Thinking clearly about “debt and deficits”

Richard Holden


The COVID-19 crisis has created a massive public health crisis, and also an economic one. The public health crisis has been handled with differing success around the world. Countries like Italy and Spain were hit early, had little time or opportunity to learn the lessons of other countries, and have been hit hard. Other countries, like the United States had time to learn those lessons but failed to do so. Australia and New Zealand acted relatively quickly and have had significant success in containing the virus. Sweden took a different path – eschewing formal lockdowns in favour of a “private lockdown – and has had dramatically worse public health outcomes than Australia, and worse economic outcomes as well.


On the economic front there has been more uniformity in the initial response. Most advanced economies quickly implemented large fiscal measures. These were particularly important in the wake of the stay-at-home orders that added to the voluntary shuttering of enterprises in many parts of the economy.


For example, In the US the CARES Act of late March 2020 included wage subsidies of up to $10,000 for businesses of all sizes, and to small businesses specifically under the “paycheck protection program” totaling $350 billion.


Other countries essentially provided wage replacement of between about 70% and 80%, up to a cap, for workers who might otherwise be laid-off because of the pandemic. These programs occurred in countries including Denmark, Britain, France, Canada, Germany, Italy, and Spain. In Australia the so-called “JobKeeper” program involved a “flat rate” of $1,500 per fortnight per eligible worker. Many countries also instituted government-funded parental leave or sick leave across the economy.


It remains to be seen whether governments will follow through with continued fiscal support for businesses, workers, and the unemployed. US Senate majority leader Mitch McConnell has already signaled an end to further fiscal measures. And in Australia, Treasurer Josh Fydenberg has warned about the non-existence of “money trees”. And while the JobKeeper program looks set to cost $60 billion less than the original $130 billion price tag, the government has talked about “banking” that as a saving rather than using those funds to further support the economy, workers, and businesses under strain.


Australia’s fiscal landscape

Coming into the COVID-19 crisis Australia had one of the strongest fiscal positions of all advanced economies. Our net debt to GDP ratio was around 18%, the second lowest among advanced economies.



Source: Rosalind Dixon and Richard Holden, Liberalism after COVID, forthcoming.

At the same time, the Commonwealth can issue 10-year bonds at an interest rate below 1% (indeed at 0.894% as of this writing). Thus, even a $200 billion fiscal response to COVID-19 would have a carrying cost of less than $2 billion per annum. In the context of a roughly $500 billion annual federal budget this is a very modest sum.

While there is also little reason to believe these interest rates will somehow skyrocket 10 years from now (indeed, there is evidence of the opposite, that pandemics since 1347 have depressed the equilibrium real interest rate for as long as 40 years post pandemic), there is the question of the principal on the debt. In other words, what happens to the $200 billion?


Paying off the debt versus shrinking it away

The “debt and deficit” mantra that has dominated the Australian political landscape in recent years holds that this debt needs to be “paid back”. This has been a particularly strong part of the Abbott, Turnbull and Morrison governments’ political narrative. But, to be fair, at the most recent federal election the Labor opposition squarely bought into the same narrative by claiming that they would run even larger budget surpluses than the government, albeit by way of various tax increases.


This narrative was misleading and destructive before COVID-19, and is even more damaging in the wake of it. The simple fact is that with the Australia government having low levels of ingoing debt and the ability to borrow cheaply, long-term, in its own currency, this debt does not need to be “paid back”, rather it can be “shrunk away” as a proportion of the economy. This latter notion rests on GDP growth being strong enough to achieve this. Indeed, this is precisely the economy path Australia followed after World War II, from a much higher debt level.


And therein lies the rub. If enough fiscal firepower is used during the COVID-19 crisis – and the number may be more like $400 billion or 20% of GDP rather than $200 billion – then the economy can be in a position to rebound strongly in the aftermath of the crisis.

In many ways, the worst of all possible worlds is that a large amount of fiscal spending is used but the amount is insufficient to heal the economy and put it on a robust growth path post COVID. This would leave Australia with significant debt, but less ability to shrink it away as a share of the economy.


Spending wisely

The two pillars involved in ensuring Australia takes advantage of its strong ingoing fiscal position is to spend aggressively, but also wisely. The mere ability to spend a lot must not be used as a license to spend on areas with a low social return.


Of course, ensuring that does not happen involves prioritising among different spending programs all of which have some constituency, and determining what constitutes a “high social return” project. This needs to go beyond the traditional cost-benefit analysis used by government to account for the social benefits that come from investing in social and physical infrastructure.


Together with Rosalind Dixon and Alex Rosenberg I have proposed a method for doing this that bridges from social science to social benefit, using the best available empirical evidence on the causal effect of government investments in everything from schools and broadband internet, to disability insurance and the natural environment.


For instance, in assessing education spending projects (such as higher pay for teachers, a longer school day, or reduced class sizes) “social cost benefit analysis” (SCBA) factors in not only the higher tax revenue and reduced government spending on welfare that comes from students with higher human capital and therefore better jobs. It also takes account of the increase in life expectancy, reductions in substance abuse and incarceration, and many other factors that are associated with poverty which improved educational and employment outcomes reduce.


A cautionary note

Rather paradoxically, it is to some extent the balanced-budget fetishism of both sides of Australian politics that has helped put us in the envious position of having low debt going into the COVID-19 crisis. That does not mean it’s wrong to spend aggressively in the face of that crisis. After all, what is dry gunpowder for if one refuses to use it when confronted with the whites-of-the-eyes of the economic enemy?


That said, if we spend imprudently then will have debt to shrink away and an economy not growing fast enough to do so quickly. If that happens, we could face the next major crisis in a less envious position than that in which we currently find ourselves.


The “debt and deficits” mantra needs to go, that is for sure. But it should be replaced with a fiscal philosophy that emphasises using fiscal force aggressively, but prudently.

Richard Holden is professor of economics at UNSW Business School.

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