Recessions and the Public Purse


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According to the World Bank (2021) after every global recession, global government debt significantly increases, rising by approximately 4-15 percentage points of the global Gross Domestic Product (GDP). The accumulation of debt during the pandemic-induced global recession of 2020 has been the largest seen in decades and this observation applies across different types of debt—total, public, and private debt; advanced-economy and Emerging Markets and Developing Economies (EMDEs) debt; external and domestic debt. For the year 2020 alone, total global debt amounted to 263% of GDP and global public debt to 99% of GDP, the highest levels in half a century. In Emerging Market and Developing Economies, total debt reached 205% of GDP. In advanced economies, total debt exceeded 300% of GDP.


The accumulation of public debt during recessionary periods is unavoidable. However, it can be argued that policy decisions play a crucial role in determining the extent to which the debt accumulates, and thus it is crucial to not only look at the policy decisions employed but extend the scope of analysis to the two views held by the policymakers— Optimistic or Pessimistic. Focusing on fiscal policymakers, the optimistic view relies on the expectation of positive growth to reduce debt, the expectation of low interest rates to keep debt service manageable, the withdrawal of fiscal support to stabilize debt in the short run, and the relaxation/flexibility of fiscal policy controls to facilitate growth-led funding.


However, drawing from past experience with recessions episodes and subsequent debt surges, the materialization of the expectations and the effectiveness of the policy measures would not coincide with lessons from history. Thus, the focus of this analysis is on the advantages and disadvantages of the optimistic approach toward the surge or reduction of public debt.


Withdrawal of Public Debt

It can be argued that the withdrawal of fiscal support measures is a double-edged sword. Withdrawing fiscal support funds aids in the process of debt stabilization during the recovery phase however, withdrawing the funds can also criple economic recovery and hinder economic growth, especially in EMDEs where a significant proportion of economic participants rely on fiscal support during recessions and the initial recovery phases. Thus, to induce positive growth some policy measures have included the support for small and medium-sized enterprises by ensuring continued access to finance amid the recession. However, such measures may crowd out private sector investment if sustained over a prolonged period in illiquid EMDE financial markets, thus reducing the prospects of attaining and maintaining positive growth in the long run.


Low interest rates

Low real global interest rates maintain the low real cost of the existing stock of debt, thereby making the servicing of the debt more manageable. Moreover, additional debt-financed government support becomes attractive. However, fiscal expansion during and post-recession has significant risks, as the current real interest rates may be below their long-term trend. This means that although the cost of debt in real terms may be low in the short run, there is a greater probability that the cost will increase in the long run. In addition, there is no guarantee that any future economic shocks will result in lower interest rates (Rogoff, 2021). Drawing from empirical evidence, the increase in interest rates at the start of the pandemic was higher for countries with higher public debt (Presbitero and Wiriadinata 2020). Moreover, EMDEs face a greater risk of a sudden reversal of interest rates than advanced economies, especially if there are other vulnerable points like foreign currency debt, financial system fragilities and commodity dependence (Gnimassoun and Do Santos 2021), hence it can be argued that the optimistic approach poses a significant fiscal risk on both advanced and EMDEs, however with greater impact on the latter.


Relaxation of fiscal rules

In the face of unprecedented economic shocks that require fiscal intervention, fiscal rules are often relaxed to facilitate fiscal support measures. It is important, however, that the use of this flexibility is temporary and transparent. Because set timelines for recovery do not exist, transparency becomes important: if countries fail to reverse their path to these escape clauses as the recovery gains traction, investors may begin to question the long-term sustainability and credibility of public finances (IMF 2021b). During the 2020 global recession, about 40% of the fiscal support from governments in EMDEs was made up of liquidity support measures such as loans, equity injections, and guarantees (IMF 2020b). Some governments have also encouraged banks to make use of available capital and liquidity buffers to support lending (IMF 2020c). While these were necessary to avoid widespread bankruptcies, they pose several risks, one being extended support for nonviable institutions if maintained far into the recovery and the other being that these contingent liabilities through the support to viable banks could eventually end up in government balance sheets should a financial crisis occur (Mbaye, Moreno-Badia, and Chae 2018).


Similar to historical economic shocks, the COVID-19 pandemic, has highlighted the various approaches used by policymakers to address the accumulation and control of public debt in recessionary environments and well into the recovery phase. Having explored the optimistic view in this analysis, it is plausible to expect optimistic policymakers to hope for an optimistic ending to the COVID-induced accumulation of debt, however, any sudden shock such as sudden interest rate hikes, a larger-than-forecast increase in debt, or other financial market shocks could result in severe debt distress (World Bank), which could have been planned for and mitigated.


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