The history of government borrowing over the past hundred years or so can be divided into three periods. Between the start of the first world war and that of the second, conflict, rebuilding and the Great Depression all placed enormous demands on government balance-sheets. During this tumultuous period, governments were often at the mercy of market sentiment. Britain sought to maintain market confidence by reducing debt—which rose to 140% of GDP immediately after the first world war—through painful austerity. The government ran a primary budget surplus (ie, net of interest expenses) of 7% of GDP throughout the 1920s.
The results were disastrous. Austerity undercut economic growth: output in 1928 remained below that in 1918. As a consequence, debt continued to rise, reaching 170% of GDP in 1930. Remarking on the bitter experience, John Maynard Keynes noted that “assuredly it does not pay to be good.” Other economies, forced into more desperate measures, fared even worse. Germany, weakened by war and unable to meet its debt obligations, sank into hyperinflation. The destruction of the currency’s value reduced its debt burden as a share of GDP by a huge 129 percentage points, albeit at an enormous social and economic cost. The default was also common. In 1933 countries making up nearly half of global GDP were in some form of default or debt restructuring.
During and after the second world war, the governments of advanced economies tried a different approach. After the trauma of the previous 30 years, austerity was no longer a politically tenable means of dealing with the debts built up over the period. Some countries defaulted or experienced post-war hyperinflations. Other governments turned to financial repression—ie, forcing creditors to lend to them on unattractive terms. Many of the tools of repression had been deployed during the war to pay for the conflict. In America, for instance, the Federal Reserve bought Treasuries to prevent yields from rising above a set level. The government also capped the interest rates banks could charge borrowers or pay depositors, and restricted bank lending. Capital controls prevented savers from seeking better returns abroad.
The effect was to force domestic institutions and households to lend to the government at below-market rates. As wartime price controls were relaxed, inflation rose to relatively modest levels and the rate of interest on government debt, adjusted for inflation, turned negative and remained so for much of the ensuing decades. According to work by Carmen Reinhart of Harvard University and Belen Sbrancia of the IMF, real interest rates across advanced economies were negative roughly half the time between 1945 and 1980. The British government paid an average real interest rate for just -1.7%; the French, -6.6%. The effect was powerful. Between 1946 and 1961 America’s debt-to-GDP ratio dropped by 68 percentage points. In the 1970s debt to GDP across all advanced economies sank to a low of 25%.
A third era began in the 1970s. Governments of advanced economies loosened their grip over capital flows and financial systems, placing themselves once more at the mercy of global capital markets. Though bond markets occasionally pushed politicians around in the 1980s and 1990s, they slowly lost their power to instill fear. Global financial integration has coincided with a rise in desired saving relative to investment, and a hearty appetite for the safety provided by the bonds of rich countries with stable currencies. Borrowing costs have fallen steadily, even as debt loads have grown. The global financial crisis only reinforced this trend. Public debt in rich countries rose from 59% of GDP in 2007 to 91% in 2013. Yet rich-world governments have been able to borrow at near-zero or negative rates over the past decade.
Money printer go brrr
Covid-19 means there is more red ink to come. A new era of sovereign-debt management could be about to begin. What this period may bring is not yet clear. The post-pandemic debt regime might resemble that of the immediate post-war era. The trials of this crisis could inspire a new wave of investment in technology and infrastructure, leading to fierce competition for available savings and higher government-borrowing costs. Repression would allow governments to manage the surge, especially if barriers to goods and capital go up in the aftermath of national lockdowns.
Alternatively, growth may prove difficult to restart as the pandemic ebbs. Central banks, to provide relief to troubled economies, are already buying up large quantities of government debt. The Fed is purchasing unlimited amounts of Treasuries; the European Central Bank recently announced a €750bn ($809bn) bond-buying scheme. A weak recovery could push central banks to finance large fiscal deficits with freshly printed cash on an ongoing basis. The experience of Japan, once considered an economic oddity, will be repeated more widely. Money-financed borrowing on that scale, with no inflationary consequences, would turn popular ideas about the limits to debt on their head. It would not be the first time a crisis rewrites the rule book.