As the chart below shows, the story of UK government debt since 1900 (as a share of GDP) is a story of crises (source).
The ratio of debt to GDP rose rapidly during WWI, stabilised thereafter and then started to fall in the second half of the 1930s, only to rise again during WWII. After WWII it fell slowly but steadily, returning to pre-WWI levels by the end of the century. It rose again during and after the Global Financial Crisis, finally rising a bit more during the pandemic.
As I explained here recently, government debt is a device that avoids sharp changes in taxes or government spending during bad times. It is therefore entirely right that during a crisis, like a world war or a financial crisis, government debt should increase substantially. To put it simply, the alternative of raising everyone’s taxes sharply would only compound the negative impact of the crisis.
For example if governments had raised taxes during the 2009 recession then the recession would have been even worse than it was. Consumers would still have increased savings and reduced borrowing during the crisis, so consumption would have fallen further than it did because taxes were higher. When governments did try to reduce their own spending and raise taxes after 2010, it caused considerable damage.
It was therefore natural for governments around the world to treat the Covid pandemic as just the kind of crisis where government debt needs to rise, to help pay for additional government spending during the pandemic. In Europe that additional spending was mainly paying large sections of the workforce to stay at home (furlough), while in the US it involved much higher unemployment benefits and other payments.
I will take the case for additional government spending during the pandemic as given. This is not yet another post from me about the wisdom of early but comprehensive lockdowns before vaccines became available. What I want to ask here is whether the reaction of most governments to keep taxes unchanged was correct? The reason that question should be asked is what happened to household savings during the pandemic. Here is the UK, and you will see a similar pattern in other countries.
In financial terms, the pandemic was not hard for most (not all) households. Instead most ended up saving much more than normal. The reason is straightforward, and goes back to something I have written a great deal about: social consumption. Most people substantially reduced their spending on activities like going out to the pub, restaurants, entertainment and travel. Sometimes this is because they were told to do so, but there are good reasons to believe this would have happened to a considerable extent anyway as people tried to avoid getting the virus from others. Social consumption amounts to about a third of total consumption, so it was inevitable that most households ended up saving a great deal during the pandemic.
There was therefore substantial scope on average for governments to pay for their additional spending during 2020 by temporarily raising taxes rather than increasing government debt. Most consumers would not have had to reduce their consumption further because they were paying higher taxes. Instead these taxes would have simply taken the place of large increases in personal savings during the pandemic.
If the pandemic was not like previous crises in that there was scope for the government to raise taxes temporarily in 2020, that does not necessarily imply that is what they should have done. For example higher taxes of whatever type will not perfectly match to reductions in social consumption, so there might be important distributional problems in raising taxes. Higher taxes might have discouraged some from working whose work was vital to keep the country going. Perhaps higher taxes would have reduced social solidarity at a time when it was most needed.
Whatever your view on this, I hope it suggests that higher government debt during a crisis is something that needs justification rather than something that should happen automatically. But strangely we do not seem to be having this conversation about the biggest global crisis facing the world today, which is climate change. So far at least the need to green the economy has not led governments to pay for that spending using deficit funding. I have talked on previous occasions about why climate change, and the need to green the economy to reduce carbon emissions, should be considered as a crisis which requires increases in government debt. Yet very recently we have seen the German courts prevent their government from increasing debt to pay for financing climate change expenditure.
The case for using deficit finance to pay for greening the economy is far stronger than paying for furlough during the pandemic. Although in theory carbon taxes fit the polluter pays model, the reality is that government spending and financial incentives have been much more effective at encouraging green energy production. As with most government investment, it is not clear why the current generation should pay for something that will mainly benefit future generations.
Why do some within Labour worry about the Conservatives weaponising their £28 billion a year pledge on green investment, and propose cutting back on those plans? Perhaps its because throughout most of the media, reducing government debt is either considered more important than preventing climate change, or the two are not connected in people’s minds. I want to propose a collective New Year resolution. If anyone claims that it is important for this or the next government to reduce their debt to GDP ratio, please someone ask why climate change isn’t the kind of crisis that should see government debt rise?