The pandemic public-debt dilemma
Michael Spence, Danny Leipziger
Increased government spending during the pandemic is essential for managing public health, supporting households that have lost income, and preserving businesses that otherwise may fail and thus cause longer-term damage to output and employment. Kristalina Georgieva, the managing director of the International Monetary Fund, has urged policymakers to “spend but keep the receipts.” Likewise, World Bank Chief Economist Carmen M. Reinhart reminds us that, “first you worry about fighting the war, then you figure out how to pay for it.”
Although these are sound recommendations for countries with solid fiscal foundations, the long-term risks of increased spending may be dangerously high for others. In 2008, the Commission on Growth and Development (on which we both served) showed that successful developing countries owe their economic growth in part to the quality of their social and capital spending. And the most successful of these countries, we found, had run their economies with savings levels at or close to investment levels, such that their current account deficits were small.
Today, however, there are many countries – some that entered the pandemic already highly indebted – that have not been effective stewards of public resources, owing to poor project selection and implementation, ineffective targeting of social spending, wasteful subsidies, or outright corruption. Both the World Bank and the IMF have effective tools for measuring the quality of public spending, and there are a plethora of indices showing how well a country’s governance fares across standard benchmarks. For governments with a poor track record, simply borrowing and spending more may not be the best course of action.
After all, a country’s citizens are not well-served when their government becomes more indebted in order to spend imprudently. For such countries, borrowing in hard currencies when exports are depressed and their own exchange rates are under duress simply makes future debt re-scheduling more likely, and it may place international financial institutions like the IMF in an awkward position, given that they are now urging additional unconditional spending.
Economic growth depends on high returns from public investment in human capital and infrastructure. Countries that have invested wisely in these areas have seen their economic fortunes rise, whereas those that have invested poorly have been left more indebted and less able to repay, especially if those debts are in a foreign currency. Given that most developing countries have limited scope to borrow in their own capital markets, any additional spending is likely to be externally and commercially financed. That is potentially a recipe for disaster.
In today’s low-interest-rate environment, it is often said that as long as borrowing costs are below the rate of growth, additional debt-financed spending makes sense. But, again, while this argument is defensible when applied to rich countries, it poses dangers in the context of emerging and developing economies, where factors such as the efficiency and equity of spending matter greatly. These issues must not be overlooked – even during a pandemic – because they can increase future debt burdens and reduce the chances of long-term successful development.
Moreover, there are more effective approaches to deal with the fiscal dilemmas facing emerging and developing economies. These include increasing the amount of targeted assistance for vulnerable populations; extending the duration of IMF lending, which could be conditional on assurances that resources will be put to good use; and combined IMF and World Bank programs that include fiscal-performance measures.
In the aftermath of the 1980s debt crises, the Bretton Woods institutions collaborated to produce medium-term policy frameworks that would both provide new financing and embed funds in sensible development plans. Such formal frameworks could now be revived in some fashion to provide greater assurances to creditors that key structural bottlenecks and governance concerns are being addressed.
To those worried about the implications of such conditionality, it is worth remembering that debt re-profiling, if it is to be done pre-emptively, requires borrowers to produce growth- and debt-sustainability frameworks that can be designed and implemented with third-party guidance. The alternative – debt re-scheduling under duress or outright default – is a far worse option than jointly financed World Bank-IMF programs that can crowd in private debt on revised and more affordable terms.
Of course, a framework that provides longer-term relief while also addressing fiscal gaps and unsustainable debt implies improved international financial mechanisms to put debt repayments on a sustainable path. In contrast to previous debt-reduction exercises (the Initiative for Heavily Indebted Poor Countries and the Multilateral Debt Relief Initiative), current circumstances indicate that debt distress will fall largely on middle-income borrowers. As such, there needs to be a new debt-rescheduling architecture that actively involves commercial lenders.
Any such initiative would need to be endorsed by the G20, which has already agreed to work toward a new global debt-restructuring framework. This approach must formally include all major creditor countries. It is in the interests of all creditors to join such an exercise, both to avoid free-rider problems and to ensure transparency of debt information.
Extraordinary times call for extraordinary measures. Failing bold action, developing countries could be on track to lose years or even decades of progress in the post-pandemic world. In the pandemic economy, fiscal shock absorbers, efficient public spending, and new instruments for pre-emptively re-profiling unsustainable debt payments are each an indispensable part of the necessary response.