Government debt phobias, and possible cures

After my Thursday post and New Statesman piece, I had a lot of comments that said something along the lines of: I see what you are saying, but we really cannot afford more government debt in this country. This is perhaps not surprising. After seven or more years of a constant stream of politicians and media folk talking about the UK maxing out its credit card, many people just feel it in their bones that the UK government has a serious debt problem. (It isn’t just the UK: here is a compilation from the US.)

How do we undo 7+ years of conditioning? It depends in part on what the fear is. Here are five

1. The country will go bankrupt
   
   
2. When will the debt be paid off?
   
   
3. Money could go on something more useful than paying interest
   
   
4. Why should my taxes be higher just to pay interest on debt?
   
   
5. What about the ‘burden’ on the children?
   

1. The country will go bankrupt

A simple truth, which you will not hear in the media, is that in an economy with a flexible exchange rate and its own central bank like the UK, the government can never be forced to go bankrupt, because the central bank can buy the government’s debt.

That of course is exactly what has been happening across the globe - not because central banks were trying to avoid the government going bankrupt, but because these banks were trying to keep long term interest rates low using Quantitative Easing (creating money). For example the Bank of England owns about a quarter of UK government debt (source). That meant that, at the slightest hint that the private sector might not have wanted to buy government debt, the central bank would have done so as part of its policy to control inflation.

At the end of the day, the central bank is a part of government, and so will always buy the debt of the government if necessary. That is why the government cannot be forced into bankruptcy. Could high and rising debt lead to inflation getting out of control? Yes, as Zimbabwe shows. When inflation is well above target and the central bank is creating a ton of money we can worry about that. When inflation is low and close to the target it would be daft to worry about this possibility.

2. When will the debt be paid off?

Here you should just stop thinking about government debt as being like personal debt. One reason it is different is that while a person dies, the country and therefore its government never do. Suppose you lived forever. Would you worry about paying your debt off?

What you should do is two things. First, use debt to spread the costs of investment over a large number of years. Many people are familiar with this, because they take out a mortgage to buy a house or a loan to buy a car. Second, use debt to smooth out fluctuations in your income. So in bad times let debt run up, but be sure to run it down in good times. Governments are exactly the same. For that reason they never have to pay all that debt back, but the ratio of debt to GDP should rise in bad times and fall in good times.

What level of debt to GDP should governments be aiming for in the very long run? This is a very good and interesting question, but to answer it you will probably have to become an economist, because it remains an unanswered question in macroeconomics.

3. All this debt interest could go on something more useful, like paying nurses more.

This was the fallacy I tried to deal with in my New Statesman piece, but here is another way of squashing this fallacy. We cannot just stop paying interest on debt, because that would involve the government defaulting on its debt. So the only way we can replace debt interest with spending more on nurses pay is to pay off all government debt. To do that, we would either have to raise taxes or spend less, and spending less means paying nurses less. It would also likely take about 30 years if you didn’t want a revolution. So 30 years of lower nurses pay just to get, after 30 years, higher nurses pay.

That does not make the idea wrong. But it does make it look rather less attractive than the impossible idea of swapping debt interest with something more useful tomorrow.

4. Why should my taxes go up just to pay interest on government debt

To help answer this question, we need to ask who gets these interest payments? For reasons we have already noted, a quarter of these interest payments go to the Bank of England as a result of its Quantitative Easing programme. The Bank then returns these interest payments to the government. In other words, on a quarter of UK government debt the government pays itself. [1]

Half of UK government debt is owned by the UK private sector. The majority of this is insurance or pension funds. In other words, the interest on government debt is in part helping to pay for your pension. And if by some magic that government debt was not there for your pension fund to buy, that fund would be forced to invest instead in some other, less desirable asset. If you are in the UK and have some money saved in the form of national savings, that is government debt too. The interest of this debt goes to you.

The key takeaway from this is that government debt is always someone else’s asset. If you think that you will end up paying more taxes to pay this debt interest than you will get back in pension payments or whatever, then debt is a distributional issue. You are complaining that you pay taxes (a small amount of which goes on debt interest payments) but you do not have enough wealth to buy government debt and receive these payments. That is a legitimate complaint, but it is part of a general complaint about how income and wealth is distributed, and not something unique to government debt.

And there is this point. If you think you want to reduce government debt because you are paying higher taxes and none of that is coming back to you or your pension, how do you think the government is going to reduce its debt? By raising your taxes of course.

So we come to the quarter of UK government debt where the taxes you pay that are then paid by the government as debt interest end up overseas. Surely that bit of debt interest is wasted, because it is going to someone overseas rather than someone here. But think about this. Suppose all government debt was owned domestically, and then some pension fund decided they would be better off by swapping their government debt with an overseas asset. Is that pension fund worse off? No, it is better off if its calculations are right. No one anywhere else in the UK is worse off because some government interest is now being paid overseas? If lots of people in the UK decide to do the same it still will not matter. It must therefore be true that selling debt to people overseas, whether directly or indirectly, makes no difference. Your concern is still a distributional issue.

To make this point another way, it would be possible to arrange the distribution of government debt such that everyone who paid higher taxes to cover debt interest received that debt interest back as a return, directly or indirectly via pensions, to their wealth. In that sense, the government paying interest on its debt is just like paying ourselves. To the extent that this isn’t true for you personally is a distributional issue. [2]

5. What about the children?

It is theoretically possible for the current generation’s government to go on a huge spending and tax cutting binge and leave the tab to be paid for by future generations. But that is not what has happened over the last ten years. Debt went up because we had a massive recession, and government deficits help cushion the impact of recessions. Should the government have stopped teaching children to avoid the deficit rising? Of course not, because that would have hurt future generations. Should the government have cut welfare payments to the unemployed to stop debt rising. Again we have good evidence that has a scarring effect on children. Should the government have embarked on an austerity programme that reduced public investment making future generations worse off. It should not.

Trying to cut the deficit by cutting public investment, or government spending that has long lasting effects like education or health, because you are worried about the burden of debt on future generations is, quite simply, idiotic. You are hurting the people you say you want to help.

Does this mean I should never worry about government debt?

In today’s economy, it is quite wrong to say government debt does not matter at all. There is a kind of simple golden rule here. When times are good, the government should be reducing its debt: debt to GDP ratios should be falling. How do you know when times are good? Not by asking politicians, obviously. One reliable sign that times are good is if interest rates are well above their floor. When interest rates are this high, cutting them can completely cushion the negative demand effects of fiscal consolidation (i.e. reducing the deficit). For this reason, austerity - fiscal consolidation in bad times - is completely unnecessary for economies like the UK.

For MMT readers

Before you start writing comments, a simple point. In an MMT world, where fiscal policy rather than monetary policy stabilises inflation, you would never worry about government debt or deficits beyond their impact on inflation. If you like that kind of world, then say that is how governments should be controlling inflation. But as it is, outwith the zero lower bound, governments are using interest rates to do this job. So to tell people not to worry about debt without mentioning the controlling inflation part is just confusing, to say the least.

Summary

We can sum all this up as follows. It makes perfect sense in many situations for the government to increase its debt. Investing when interest rates are very low is one of those situations, a recession is another. Those who tell you government debt should be reduced in all situation at whatever the cost should be ignored, because they are either fools or they have a hidden motive.

It also makes sense for governments to reduce their debt in good times, when interest rates are higher than they are now. [3] But in a economically advanced democracy the reasons why ever rising debt (often called deficit bias) is a problem are to do with economicky things like disincentive effects, and not because it will mean we are all doomed. You should not be frightened about allowing debt to rise when the situation demands it.

[1] Why is the debt held by the central bank counted as debt? One answer is that one day the Bank might sell it to the private sector, so it is a potential liability. But central banks may just let this debt run to term, so it will never be a liability. An alternative theory is that government debt owned by the central banks is kept in the figures to make them look more scary.

[2] Of course no one knows if their taxes are paying this debt interest or not. Even if we are paying ourselves, there is still a problem, which is that these taxes are not lump sum, so they involve a disincentive effect. This is a valid reason for wanting to keep government debt low, but it is not the reason most people worry about.

[3] How about now in the US? Should we worry about the Republican tax bill because it will increase the deficit? As interest rates are off their lower bound and rising, I would say we should, particularly as those who get most of the tax cuts are unlikely to spend them. But we should worry about it a lot more because it is a transfer from most people to a plutocratic elite.