A government is not a household and reasoning from wrong assumptions can lead to errors. In the last recourse, households cannot print their own currency. And where people cannot ask their employers to pay them more in a crisis, governments can compel all of us to pay more in taxes.
But the analogy can still be illustrative.
Households that prudently manage their finances will have room to take on more debt when a crisis hits that is bigger than their ability to manage by dipping into savings or and cutting back on spending. If a second mortgage isn’t enough, selling the family’s second car might square things. It can be a good idea to take on necessary debt in a crisis. But that doesn’t mean a household should take on debt to add a few nice-to-haves to the shopping list – even if the banker says there is room for another $100k on the mortgage. Debt must be paid back. And maintaining space to take on further debt is a prudent thing to do when misfortunes can unexpectedly pile up.
From the government’s perspective, taking on debt to fund the response to Covid-19 made eminent sense. It would have been imprudent not to, if the spending passed cost-benefit assessment. Recessions always come with increases to benefit spending and reductions in tax revenue. Not taking on debt when dealing with a pandemic while trying to mitigate its worst economic consequences would not have been easy.
After suffering a house fire, an underinsured household would likely need to take on debt to deal with the problem – and that could be fine. But if it then took the opportunity to add a swimming pool to the property, while pushing the mortgage amount to the upper limit, one might wonder about the household’s prudence.
Similarly, the elected Government has been adding metaphorical swimming pools to its shopping list by extending the 2020 Budget beyond what was necessary to deal with the Covid crisis. This raises sharp questions about the Government’s commitment both to fiscal prudence and the Public Finance Act.
Let’s go through these.
The Public Finance Act sets out the basic principles undergirding three decades of responsible bipartisan fiscal management. It does not tell a Government how much to tax or spend, only that operating expenses should be covered by tax revenues not by adding more debt. The Act requires all debt be reduced to and maintained at prudent levels, but does not define those levels or how long the Government should take to achieve them.
The Act also creates options for what to do in a crisis. During emergencies, like a pandemic, the Government may temporarily depart from the Act’s principles if the Minister states the reasons for doing so, how it intends to return to normal and how long that might take.
Deviating from the government’s stated targets for prudent debt levels during a crisis is perfectly fine. But taking on new spending commitments could also be a problem. Even if those new spending commitments fell within the Government’s ability to fund them when tax revenue returns to normal, it still needs room to bring debt back down to levels consistent with normal times.
This Government has left itself precious little room to do that – if it has not changed what it means by prudent debt levels.
Prudence does not just mean maintaining a strong credit rating. This only signals how likely a Government is to fulfil its current debt obligations and incremental additional bits of borrowing. In a small country like New Zealand with higher than normal risks from earthquakes and volcanos, prudence requires maintaining room to borrow substantially more at reasonable rates if something bad happens.
Because of New Zealand’s small size, regional events like the Canterbury earthquakes affect a larger proportion of the overall economy and often lead to borrowing money from abroad to help repair.
Countries in Europe backstopped by the European Central Bank and with access to emergency funding through the EU do not need to maintain the kind of borrowing headroom that New Zealand needs. And lenders there don’t worry that a European government might devalue the currency to reduce the real value of its debts.
That means prudent debt levels in New Zealand are much lower than those in larger and safer places.
One year ago, outgoing Secretary of the Treasury Gabriel Makhlouf summarised the Treasury’s thinking on prudent debt levels. He argued that because the Government requires capacity to increase debt to 50-60% of GDP if managing a large shock, or two smaller ones, it should aim for net debt levels at no higher than 30% of GDP – and potentially lower if the Government weighed more heavily the potential for bad events to follow each other in quick succession.
Budget 2020 forecast net core crown debt as reaching 53.6% of GDP in 2023 and 2024, declining slowly from there to 42% of GDP by 2034 – about twelve percentage points over a decade. The last time it reached that level, relative to the overall economy, was in 1992. By 2002, the debt to GDP ratio had dropped by over thirty percentage points to 20% of GDP – and to less than 10% of GDP with strong economic growth prior to the Great Financial Crisis and Christchurch earthquakes.
The Government’s projected path for paying off new Covid debt is very slow, and predicated on some perhaps optimistic assumptions about core government spending returning to more normal levels after 2024. Combined with its willingness to take on more debt to fund ongoing initiatives like higher pay in childcare centres and expanded school lunch programmes, it appears the solid bipartisan consensus about prudent debt levels has been broken.
Before Covid-19, the targeted net core Crown debt range was 15 to 25% of GDP. During the budget lockup, Finance Minister Grant Robertson was asked if his projected debt levels in 2034 represented a “new normal” for prudence, or if he expects a continued slow path back to pre-pandemic levels. Unfortunately, he declined to answer – simply defending the new debt as necessary and prudent.
But prudence in a crisis like this also requires making it easier to win back the necessary headroom for dealing with future misfortunes. Treasury’s modelling was based on the likely need to increase debt by about 20% of GDP should Wellington be hit by a major earthquake. Since no one knows when a geological fault might open up, taking a decade or two longer than necessary to win back that headroom seems just a little imprudent.