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Dealing with deficits

From Keynesianism to Monetarism to Modern Monetary Theory, experts have argued how to allocate and spend money for decades. In light of the current COVID-19 crisis, the discussion was in the political spotlight yet again. Our Group Chief Investment Officer, Yves Bonzon, explains why he believes that deficits will remain a permanent feature of the economic landscape.




The COVID-19 recession has triggered a massive loss of income for the private sector. This income loss has been partially compensated for by governments, which in turn has triggered a significant increase in fiscal deficits across most countries. In the US, for instance, they should be close to a 20 per cent deficit at the budget level for 2020. These deficits are unheard of today. The last time such deficits were created was during the Second World War.

People are wondering whether these deficits will be sustainable and how they will be financed, especially because we don’t know how deep they will be and for how long we will need to continue in this way. This is a function of how well the economy recovers and how long it requires fiscal support. In general, there are three ways to finance deficits:

  1. increase taxes, which can be seen as a transfer of money from the private to the public sector
  2. borrow money from the private sector
  3. print money, using a technique called the ‘printing press’. This is where Modern Monetary Theory comes into play

Modern Monetary Theory: controlling your own currency implies spending it freely
The dominant economic theory until the Second World War was Keynesianism. Monetarism followed in the post-war decades, and the 21st century is shaping up as the era of some form of the so-called Modern Monetary Theory. In this theory, fiscal policy is a continuum of monetary policy. 

Deficits will remain a permanent feature of the economic landscape.

Yves Bonzon, Group Chief Investment Officer

When you look at the finances of a country that is printing the money it borrows, the problem is fundamentally different from a household that cannot print the money used for its expenses and taxes. Households or private corporations therefore have constraints that sovereign governments do not. This money printing is, of course, triggering questions about if and when inflation will start to get out of control and whether we are potentially exposed to debt defaults or debt restructuring in the not too distant future. 

Europe is a good example to illustrate the problem. In the post-war decades, private sector demand in Europe was very strong. Whenever government expenditures were increasing rapidly, they were tapping into productive resources of the country, straining these resources and therefore triggering inflation. In other words, in the 60s or 70s public deficits in Europe were inflationary.

Debt-to-GDP ratios and the search for inflation
Looking back at the last 20 years, this paradigm has completely changed. There has been massive monetary stimulus, but hardly any traction on inflation, and the stated objective of 2 per cent was never really reached. This is because private sector demand has been structurally weak in the developed world, in particular in Europe. As illustrated by Japan for over 20 years, in a country suffering from a structural deficit of private demand, including deficits, debt-to-GDP ratio can increase way above the commonly accepted limit of 80 per cent to GDP, without triggering either crisis or inflation. Consequently, it could be argued why arbitrary constraints such as debt-to-GDP-ratios of 60 per cent were invented. These ratios can be seen purely as protection against politicians spending money way above and beyond their means. 

How to allocate and spend money?
Fundamentally it all boils down to a governance problem, which asks how governments allocate and spend money. It’s a function of the point at which productive resources are overstrained. This will be the political debate for the years to come. Deficit will remain a permanent feature of the economic landscape.