The sharp rise in public sector debt due to the Covid-19 pandemic was an inevitable consequence of the automatic fiscal stabilizers, given their function. This was desirable and even necessary, given the key role of government decisions to support economic entities and boost demand. However, this increase raises the question of the future path of fiscal policy.

In the coming months, this subject will become increasingly heated in view of the debate on budgetary rules at EU level combined with the prospect of a tapering of quantitative easing resulting in fewer securities purchases by central banks. This debate will focus on debt sustainability and the presence, or absence, of fiscal space. The former generally refers to the ratio of public debt to nominal GDP, while the latter focuses on discretionary policy, i.e. the ability of governments to take action within existing plans without jeopardizing market access and public debt sustainability as defined by the IMF.

In a logical perspective, these two concepts are closely linked. A lack of fiscal space would reflect a level of indebtedness at the limit of sustainability, or even beyond that, a situation that would also complicate market access with an increasingly high risk premium. The significant decline in bond rates has gradually led to a reduction in the average cost of the existing debt for various reasons, and to a decrease in the difference between this cost (r) and the long-term growth rate of nominal GDP (g). This dynamic has reduced the non-interest budget surplus (primary surplus) that countries need to stabilize the debt-to-GDP ratio, when r is higher than g, or, in the opposite case, increased the level of authorized primary deficit.

A lack of fiscal space creates visible costs compared to more comfortable financial situations: lower ratings of the sovereign debt mean higher financing cost, but also brings on a latent feeling of discomfort amongst economic agents, who are aware of the government’s difficulties when it comes to shoring up the economy in a new economic crisis. The quantitative easing (QE) policy of central banks has reduced these visible costs. Spread compression in sovereigns has appeared in the Euro zone (the additional cost of a lower rating has fallen) while QE, through its influence on long rates, has created fiscal space, leading some to argue that it is sufficient to stabilize public debt without having to support fiscal consolidation. Such a recommendation implicitly assumes that the central bank will always reinvest the proceeds of maturities, that QE will be renewed to face a new recession, that there will be no shocks that could permanently reduce the growth rate, etc.

A lack of fiscal space can also create hidden or inconspicuous costs. For example, the need to set a high level of taxation, compared to other countries, may influence the country’s economic growth or the establishment of new businesses, and thus also have an impact on the creation of added value. High debt levels may imply an opportunity cost, such as lower potential GDP growth due to the inability to fund structural programmes (education, training, research, climate change, investments, etc.). It can make economic sectors more sensitive to certain shocks because they are directly and heavily exposed to them (i.e. banks with large sovereign debt positions) or because the government does not have the flexibility to support economic activity during a recession.

This latter point was recently addressed in a Bundesbank research paper. The authors analyzed the behaviour of short sellers of equities when the Covid-19 crisis erupted in the spring of 2020. Specifically, the researchers studied whether investors’ behaviour was different in a situation of cash-poor companies headquartered in a country with a low sovereign debt rating from that of the situation of companies with the same financial characteristics but headquartered in a country with a good rating. It turns out that a weak fiscal space (represented by the sovereign debt rating) is most detrimental to companies with low cash flow. The impact is felt on stock prices. For example, the authors found that, well before the sharp market decline on 24 February 2020, short sellers had built up short positions in financially fragile stocks in countries with little fiscal space. It could be argued that periods of crisis are relatively rare and that the economic consequences of these findings are unlikely to be long-lasting. In contrast, the visible and hidden costs of a lack of fiscal space show the importance of the effort required to rebuild it when it becomes exhausted in the wake of a crisis.

 

Reproduced with the kind authorization of L’Agefi