One consequence of the Covid - 19 pandemic and the response to it, is the accumulation of debt by governments and private companies alike. The question, hence, is rightfully raised, what this might mean for growth and stability going forward and what additional policy responses might be necessary, to protect macroeconomic stability, the efficacy of the banking sector and the viability and vitality of the corporate sector.

We are not just dealing with Covid -19 and its legacy problems. We are also dealing with trends that pre-dated Covid as well as an ongoing economic transition that will change both production and funding activities. This combination of factors makes the current situation especially challenging and the appropriate policy response even more urgent.

Challenges going forward

In a nutshell, the accumulation of debt to the highest levels since the end of the Second World War, limits the extent to which additional debt can be issued, the so called Modern Monetary Theory notwithstanding. The risk of rising bankruptcies in the private sector will be escalating as fiscal support will be necessarily restricted and therefore non-performing loans will be rising in varying degrees across countries and sectors.

Banks are well capitalized and have significant buffers to face off pressures on their balance sheets, but the fact that profitability is low amidst ultra-low interest rates, raises other questions regarding their long-term efficacy.

At the policy level hence, the responses will necessarily focus on debt sustainability, on corporate and sector reorganization, and on further strengthening the banking sector in the EU as a whole.

An unprecedented European response

The Covid - 19 pandemic and the lockdowns that followed had been extremely disruptive. To varying degrees economic activity had come to a halt and many sectors were literally shutdown. The travel and hospitality sectors were affected the most. Trade and manufacturing were also affected severely. A disruption of economic activity of this scale, if sustained over a long period of time, it becomes destructive. Governments had to react massively, to protect the productive capacity of their economies and along with it, to protect jobs. That was done correctly. Central banks extended quantitative easing and liquidity operations, and governments supported household incomes and subsidized businesses.

The European Union for its part, responded in exemplary manner. It immediately approved a package of fiscal measures that were made available to member states on a need basis. These included loans from the European Stability Mechanism and the European Investment Bank and loans from the European Commission under the SURE programme for jobs protection. In total those measures amounted to €540 billion.

Furthermore, the European Union approved as early as July, the Next Generation recovery funds for €750 billion in grants and loans to be distributed over the next three to five years. For the European Union these steps were unprecedented both in terms of the amounts that have been made available, their distribution between grants and loans, and in terms of the financing modalities. For the first time, the European Commission will issue its own bonds which will effectively become a common european debt.  

The limits to borrowing and debt accumulation

Total debt in the global economy, public and private, is now more than three times GDP, and even higher in the advanced countries. Cumulative government debt now exceeds GDP in most developed countries. The low prevailing interest rates provide comfort making debt affordable in terms of servicing costs.

Debt service costs in the advanced economies are now lower than a decade ago even as total debt is significantly higher. Modern Monetary Theorists even go as far as to argue that as long as debt is issued in a country’s national currency and there is spare capacity in the economy, governments can increase their debt without the fear of igniting inflation and higher interest rates. But spare capacity is fickle, and it is not always the criterion that determines the ability to borrow without inflation.

How much a government can borrow and how much debt it can issue, it is not only a matter of being able to pay the interest on its debt. The government must also demonstrate it can pay the principal. Investors will buy any new debt as long as they are confident the government can repay all its debt from its prospective revenues. When a government reaches the limits of the amount of debt it can repay new debt holders would demand higher interest rates including perhaps a premium for inflation risk. This will mean eventually the end of the era of ultra-low interest rates.

Public spending must be sensible and debt sustainability will be a crucial factor in determining fiscal policy going forward. This means that fiscal measures will have to become more targeted and more growth oriented.

The limits of the company sector

In the private sector, there is no doubt that high levels of debt limit growth potential in the medium term. We have seen this in the aftermath of the financial crisis of 2008. Firms that were highly indebted were investing much less. Therefore, grants, equity and long-term debt instead, would be more useful instruments going forward.

In this sense, Europe’s Next Generation recovery funds do the right thing. They provide grants and low-cost long-term debt. The challenge in a post-Covid world is how to break this vicious circle between high indebtedness and low growth.

A recession when it happens, cyclical or otherwise, entails a corporate restructuring amidst rising and declining sectors that necessitates the reallocation of resources. Unproductive and non-viable companies are being phased out and capital is thus freed to fund a new cycle of investment and growth. This is the creative destruction that economists speak about, which should occur if we will avoid creating zombies instead of innovation driven new and more productive companies.

The financial sector framework will need to be revisited

Bankruptcies will be increasing in this context. The priority is to rescue firms and sectors of economic activity that will be viable in the long run.

Looking into the banking sector it is clear that banks have improved their positions markedly over the past ten years. Banks now have significant capital buffers, which provides comfort for weathering the repercussions of the crisis.

But whilst we take comfort in that, there are still concerns. First, the longer the crisis lasts the more expensive it will be and the more complicated for companies. This will mean more non-performing loans and where government guarantees become effective, there will be more stress for the government balance sheet.

Banks in the euro area continue to face problems with low profitability which is reflected in their low price-to-book values. This means that the own capital generating capabilities of the banking sector are limited. Support that might be needed in the future will also have to come from the public side. In consequence, we need to create the conditions for a profitable banking sector which means institutional changes at the EU level including the strengthening of the resolution framework and more progress in completing the banking union.

In conclusion

It is a mistake to assume that all that is wrong with the global economy is because of the Covid pandemic. The trends that pre-dated Covid - 19, the legacy of Covid itself and the ongoing economic transition create multiple pressures on the global economic system. The challenges will be to protect debt sustainability at the public level; to allow corporate restructuring to occur; and to protect the capital adequacy of the banking sector without jeopardizing its intermediating role.

Fiscal policies will be more targeted and more growth oriented. In the financial sector reform will be necessary to strengthen the resolution framework and the efficiency of the courts; and to complete the banking union including the role of the European Stability Mechanism, as a back stop. Ultimately more equity finance will be needed in the European Union at large, which will raise the question of how we advance the capital markets union, beyond the foreseeable future.

Ioannis Tirkides, Economic Research Manager