Continuing the theme of our previous post (“Are you feeling (financially) repressed yet…?”), we now examine the issues posed by the pandemic from another perspective- that of fiscal policy and sustainable levels of government debt.
The level of fiscal support or “stimulus” to their economies being provided by governments across much of the developed world already far-exceeds those seen in the wake of the GFC. Yet it is not really a “stimulus” (as HSBC pointed out in a recent paper entitled “Borrowing from the Future”): in reality it is insurance- a pay-out intended to help the recipient recover from an unexpected disaster, or economic CAT caused by an combination of a highly-contagious virus and subsequent government actions. However, the difference from insurance as such is that many governments do not have reserves set aside to address such an eventuality. Instead, they rely of the unique coercive power of the state to raise revenues through taxation, which, of course, ultimately depends upon the ability of its underlying economy not only to generate wealth sufficient to pay those taxes, but do so in ways that do not themselves inhibit wealth creation.
The general absence of a reserve means that in reality most governments (except those that have specific funds to act as a buffer against a decline in future revenues, such as most “petro-states”) raise the necessary funds in the short term through issuing debt in one form or another, to be repaid from future tax revenues.
The long-term downward trend in absolute and marginal levels of taxation across much of the world, coupled with rising (and now accelerated) ratios of government debt to GDP to levels not usually seen outside wartime, means that there is going to be a reckoning, because the pandemic will result in “economic scarring” in ways that are still unclear, but almost certain.
The scale and persistence of such “scarring” matters, because the intention behind the “insurance payout” by a government during the pandemic is to preserve not just income levels but to avoid the loss of future productive capacity in the economy. If the “scarring” is worse than expected, this will lead, amongst other things, to lower tax revenues and fewer jobs, and so likely lengthen the period over which government budget deficits persist at elevated levels, leading to more borrowing. Of course, this issue also has to be viewed in the context of the level of nominal interest rates on sovereign debt, when set against the nominal rate of growth in the same economy. As long as the latter exceeds the former, debt servicing is sustainable.
The situation is further complicated by the fact that the shape and trajectory of any economic recovery from the pandemic is still unclear for most economies. Anything other than a “sharp V” or “truncated U” means that the “scarring” will be real, while the recent general decline in many economies’ productivity is also cause for concern, particularly if it proves to be secular rather than cyclical.
Taking all the factors into account, any forecasts are merely estimates of possible scenarios. It is far too early to make any robust forecasts, so one has to remain wary about the build-up of the risks within economies, which always arise when a sovereign’s ability to raise and service its obligations becomes impaired. For Awbury, this is just another component in our systematic and continuing assessment of all the potential risks that may have a material impact on our existing portfolio and future business.
As Morgan Housel recently said: “Wounds heal; scars last”.
The Awbury Team