The Danger of Free Money is Real

By Tudor Bindea, BSc Politics, Philosophy and Economics Student at King's College London

Few scholars of economics had expected 2020 to bring such a drastic change to what until recently was the consensus among leading policymakers, economists, and central bankers: high national debt inevitably leads to economic instability, social unrest and hinders prospects for growth. So strong was this vision held by politicians that in the aftermath of the 2008 Financial Crisis many of the South-European governments imposed tight austerity measures in an attempt to curve the budget deficit, increasing taxes and slashing spending on services and other public goods. The results were catastrophic: hurt by soaring unemployment and higher income taxes household consumption decreased, investments in education, healthcare, or infrastructure stalled, and the prospects for economic growth soon became gloomy. This led to social unrest, political instability, and mass immigration, with countries such as Greece, Italy, or Spain still trailing their Northern European counterparts in terms of economic growth and living standards. 


The lessons of the 2008 Financial Crisis and a recent rethinking of the purpose of economics were already an indicative that higher state intervention in the economy is desired, at least by some policymakers, in order to cope with the rising income inequality, uneven racial wealth distribution, or the dangers of climate change. Nevertheless, for many these changes represented a utopic rethinking of capitalism, facing skepticism from the major governments of the West and some leading economists. With the Conservatives in power in the United Kingdom, or the Trump administration in the US, the free market economy was seen as being well protected against fears of large government intervention. And then the Coronavirus pandemic came, throwing the global economy into its worst contraction since the Great Depression, leaving millions unemployed, shutting down businesses due to draconian lockdowns, and taking the lives of more than a million people – and counting.

As a result, governments around the world rushed to inject money back into the economy through large fiscal stimulus packages. These measures were supported by monetary policy from Central Banks who slashed interest rates to all time lows and started buying government bonds, through a process called Quantitative Easing. This in effect drove down the interest government pays on its debt, making debt more sustainable and allowing for larger deficits. The US government alone spent more than $3 trillion into unemployment benefits, credit facilities, or even non-repayable checks sent to American households, thus sending public debt to record levels unseen before. The UK’s No 10 Furlough Scheme had seen 80% of furlough workers’ wage being paid off by the government for months – although many of those jobs were simply not there anymore.

Source: Federal Reserve Bank of St. Louis and U.S. Office of Management and Budget, Federal Debt: Total Public Debt as Percent of Gross Domestic Product, October 14, 2020.

While these were meant to be temporary measures, the prolonged nature of this pandemic and the arrival of the second wave in Europe had seen governments being forced to reverse the easing of lockdowns, forcing businesses to shut again or limit their opening hours and number of customers. This will mean that in the absence of the factors driving a normal economic recovery, such as increased consumption and lower unemployment, the governments will have to provide new fiscal packages to stimulate an artificial economic growth. While these fiscal policies had undoubtedly helped many households maintain normal levels of income and avoid poverty during the recession, the rising levels of debt due to the unprecedented fiscal response will prove detrimental to the long- term economic growth prospects.

Take the rising government debt first, which exceeded 110% of the advanced economies GDP in 2019, right before the COVID-19 recession started. Economic theory says that there is no maximum level of debt a country can accumulate, and once economic growth starts to kick off the government can “grow its way out” of debt as far as the growth rate of GDP exceeds the interest it has to pay on its debt. In the current environment of low interest rates which are likely to stay right above 0% for the time being, even an impaired economic growth can help reduce the budget deficit, or so it is thought. Nevertheless, such an argument fails to see the long-term implications of large budget deficits: the real burden will not fall on current generations, which are also the beneficiaries of these policies, but on the ones to come.

The demographic crisis we are currently facing means that by 2027 more than 4 million baby boomers will leave the workforce and go into retirement every year. As pension funds are among the main holders of government bonds, in a world of low interest rates this will mean lower returns on savings and thus less money for retirement. This will add up to the financial pressure governments will face to cover the pension payments of an increasingly larger part of the population with higher life expectancy, while in the same time work its way out of the debt accumulated during the COVID-19 pandemic. Unfortunately, this will likely mean that certain policies to redistribute more income earnings from the work force to retirees will need to be enacted. These policies will squeeze the incomes of a young work force already indebted by the rising cost of education - the total student debt owned in the UK exceeded £71bn in 2017 – and soaring house prices making it harder for young people to own property.

The second argument against large government intervention lays deep in the structure of the economy. As businesses go bankrupt during times of economic volatility, these are in turn replaced by new more efficient enterprises that manage to adapt to the new circumstances and allocate resources in a more productive way - a process described by economists as creative destruction. Although the short-term impact will mean higher unemployment rates and lower GDP, the creation of new businesses will translate into new jobs created and higher returns on capital in the long run. This is best observed empirically in the evolution of the workforce in the US and the UK, which had taken different approaches toward fiscal policies during the COVID-19 pandemic. While in the US the government limited itself to providing one-off checks to distressed households and rise unemployment benefits – thus maintaining a constant level of consumption, the UK government decided to subsidize furlough workers’ wages, thus keeping them and their employers in business.

Although initial unemployment figures soared in the US to reach 14% in April, the recent recovery in the number of new jobs created can be explained by a fast dynamic relocation of resources and workers from bankrupt businesses to new productive ones. The same cannot be said about the UK, where a large number of furlough workers’ wages are still being paid by the government for jobs that do not longer exist. In the long run, this will mean a less efficient allocation of resources as distressed businesses will remain in the market due to the government’s support, a less dynamic and lower income work force, and lower economic growth. The political benefit of keeping people employed might be high, but the risks of injuring economic performance for a long time are simply not worth the trade-off.

While it is hard to argue that the unprecedented fiscal and monetary response to the COVID-19 recession did not have positive effects on distressed households and helped avoid a larger contraction in GDP, Governments should avoid the lure of uncontrolled spending and consider the long lasting effects this will have on the economy.

Reference list: 

[1] The Economist, 8 October 2020. “The Right Kind of Recovery” 

[2] The Economist, 12 September 2020. “Governments can borrow more than was once thought”. [3] The Economist, 25 July 2020. “The Covid-19 Pandemic is forcing a rethink in macroeconomics”. 

[3] Washington Post, 15 April 2020. [4] Coinspeaker, 18March 2020. [5] Financial Times, 21 June 2020.

[6] Independent, 18 February 2018. debts-so-high-students-suffering-increased-mental-health-problems-can-t-afford-food-graduate loans-a7587656.html

[7] Financial Times, 9 October 2020.

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