Governments and central banks around the world have responded in a massive and unprecedented manner to the economic disasters caused by Covid-19 lockdowns. Not even in war and in the wake of other disasters has there been such a gigantic response.
The impact of this spending is difficult to calculate with precision, but the International Monetary Fund (IMF) estimates that in the absence of special Covid-19 stimulus packages from governments, the global contraction could have been three times worse than it was. Global output is estimated by the Fund to have contracted by 3.3 percent last year.
Large stimulus packages
The stimulus packages are one of the largest economic experiments that have been ever undertaken. Allowing a massive number of businesses to go under due to an extreme event would have been highly inefficient. It would have almost certainly damaged the speed and strength of any future recovery as large amounts of productive capacity would have been taken out with many companies going out of business. The benefits of this largesse have been in preventing the world economy from virtually stalling, but there will be a price to pay.
The most frequent outcomes of policies of fiscal and monetary largesse are inflation and gigantic burdens of public debt. Some fast-growing countries, like China, will be able to use this largesse to good effect to put themselves on accelerated growth paths, but for most there is likely to be a high price. Growth usually generates inflation, but if production quickly rises, growth is balanced and inflationary pressures tend to dissipate. In addition, with growth the debt burden decreases due to a rise in tax revenue.
Given the severity of the contraction, few economists see high inflation as an imminent threat. That is although it is very difficult to gauge the impact of fiscal and monetary policies to such dire situations with precision.
Benign inflationary outlook predicted
Both the IMF and the South African Reserve Bank forecast a benign inflationary outlook. The Fund expects the current rise in commodity prices to push global inflation higher, but these effects will fade over time after the increases take place. And with the power of labour reduced by unemployment in many countries, it sees a reduction in inflationary pressures.
The Reserve Bank’s Monetary Policy Review, released last week, expects a moderate rise in inflation in South Africa to accompany the global recovery due to the rise in commodity prices, supply constraints and strong demand.
But for Lawrence Summers, a Harvard economics Professor, US Treasury Secretary during the Clinton Administration, and a former World Bank Chief Economist, there is a an elevated chance of high inflation due to overspending by the Biden Administration. The US fiscal response to Covid-19 is at 14 percent of the country’s GDP, one of the world’s largest as a share of the economy.
Summers, who is a lifelong Democrat, recently told Bloomberg that President Joe Biden’s $1.9 trillion Covid-19 economic stimulus packages and the discussion of more to come is the “least responsible” economic policy in four decades.
He has also told the Financial Times that much of this assistance is not just temporary Covid relief, but is “a harbinger of a major transformation in social policy, which suggests that at least some of it will be continued indefinitely.”
Summers thinks this could all add up to a period of excess, comparable to the guns and butter policies of the US “Great Society” which saw massive welfare and other spending at the time of the war in Vietnam in the 1960s and ’70s. The Biden administration’s policies risk fuelling excessive demand and that will raise the inflation rate, Summers believes. He expects that will result in the Federal Reserve sharply raising interest rates, which will push the economy into recession.
South Africa exposed
The consequences of US expansionary policies and a crackdown by the Federal Reserve are likely to be felt by the world. South Africa is not in a good position to insulate itself from the effects of sudden reversals in capital flows that would follow any tightening of monetary policy in the US. We rely on these flows to finance much of our public debt and growth.
South Africa’s fiscal response to the lockdown crisis with President Cyril Ramaphosa’s Covid-19 stimulus package announced in April last year amounted to R500 billion, about 10 percent of GDP. As a share of the economy, this was way above that of other emerging markets. With lower public debt burdens, more favourable financial market access, and solid long-term growth prospects, most advanced economies are better able to afford such largesse.
The R350 Social Relief of Distress Grant that was put in place during the lockdown will not be extended beyond the end of April. But there have since been additional long-term stimulus measures, such as a plan to create 800 000 jobs and for heavy public investment in infrastructure.
Ideally, when he launched the R500 billion package, the President should have also come up with a big-bang reform programme. That would have given a stimulus to ease the economy’s pain, but also made deep changes in the management of public enterprises and the labour laws to reduce unemployment.
Even if there is moderate inflation and strong medium-term global growth, countries which are highly indebted and slow growers, like South Africa, could face risks.
The Reserve Bank sees no continuous threat from a rise in US interest rates to our economy. The recovery, it says in the Monetary Policy Review, has improved the risk appetite of foreign investors to South Africa and other emerging markets. And threats of US interest rate rises “can and will prompt bouts of risk aversion and generate volatility in capital flows.”
But with a steep rise in US rates we might face more than “bouts of risk aversion”. A steep rise in US rates could result in a strong pull out from our bond and equity markets. This could make it difficult to fund our government debt.
South Africa faces enhanced risks due to difficulties in cutting public spending in the face of endless demands from failing state enterprises and civil servants for higher settlements.
The are other prices the global economy will have to pay. Having taken on a lot more debt, governments will have less room to borrow in the future and their budgets will be burdened by greater debt service.
Should there be another economic crisis due to a financial collapse or a pandemic in the next decade, most governments and central banks will be highly constrained. They have substantially depleted their firepower and will have to wait years before this can be rebuilt.
A short sharp rise in the US rates could also end the long boom on equity markets, causing spillover effects that could trigger crises across markets. With reduced company earnings prospects and higher interest rates investors would abandon shares for government bonds.
Given the sheer scale of the economic rescue over the past year, it is unimaginable that there will not be a heavy long-term price to pay, and that the initial growth bounce from the lockdowns will result in a smooth growth trajectory.
The views of the writer are not necessarily the views of the Daily Friend or the IRR
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