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COVID19: When is national debt too high?        

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The Covid-19 virus has had a massive impact on national budgets and particularly national debt. Faced with the prospect of unprecedented unemployment and economic recession, governments have borrowed and spent as never before.

Will rising debt levels lead to periods of future austerity?

Are we burdening future generations, our children, with huge debts?

As governments pump increasing amounts of money to support coronavirus-hit economies, these questions are the subject of intense debate.

The traditional view of fiscal conservatives has been that a high percentage of national debt (relative to Gross Domestic Product) can lead to runaway inflation and economic disaster.

There is no shortage of examples.

Brazil, Argentina, Bolivia, Venezuela, as well as numerous other countries around the world can bear witness to the potentially ruinous impact of excessive debt.

To guard against excessive national debt and deficits the European Union established the European Stability and Growth Pact.

This lays down a national debt target for member nations of no greater than 60% of their GDP.

This target was closely monitored (often by the Troika) for many years.

There were even provisions for penalties for countries exceeding the target. But once the pandemic hit, all this was brushed aside with scarcely a murmur.

The recent financial stimulus package provided by the European Commission to counter the economic impact of the pandemic will inject €1.8 trillion into European economies, mostly in the form of new debt.

Countries which already exceed the 60% limit will be major recipients.

Italy’s debt will increase from a current 134% of GDP to a projected 167%.

Greece, with a current national debt of 177% of GDP will be another major beneficiary, as will Spain whose current debt is at 110% of GDP.

Having recently fallen below 100% of GDP, the national debt of Cyprus is set to rise close to 112%.

Even Germany, which championed the 60% target, now looks forward to an upswing in its own national debt to 77% of GDP.

Experience with high debt levels

High and rising national debt levels are not a recent phenomenon.

During the great recession of 1929, Herbert Hoover, the president of the United States relied on traditional “sound money” policies.

He struggled to hold budget deficits down. His view was that “prosperity cannot be restored by raids upon the federal treasury”.

The national debt ratio when he took office in 1928 stood at less than 20% of GDP.

He fought against any measures and projects to alleviate the record unemployment of that time.

Nevertheless, when he left office the debt ratio had increased to 32% of GDP, considered at that time to be high. The recession worsened.

Hoover’s successor implemented a quite different approach.

Roosevelt’s “New Deal” called for state intervention in the form of government-funded projects aimed at increasing employment (about the same time as a young economist from Cambridge, John M. Keynes published his “General Theory”).

The national debt increased to over 40% of GDP, considered by many as “too high”. The American economy improved.

Although Roosevelt’s policies brought about major improvements, some economists point out that full employment was not reached until the wartime expenditures brought about by WW2.

Fueled by wartime expenditures, the American national debt ratio at the end of WW2 reached an unprecedented level of over 120% of GDP.

The recession predicted by some did not follow. The period after the end of WW2 introduced a record-breaking economic boom.

Is debt too high?

There are concerns today that debt which has been run up to counter Covid-19 will lead to austerity as it is repaid.

Some governments are even considering the possibility of higher taxes and then a need for future austerity. Of course, debt repayment is necessary. Or is it?

The Nobel Prize-winning economist, Paul Krugman points out that the U.S. “massive” post WW2 debt of $224 billion (debt to GDP ratio of 120+%) was never really repaid.

In subsequent years, the American national debt continued to rise in money terms far above €224 bln.

But over time economic growth and inflation can reduce debt ratios.

The US national debt by 2010 had reduced to 91% of GDP, even though in money terms the debt amounted to more than $13 tln.

With the pandemic, it is once again rising above the 120% level, amounting to some $25 tln.

History suggests that perceptions of what level of national debt is “too high” has moved steadily upwards.

National debts that today are thought as acceptable (e.g., 60% of GDP) were a few decades ago considered too high.

Secondly, it is clear that high debt levels can be dangerous but properly managed do not invariably lead to runaway inflation and recession.

Fiscal conservatives take a different view. The debate continues with strong arguments on both sides.

Dr Jim Leontiades is a former Director of the Cyprus International Institute of Management (CIIM) www.ciim.ac.cy