Winner of the New Statesman SPERI Prize in Political Economy 2016

Saturday 26 November 2016

Whatever happened to the government debt doom spiral

A number of people, including the occasional economic journalist, are puzzled about why government debt at 90% of GDP seemed to cause our new Chancellor and the markets so little concern when his predecessor saw it as a portent of impending doom. I always argued that this aspect of austerity had a sell by date, so let me try to explain what is going on.

The 90% figure comes from a piece of empirical work which has been thoroughly examined, and found to be highly problematic. (Others have used rather more emphatic language.) Part of the problem is a lack of basic thinking. Why should the markets worry about buying government debt, beyond the normal assessment of relative returns. The answer is that they worry about not getting their money back because the government defaults.

If a government cannot create the currency that it borrows in, then the risk of default is very real. Typically a large amount of debt will periodically be rolled over (new debt sold to replace debt that is due to be paid back). If that debt cannot be rolled over, then the government will probably be forced to default. Knowing that, potential lenders will worry that other potential lenders will not lend, allowing self fulfilling beliefs to cause default even if the public finances are pretty sound.

The situation is completely different for governments that can create the currency that the debt they sell is denominated in. They will never be forced to default, because they can always pay back debt due with created money. That in turn means that lenders do not need to worry about forced defaults, or what other lenders may think, so this kind of self fulfilling default will not happen.

Of course a government can still choose to default. It may do so if the political costs of raising taxes or cutting spending is greater than the cost of defaulting. But for advanced economies there is an easier option if the burden of the public finances gets too much, which is to start monetising debt. That is what Japan may end up doing, and what others may also do if QE turns out to be permanent. But this is a very different type of concern than the threat of default. And it does not, in the current environment, lead to the emergence of large default premiums and market panics.

How can I be so sure? Because with QE we have had actual money creation, and it has not worried the markets at all. It seems hard to tell a story where markets panic today about the possibility of monetisation in the future, but are quite sanguine about actual monetisation today.

So for economies that issue debt in currency they can create, there is no obvious upper limit anywhere near to current debt/GDP ratios when economies are depressed and inflation is low. Japan shows us that, and we must stop treating Japan as some special case that has no lessons for the rest of us. (How often did we hear of their lost decade in the 1990s that it couldn’t happen anywhere else.)

It was good that the IFS suggested Hammond has a look at Labour’s fiscal rule. As I explained in this post, Hammond’s new ‘rule’ is pretty worthless. But one key part of Labour’s rule that keeps being ignored but is crucial in today's environment is the knockout if interest rates hit their zero lower bound. It is for the reasons described above that this knockout is there and is perfectly safe: when interest rate policy fails you can completely and safely forget the deficit and debt and use fiscal policy to ensure the recovery. It is the basic macro lesson of the last 6 years that is fairly well understood among academic economists but still remains to be learnt by most people who talk about these things. Whether senior economists in the UK Treasury need to learn it or just keep quiet about it for other reasons I do not know.


  1. Presumably, even for countries that can issue their own currency, there is still a level of debt at which the markets will take fright. What happens first? Does the currency devalue? Then govt borrowing becomes more exorbitant?
    Are there signs we should be looking for? That presumably are not currently present in the UK?

    1. There is no evidence of this - see Japan. And why should they 'take fright'? As Simon has explained, a government that issues it's own currency can never be made to default. There could be inflation risk, if the government started to spend way beyond the economy's potential. But then the BoE would raise interest rates to offset it.

    UK government debt to gdp has fallen year on year in each of the last five months. It doesn't get much of a mention as reports comments on amounts not percentages.
    With good growth likely to continue in the next few quarters I don't see why the reduction will not continue. Unless the OBR projections result in unnecessary increased borrowing. That will happen if their gdp forecast is too low. For 2016 this week it was at 2.1 annualised but the actual annualised rate is already 2.3. With further growth in the last quarter, as seems very likely, the OBR growth projections will be too low and result in increased and unnecessary borrowing.

    By John Cassidy , APRIL 26, 2013, The New Yorker.

    George Osborne February 2010:

    "So while private sector debt was the cause of this crisis, public sector debt is likely to be the cause of the next one. As Ken Rogoff himself puts it, “there’s no question that the most significant vulnerability as we emerge from recession is the soaring government debt. It’s very likely that will trigger the next crisis as governments have been stretched so wide.”
    The latest research suggests that once debt reaches more than about 90% of GDP the risks of a large negative impact on long term growth become highly significant. If off-balance sheet liabilities such as public sector pensions are included we are already well beyond that. And even on official internationally comparable measures of debt, we are forecast to break through 90% of GDP in just two years time…

    To entrench economic stability for the long term, we need fundamental reform of our fiscal policy framework….As I have made clear, our aim will be to eliminate the bulk of the structural current budget deficit over a Parliament."

    The BBC article, 'Reinhart, Rogoff... and Herndon: The student who caught out the profs' Ruth Alexander 20 April 2013, makes no mention of Osborne and I cannot find on the BBC website reference to that Osborne speech despite it being the cornerstone of his jerrybuilt economic policy.

    How do the Tories keep getting away with it? Because the BBC is an anti-university shambles.

  4. Unfortunately, not even Labour talks about the ZLB knockout. In fact Rebecca Long Bailey on Any Questions didn't even want to admit that more investment spending means higher borrowing in the short term. The dominant narrative is still that government borrowing is inherently bad, and currently 'too high', e.g. the BBC hysterically quoting big numbers - on the Today programme the other day they went on about how 'the debt is 2 TRILLION POUNDS - higher than during ww2 or the financial crisis!!!' ignoring that in terms of debt/Gdp it is not particularly high by historical standards and certainly nowhere near the level it was after ww2. And as Simon points out, any level is manageable for a government that can create the currency. Labour seems unwilling or unable to fully explain their own fiscal rule, including all its subtleties. I wonder if their team even understands it themselves!

    1. Sigh. What I have always wanted to do is talk to MPs directly about austerity, and I've never had the chance. Not just soundbite stuff, but say a 15 minute talk and the same for Q&A.

    2. I can't understand why Mcdonnell doesn't invite you to brief the shadow cabinet. Is the EAC still suspended? If so would it not be helpful to unsuspend it?

  5. The way you put it makes it sound like the reason government debt is safer is because the government can order the central bank to buy it. But even with a rigidly independent central bank, the debt would be safer because the revenue base of the (national) government is the same economy that the central bank is managing. So in the event of an ordinary business cycle recession, the central bank can guarantee that the government won't default without hindering its primary objective of price stability. There's no conflict.

  6. "If a government cannot create the currency that it borrows in, then the risk of default is very real."
    So very true.
    And so very important that once a one very important academic admited it clearly and without doubt. Im in awe, now.
    Thanks for such daring sentence.

    So, what are those countries that do not borrow foreign currencies?
    US, Canada, Australia, UK, Japan, Swiss and some more but not many more.

    Hmmm. Mostly "former" empires while "former" colonies have to borrow empire's money to trade with them.
    This is the main reason that countries have to borrow in foreign currencies. In order to trade, they have to trade in their currency, not the one they can print.
    US, UK, Aus, Japan do not want to trade in foreign currencies only in Dollars and Yen. This is what makes an empire today. Colonization is just done with trade in foreign money and empire's bank can decide not to roll over colony's debt if a collony tries to be independent and not blindly listen to Empire.
    No more army is needed for colonization, banks do it now.

    Keyness tried to prevent that unfairness with Banccorp but US did not allow it and Bretton-Woods was implemented. Which failed as it had to.

    Initial problems of sovereign debt applys only to collonies that have to borrow foreign currencies to trade.
    Now lets talk about benefits of "free trade" shall we??????????
    But where is such free trade, i do not see it in the real world. International trade is totally unfree and totaly unfair.

    What is implication of such unfree trade. Countries that trade only in their own money they can create can enjoy supply of the whole world, not only of their own economies. Anyone will sell them anything for dollars, so the model MV=QP includes Q of the whole world, no possibility of inflation from import debts, or printing money.

    Only inflation will show up in markets that can not be imported, like housing and health services.

  7. Simon, are you rich enough to attend, say, a lecture at J P Morgan given by George Osborne? (How else, beyond charging the audience, were JPM able to pay him £81,000?)
    I assume that JPM got more from him than the platitudes he delivers in speeches in Britain. Maybe some embarrassing admissions: "okay I admit it I did stop the recovery in its tracks in 2011. And yes, I did practice deficit deceit."
    Simon, get yourself off to his next lecture (in America, in private board-rooms far away from British economists). Maybe you can smuggle a video camera past security....

  8. "Whether senior economists in the UK Treasury need to learn it or just keep quiet about it for other reasons I do not know."

    Perhaps it's time for an Post-Keynesian update to :

    MMT is clearly an accountants tool, and I don't wonder why Haiti doesn't try it.
    As an economist with connections to some of the best brains on the planet when it comes to theories for the common good, I'd have thought some sort of back-handers might be coming into play. Game theory with FIAT?

    Whilst many suspect the game is rigged, it would be good if Treasury economists' theory were better explained and scrutinised.
    Now BoE has Kumhof. I doubt it is as simple as N Shaxson explains it, but the vested interests like to keep it just so?
    but I might be wrong.

  9. As long as the central bank has a mandate to maintain a target short-term interest rate, the size of its purchases and sales of government debt are not discretionary. Once the central bank sets a short-term interest rate target, its portfolio of government securities changes only because of the transactions that are required to support the target interest rate.

    The central bank’s lack of control over the quantity of reserves underscores the impossibility of debt monetisation. The central bank is unable to monetise the debt by purchasing government securities at will because to do so would cause the short-term target rate to fall to zero or to the support rate.

    If the central bank purchased securities directly from the treasury and the treasury then spent the money, its expenditures would be excess reserves in the banking system. The central bank would be forced to sell an equal amount of securities to support the target interest rate. The central bank would act only as an intermediary. The central bank would be buying securities from the treasury and selling them to the public. No monetisation would occur.

  10. All that is promised is a spredsheet operation.

    An interest bearing treasury security is swapped for a non interest bearing reserve balance.

    No children or Grandchildren insight.

    If you look at the US Daily Treasury statement. At the end of the last fiscal year the US repaid over $ 95 Trillion and nobody even noticed.

  11. "For the mountains may be removed and the hills may shake, But My lovingkindness will not be removed from you, And My covenant of peace will not be shaken," Says the LORD who has compassion on you.

    I guess that applies to mountains of government debt, particularly in it's own paper. Still, some won't be happy, but they never are.

  12. The mainstream media commentators never seem to mention the fact that, following QE, 25% of the debt is held by the Bank of England, which means the 90% figure is arguably misleading. I also don't understand the media's obsession with debt and deficit levels, rather than debt service costs.

  13. There is a more serious point to be made following my earlier flippant post on George Osborne lecturing in America. The ex-Labour Prime Minister Tony Blair is no stranger to the lucrative American lecture scene and he is pursued with much more hostility by that overwhelming part of the British press that dislike him than Osborne ever is. Yet even they never (rarely?) publish the content of Blair's lectures.
    As I said jokingly in my first post it's easy to believe that "truth will out" at these lectures---witness Theresa May's remarks on the hit the UK economy will take on Brexit, made privately to an audience at a London bank before the referendum. Yet the content of these lectures is rarely leaked. May was unlucky in that someone recorded her remarks and released them to the media.

  14. In the US (and the UK which maintained its own currency) in the short term, this is an apt analysis. Really long-term debt is a matter of current laws, expectations and demography. Unfunded and as yet unrecorded liabilities (nothing recorded on a ledger as yet) is an increasing worry. Inculcate the demographic part of the equation, then extrapolate. Any currency is only worth what it can be traded for. All I'm saying is most people can't separate the near term situation from long term prospects; to most the matter is conflated.

  15. This is unfortunately another "mainstream economic theory tells us everything we need to know" post. Even though mainstream economists caught on to the 'borrow in your own currency thing' quite late.

    But it is actually not as simple as that. There are reasons why certain countries currencies' are safe havens which cannot explained by neo-classical theory and which require knowledge about how the world actually works. For example an import dependent country might have to import and export in US dollars and may have to have trade surpluses to build up foreign exchange reserves in order to buy those dollars to trade. This could require tight or consistent monetary policy. Issues of power structures (the US hegemony for example) and geopolitical relationships become very important. Understanding these factors is important in understanding why many countries joined the Euro.


  16. I can see the logic of your analysis but there has to be the latent (or actual) threat of inflation if debt monetisation becomes established. I realize that this is what bodies like the BOJ may want but there has to be the risk that it takes off then the whole basis of the monetary system is undermined and, potentially, destroyed. At the end of the day it is a trade off of course and, under the circumstances the BOJ finds itself in, then maybe it's justified.

    I can't understand why Labour's debt rule fell by the wayside. It seems to me a perfectly sensible thing to do to distinguish between self liquidating debt and non self liquidating debt.

  17. Interesting information.
    "for economies that issue debt in currency they can create, there is no obvious upper limit anywhere near to current debt/GDP ratios"
    This is especially relevant for the the US where public, private and off-balance sheet debt is said to be in excess of 1000% of GDP and rising - a horrifying figure. But the markets aren't worried yet, so that's OK.
    No doubt the attitude will change when this financial hegemon is overtaken by the next, and so on. Such is unilateralism. The cause of much financial instability in the global economy.
    An argument here for restoring and building on the global financial discipline the US nation was allowed to destroy in 1971 in its effective default.

  18. But isn't it the case that, while lenders might not rationally fear default or the erosion of their investment through inflation, they might nevertheless find UK government relatively unattractive in relation to other options - in which case we're in trouble

  19. "(Others have used rather more emphatic language.)" I suppose that one should not mention phrases like "Academic fraud".

    "It may do so if the political costs of raising taxes or cutting spending is greater than the cost of defaulting." Thanks for mentioning the third option, creating the money. It helps if one realizes that taxes paid go straight into the bit bucket -- or are shredded if paid in physical paper money. Then new money is created to pay debts -- the same way that new points are created to award for touchdowns and field goals in football.

    If only President Obama had minted the trillion-dollar coins, that would have settled the default question. Sure, it would have debased our currency -- making them want to demand more dollars for the same goods and currency: inflation. Sufficiently increased inflation would have pulled us from the zero lower bound, allowing the Fed to adjust rates at will to benefit or harm the economy.

  20. It occurs to me that the structure of the debt has changed significantly since 2007. Most obviously in terms of proportions. About one quarter of it is now held by the BoE APF up from zero, another quarter by financial institutions and pension funds down from around one half, another quarter is held overseas down from around one third, and the final quarter by miscellaneous entities including a small proportion held by the general public.

    The risks posed by each doesn't seem to be the same. AFP's holding seems to pose no real risk, and little cost, and perhaps this amount should be officially discounted according to the likelihood of it being unwound any time soon it ever, (perhaps it is effectively discounted by some experts).

    It seems unlikely to me that the institutional financial holders are likely to ditch gilts given that they have requirements to meet on their holdings of safe assets.

    The overseas holdings are perhaps a little more problematic. Even if there are willing buyers offering sterling for tha debt, their realising their investment in their own currency would seem to require either for other foreign investors to take up the slack by purchasing other UK assets or for the UK's foreign currency reserves to be depleted.

    I can see that their is no risk of involuntary default in sterling terms, Remembering that foreign held goverment debt exceeds UK's foreign currency reserves; I do not yet see why there is no risk of an involuntary currency crisis. We may not be able to run out of sterling but we cannot invent foreign currency reserves in the same way.

    Not knowing any better, I must find the risk of a sterling crisis worrying.

    Is the risk real and pressing? If not where should I look for reassurance?

  21. Would it be possible for you to explain why we have had QE but not debt monetization? Or even a mix of both? What is the difference between creating money to buy private debt and creating money to buy public debt?

    I'm sure the answers are obvious but as a lay reader I am struggling to understand.

    Given the importance of the debt/deficit narrative in political discourse over the past 8 years it seems that it would have been extremely useful for the Government if they were able to simply print money to keep debt as a percentage of gdp lower.

    Many thanks


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