The world economy has changed spectacularly, but Europe’s consensus on debt and inflation remains relatively hawkish and assumes that the inflationary forces of the 1970s are still intact. Yet, population ageing, high income and wealth disparities, and excessive private debt, coupled with strong global demand for safe assets, indicate that aggregate demand and inflation will continue to be weak for the foreseeable future, unless governments act very boldly.
At the time of writing, even though the worst of the COVID-19 pandemic seems to have receded and an economic collapse has been prevented, Europe’s growth prospects are well short of stellar. It is worth remembering that, in the aftermath of the global financial crisis of 2008 and the ensuing crisis in the Eurozone, those in favour of a swift end to fiscal support won the argument, causing widespread economic harm.
This time, policy-makers across Europe have supported firms, workers and families through furlough schemes, income support and loans are continuing to provide new forms of aid. The European recovery fund offers €750 billion in grants and loans to poorer and harder-hit countries. Pragmatism won the day, but only just, because policy-makers in Europe are reluctant to use the full arsenal of the government balance sheet to spur a full and swift recovery in the way the Biden administration in the US is doing.
In universities all over Europe, economics students are thought that a crucial function of the state is to provide and organise insurance to guard against such risks as health, unemployment, poverty and ageing. In contrast to the State, the individual cannot take out any form of private protection against such macro-risks as economic crises, deindustrialisation, natural catastrophes or pandemics.
But, in the real world of European politics, most politicians fear that high debt could spark inflation, that rising interest rates may render government debt unsustainable, or that the cost of servicing high public debt could lead to higher taxes and have a detrimental effect on economic growth.
So, though they created the Eurozone with a shared currency, they also made it a monetary union without a strong fiscal and political union. The result is that the European Central Bank cannot easily be forced to print money. There is thus no bold central bank, like the Federal Reserve in the US, that unequivocally stands behind public debt and gives governments further freedoms. On the contrary, the German Bundesbank, always averse to high public debt and inflation, acts like a brake on the ECB.
Sometimes, one wonders whether policy-makers realise that, over the past five decades, labour’s share of income, as opposed to income that flows to the owners of shares and other forms of wealth, has declined considerably across most economies. When a larger share of income goes to the rich, who save more of it than the poor, demand declines – unless new investment creates additional demand.
The problem is that the world is running low on investment opportunities. Investment as a share of GDP has been remarkably stable for decades, and there may be less need for machines and factories in the era of digital technology and globalisation.
The Eurozone and Germany have had a stable situation for much of the last decade. Malta’s investment has changed rather more. After a period of consistent decline between 2008-2014, gross capital formation as a percentage of GDP started rising and outperformed that in the eurozone, though it has stabilised in the last couple of years. It has also been better than Cyprus’s and Germany’s, though not tiger-like, like that of Ireland. In the last eight years, it has been 1.5 percentage points higher than in the previous five years.
Ways of recycling the surplus savings of the rich have failed. The US is no longer the consumer of last resort, whilst China’s investment boom cannot compensate for under-consumption at home and abroad.
The rest of the world has a demand problem, and unless there is a major shift in bargaining power towards workers and thus a shift in income away from the rich, it will continue to have one for the foreseeable future. A large short-term stimulus might generate some inflation, but the re-emergence of sustained inflationary pressure, as seen in the 1970s, is unlikely.
During the pandemic, we have seen that households with strained balance sheets in the EU, have used more of their income to service and pay down debt. Meanwhile, firms in advanced economies have for several years become net lenders: instead of borrowing money to invest, like they used to, they have saved and accumulated assets. As corporate saving has outpaced companies’ willingness to invest, it has contributed to the demand problem – and there is little reason to believe the trend will reverse.
Ageing populations have piled on a further problem. In theory, older societies may save less as pensioners spend their savings. There may also be a shortage of workers, spurring firms to invest more in technology and machinery to replace labour, and leading to higher wages for the workers that remain. Both effects would tend to drive up inflation and interest rates. But so far at least, ageing has been deflationary. Politically, people also tend to become more averse to inflation with age because pensioners usually own assets that pay them a regular nominal income, and that loses value if inflation rises.
For these reasons, Europe needs a new consensus on public debt. This time, Europe should act differently. The foremost concern should not be public debt, but how to support a swift economic recovery, reach full employment, and bring inflation back to its target level of 2%. Europe needs a new consensus that recognises the benefits of higher public debt, such as increased public investment and more safe assets to invest in and is less obsessive about the potential costs of debt. Low interest rates are most probably here to stay; and faster growth, not austerity is the best way to stabilise public debt.
Nor should that new consensus shy away from debt monetisation as a potential safety valve. Central banks are public institutions and can be enlisted to help states fund themselves in times of rising interest rates. The risk of temporarily higher inflation should be seen as part of a cost-benefit analysis, and not something to avoid at all costs.
After all, despite higher public debt, Eurozone governments paid less in annual debt service in 2019 and than they did in 1995. So long as the interest rate remains below the growth rate, the public debt stock is sustainable because it will automatically fall relative to the size of the economy over time. In these circumstances – as even the German ‘council of economic experts’ argued in their 2007 study that laid the foundation for Germany’s ‘debt brake’ – a debt limit cannot be convincingly justified.
As far as Malta is concerned, our public debt is significantly lower than that of the Eurozone and Germany. After a relatively stable rate of 66% of GDP between 2008-2013, the rate declined rapidly to 42% in 2019. Even despite the COVID-induced hike in 2020, the rate remains considerably below that in 2013.
There are ample arguments, therefore, why an increase in public debt will not lead to high inflation, and certainly not hyperinflation. It also needs to be acknowledged that higher public deficits have benefits, such as protecting people’s incomes through the pandemic or investing in much-needed public goods. Those benefits are the flipside of a small risk of somewhat higher inflation in the future.
The Government should not shy away from this policy stance. The Opposition may rail against it as much as it likes, falling again on the side of the economic nincompoops, but it is a policy that will deliver the desired results.