Last week’s post-Covid fiscal and monetary policy workshop, hosted jointly by the Reserve Bank and Treasury, seemed designed to warm the policy economics community to higher levels of public debt.
While low interest rates mean investment projects that might not normally make the grade can now stack up, stacking up debt builds its own fragility.
If the core of the public sector is happy with higher debt levels, despite clear failures in ensuring that funded projects pass any reasonable cost-benefit assessment, greater prudence is needed in how that debt is issued. There may be a stronger case for issuing some new debt as catastrophe bonds.
We will return to the case for catastrophe bonds.
Treasury Secretary Dr Caralee McLiesh opened Tuesday’s event by drawing some of the past year’s lessons for the public sector. She noted the strong fiscal and monetary response mitigated potentially far worse economic consequences of the pandemic.
But Treasury also took as lesson that fiscal policy – tax and expenditure – can be far nimbler than has been considered possible. That, combined with lower interest rates and practical difficulties in reducing interest rates below zero, made an argument for greater use of fiscal policy in economic stabilisation and for higher overall debt levels.
Prudent debt levels had been considered to sit around 50% to 60% of GDP, with room left beneath that for taking on debt to deal with emergencies like earthquakes. But with low interest rates and higher government debt levels elsewhere, Treasury was coming to view higher debt levels as prudent if the debt funds investments providing strong value for money.
Normally, economists argue for monetary policy in downturns not only because lower interest rates stimulate activity across the economy, rather than just in the areas selected by government fiscal policy, but also because it can move quickly. New spending initiatives typically require months of preparation. A Reserve Bank can hold an emergency meeting and shift interest rates far more quickly.
Fiscal policy was able to move very quickly last March in setting the wage subsidy programme and in getting funds out to firms at lightning speed. But it is not an approach that seems at all generalisable.
Other parts of last year’s fiscal response were rather less successful and point to the very real risks of relying on fiscal policy as economic stabilization tool. The government’s “shovel-ready” infrastructure project was designed when most economists expected catastrophic economic conditions and lots of unemployed construction workers. The projects were selected with no normal cost-benefit assessment; the primary objective was to keep people employed, and to get projects funded quickly.
But when economic circumstances proved far friendlier than expected, the government could not reverse course. It was obvious by October that mass unemployment was unlikely. The projects continued, drawing scarce construction workers away from private sector projects. When I asked Minister Robertson at May’s Budget lockup whether the government might scale back those projects so that private projects would not be stymied for want of workers, he said it was too late as contracts had already been signed.
Later workshop papers went through ways of using fiscal policy for macroeconomic stabilisation. They estimated multipliers of government investment spending on overall economic activity under assumptions that the funded investments actually make sense. And they explored interactions between fiscal and monetary policy that might hold in large economies like the United States but might seem a bit risky to apply to small open economies like New Zealand.
Overall, the workshop felt designed to warm the economic policy community to higher public debt levels for a longer period. The risks of the approach were noted: interest rates can rise, and there will be problems if they do. And the approach only makes sense if projects funded by that debt really do pass cost-benefit assessment. That conventional cost-benefit assessment processes ensuring value for money seem out of fashion was not noted as any substantial constraint.
Higher levels of government debt bring risk not only in case of interest rate increases, but also in case of natural disaster. Maintaining headroom to take on a lot of debt in a crisis has been important. If public debt is higher for longer, and global credit conditions become less friendly, the Alpine Fault becomes even riskier.
If the public sector is determined to encourage politicians’ imprudent pursuit of higher debt levels, it should encourage that some of that debt be funded more prudently: through catastrophe bonds.
Catastrophe bonds pay investors more during normal times but void most or all of the bond if a triggering event happens. If an earthquake required substantial government funding, existing catastrophe bonds would void and would provide some of the necessary headroom.
They may be a more prudent approach in imprudent times.