1. Home
  2.  / Is This the Other Long Covid?
Is This the Other Long Covid?

Is This the Other Long Covid?

Governments have accumulated massive debt since the pandemic which could lead to financial headaches and is likely to mean a lockdown on public expenditure, writes Andrew Kenningham.

19 June 2024

Larry Fink, who is the head of the world’s largest asset manager (Blackrock) said recently he gets frightened when he looks at United States public debt.

One statistic he will be worried by is that the US fiscal watchdog, the Congressional Budget Office, warned that the US debt will soon exceed its World War II-era record of 115 per cent of gross domestic product.

There are similar concerns all around the world. All major economies have come out of the pandemic with much bigger debts than they had going in. This partly results from governments ramping up spending to help people and businesses during the health emergency and partly from the slump in tax revenues as businesses were shut down.

In Europe, governments also helped households and firms with the energy crisis following Russia’s invasion of Ukraine.

So how worried should we be about these debt burdens? Will they ever be repaid?

In truth, governments do not ever repay their debts in full. Instead, they take on fresh loans to service existing debt. The key issue is whether governments maintain the confidence of investors. This is only possible if people believe the public debt burden is under control.

This brings us to the so-called fiscal arithmetic. The path of public debt as a share of GDP is governed by an equation involving three variables: the budget balance, the interest rate and economic growth. The higher the growth rate and the lower interest rates and the deficit, the easier it is to contain the debt burden.

The problem today is that economic growth has slowed compared to the pre-pandemic years, and interest rates and budget deficits have both risen. That is what Larry Fink will find frightening.

AI revolution

It’s very difficult to predict what will happen to all these economic variables. The medium-term outlook for growth may not be as bad as many now assume if the AI revolution delivers a meaningful improvement in productivity growth – something that seems quite likely in the US, but less so elsewhere.

On the other hand, long-term pressure on public finances from other sources, including ageing populations and the cost of the net zero transition, look set to intensify.

What can be done?

Governments cannot do much about interest rates because, under current laws, central banks decide on monetary policy independently. And despite politicians’ promises, they have no magic wand to boost the rate of economic growth, particularly in the short term.

So, the only variable in the debt equation governments can really control is the budget deficit.

Austerity anyone?

Looking around the world, few politicians are even talking about deficit reduction. Neither of the current US presidential candidates – Joe Biden or Donald Trump – is promising to bring the debt down. On the contrary, Trump has promised to reintroduce the tax cuts which pushed the debt up during his first administration.

That said, the US has one big advantage which means it may be able to get away with higher debt burdens than most. The dollar is the world’s “reserve currency” which means central banks, sovereign wealth funds and private investors all want to hold huge amounts of US government bonds even if US debt is high. That may give the US more leeway than most countries to borrow and spend.

Europe in bigger trouble

Other countries face bigger problems. The then British Prime Minister Liz Truss’s 2022 budget triggered a panic in the government bond market. Investors took fright, causing mortgage rates to skyrocket and the pound to slump. Truss resigned after only 45 days in office.

Italy and, to a lesser extent, France are also running into fiscal difficulties. Problems in these countries could spill over to the rest of the euro zone as the region shares a currency and has one central bank. In Italy, the budget deficit rarely features in political debates. In France, the government has a clear ambition to reduce the deficit, but it has run into strong opposition in parliament and on the streets. There have been huge protests in Paris against plans to raise the retirement age.

So, what does all this mean? One possibility is that, at some point in the coming year or two, countries will experience financial crises with the bond market selling off, causing interest rates to spike and currencies to collapse.

Perhaps the more likely scenario is that governments are forced to restrict public spending and keep tax rates high for many years to come.

So even in the world’s wealthiest economies, many people will feel that their standard of living is being squeezed and the quality of public services is deteriorating.

Informed Investor's content comes from sources that Informed Investor magazine considers accurate, but we do not guarantee its accuracy. Charts in Informed Investor are visually indicative, not exact. The content of Informed Investor is intended as general information only, and you use it at your own risk.