Paola Subacchi
The year 2021 will prove to be memorable for the global economy.
After the deep recession caused by COVID-19 in 2020, the recovery is now in full swing. Projections point to a solid 5.9% increase in the world's real GDP for 2021. Growth is due to slowdown in 2022 but should remain robust.
Still, the Organization for Economic Cooperation and Development estimates that only the United States and China, among its 38 member countries, will have recovered from the losses by the end of this year, with their economies larger by about 1% and 9% respectively than in 2019. Europe and Japan, on the other hand, will not have recovered, with their economies 1.5% below and almost 3% below where they were in 2019.
People and countries are now gradually returning to pre-COVID life mingling with each other in many different social contexts but the question on everybody's mind is how long it will take to switch economic policy back to normal and remove the support that monetary policy has been providing since March 2020.
While governments have been giving massive fiscal support, central banks have ensured short-term liquidity through market interventions and increased bank lending capacity.
In the wake of COVID, the U.S. Federal Reserve bought $375 billion worth of Treasury securities and $250 billion worth of mortgage securities and has continued to do so "in the amounts needed to support smooth market functioning and effective transmission of monetary policy." Similarly, the European Central Bank allocated 750 billion euros ($869 billion) to the Pandemic Emergency Purchase Program to buy government and corporate debt.
Central banks, in other words, have torn the pages out of their instruction manuals and embraced money financing. As market interventions underpin expansive fiscal policy, the central bank pays interest on the government debt and passes that money on to the Treasury. As short-term interest rates are lower than the interest on long-term government debt, this reduces the cost of a fiscal stimulus. In the U.K., for instance, it will save the public sector a total of 17.8 billion pounds ($24.1 billion) this fiscal year.
The massive fiscal stimulus in the U.S. -- the latest addition being the $1.2 trillion infrastructure bill approved at the beginning of November -- would not have been possible without the support from the Fed. This does not mean, however, that budget deficits do not matter and that just because governments have access to a printing press, they can finance their spending through the creation of cash.
The idea of governments as currency issuers is at the core of Modern Monetary Theory that hit the headlines during the U.S. presidential election campaign last year and contributed to the argument that monetary policy should not be the only policy in times of crisis.
With government debt among OECD countries standing well above 100% of GDP, the question now is not whether we should ignore the debt or turn it into a political battleground, but whether the debt itself is sustainable. Will a return to normalized monetary policy trigger financial instability? Also, should central banks keep interest rates low so that the cost of servicing the debt does not become a further burden on public budgets?
Inflation is the critical variable here. In September, consumer prices increased by 5.4% in the U.S., 3.4% in the euro area and 4.6% in the OECD -- the highest since 2008. Views have been diverging on whether this increase is temporary and whether labor shortages will lead to wage increases, thus adding to inflationary pressures. In the U.S., the latest figures indicate that job creation picked up in October with unemployment falling to 4.6%. Wage pressures are less of a concern in the euro area, where the ECB expects inflation to slow to 1.5% in 2023.
As the ECB is adamant about not undermining the economic recovery, it is unlikely to shift its monetary policy for the time being. Fed Chairman Jerome Powell has also made it clear that improvements in the labor market need to be long-lasting before a change in direction is considered. Unlike the ECB, the Fed is already on the path of reining in market interventions by slowing monthly asset purchases, a process that should end by mid-2022.
President of the ECB Christine Lagarde, pictured on Oct. 28: ECB is unlikely to shift its monetary policy for the time being. © ReutersCentral banks need to act carefully and minimize the scope for policy errors. Tightening too much and too soon would undermine economic recovery, but underestimating price increases might usher in long-lasting inflation.
While a bit of inflation would help share the debt burden, shifting it slightly from private creditors to public debtors, a stagnant economy would make debt stabilization relative to GDP an impossible task. Indeed, the ideal situation would be seeing interest rates remain below economic growth rates, keeping debt servicing manageable.
Both in the U.S. and in Europe, a portion of the massive increase in public spending has been linked to improving obsolete infrastructure. This should support demand and strengthen economic growth in the long term.
If this happens without excessive inflation, then the accumulation of debt on the back of the pandemic will easily be refinanced, and not just because of the government's ability to issue money. This is a calculated risk, but the alternatives are also limited.
The challenges the world is facing to stop environmental collapse are such that they will require active public policies and the use of both monetary and fiscal policy, coupled with an enlightened private sector willing to sacrifice short-term gains for long-term benefits.
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