when yields rise, investors benefit from an implicit asymmetry of highly convex bonds. Indeed, the price of a bond with high convexity falls less when yields rise than it rises when yields fall.

Every variant has winners and losers

And the moral of the story? The multitude of historical examples of debt consolidation today inform us about different options: with and without austerity, with and without (de facto) debt repudiation, with and without financial repression or inflation. Surely, combinations of different variants are also possible, which allows policymakers to pursue the strategy of consolidating or disposing of high pandemic debt with multiple instruments.

It should also have become clear that there is no such thing as a 'jack-of-all-trades', but that each variant will produce winners and losers, whether they are governments, their taxpayers or bondholders. Who wins or loses exactly how much and when must ultimately be decided in the democratic process. For the selection and weighting of these options is the responsibility of neither economists nor journalists, but parliaments, governments and their voters, who should be as well informed as possible about the consequences of these decisions.