Some myths about government debt and how it is financed

That the Bank of England was temporarily eliminating the limit on the Ways and Means Facility caused a bit of a stir last Thursday (9th April). It in effect meant that the Bank of England could credit the government with as much money as it needed in the current crisis. That it should cause such a stir illustrates how pervasive many of the myths are around government debt. Here are three familiar examples.

1. It doesn’t matter that we are in a developing economic crisis, like a recession or a health pandemic, we still need to worry about what is happening to government debt.
   
   This is false for any country that prints its own currency, like the UK. In a crisis you should worry about dealing with the crisis. Government debt is what allows the government to put all necessary fiscal resources into fighting the crisis. To worry about debt is like worrying that a fire engine putting out a fire is using too much water.
   
   
2. OK, but we should worry about government debt the moment output stops falling (or in a pandemic, the moment any lock down is relaxed).
   
   Again false. This was the mistake that some large economies made after the Global Financial Crisis (GFC). By worrying about debt they either slowed down, killed or reversed the recovery. Because governments can get the Bank of England to buy its debt (or continue to create money), there is no need to worry about debt until the economy has fully recovered from the crisis. This will be equally true in any recovery from the pandemic.
   
   
3. When the government starts financing its deficit by printing money rather than issuing debt, rampant inflation is just around the corner.
   
   

Many thought this after the GFC, when central banks started buying government debt through their Quantitative Easing programme, because they bought the debt by creating money. Subsequent events have shown that those who thought inflation was inevitable were completely wrong, as many of us said at the time. The reason they were wrong is because interest rates are at their lower bound, and at the lower bound it does not matter too much how the government deficit is financed. The reason is intuitive: when rates are zero, you are indifferent between cash and short term debt. So why would issuing money rather than debt cause inflation when rates are zero? No reason at all.

Which brings us to the Ways and Means Facility. In practice this lifting of the limit is likely to be simple cash flow management, with the government still issuing debt at the end of the day. But the Bank of England will keep buying debt as part of their new QE scheme. Ironically it is possible that we may get some inflation this time round, but it will have nothing to do with QE, and everything to do with some sectors not hit by the pandemic taking advantage of high demand, or sectors still functioning but with some labour shortages passing on higher costs. The Bank of England is likely to ignore that inflation if it happens.

Why does the government prefer to issue debt rather than create money to cover its deficits? After all, doing so costs it money. Even when short term interest rates are zero, interest rates on long term government debt are higher, to compensate for having the money locked up or the capital risk in selling it earlier. To say that financing deficits by money creation creates inflation is too trite, because it appeals to a simple linkage between prices and central bank created money that we just noted fails to happen in recessions.

A better answer is the one Keynes gave. In a recession you can create a lot of money, because it is willingly held by nervous banks and investors. But outside a recession investors and banks will want to get rid of that money, which will force down rates of interest in the economy, encouraging too much borrowing and discouraging savings. That excess demand will create inflation. Central banks are only able to control the general level of interest rates in the economy by restricting the amount of money they create, which is why government deficits are largely financed by issuing debt.

If we shouldn’t worry about government debt during crises, or as crises are coming to an end, should we worry about it at all? It is a good question, which can only be answered by looking at why having high levels of government debt might be bad. So let’s look at three myths or misunderstandings about government debt.

1. High debt risks financing crises.
   
   The general view at the moment is that there is a shortage of safe assets in the world, and the clearest evidence for that is low interest rates on government debt. As to short term market panics, we have seen that for a country that prints its own currency that is not a concern.
   
   
2. It is a burden on future generations
   
   

The idea here is that any debt has to be serviced (the interest has to be paid), and this can only be done by raising taxes. But the level of debt interest depends on interest rates as well, so when these are low, debt can be higher with the same ‘burden’. The other thing to be said (which should be obvious but is often missed) is that failing to stimulate in a recession can cause lasting damage to future generations. As can not dealing with climate change.

The same point applies to the idea that higher taxes to service debt discourages labour supply. When interest rates are very low, the impact of debt service on taxes is also low. There is a common error often made here. People note that the amount of money required for debt service could build many new hospitals, so let’s reduce debt to get more hospitals. But getting debt down to zero would require severe fiscal consolidation for decades before that goal was achieved.

3. It crowds out investment
   
   

This is an obvious mistake during an era of low real interest rates. Government debt crowds out private capital in OLG models by raising interest rates. So if interest rates are low enough to finance any decent investment, there can be no harmful crowding out.

To sum up, in an era of very low interest rates government debt can safely be much higher.The case for reducing the debt to GDP ratio from what it ends up being after the pandemic is over has to be made, and that case needs to take account of what causes real interest rates to be so low (secular stagnation) as well as the literature on safe asset shortages. In particular, as Olivier Blanchard has emphasised, if real interest rates on government debt are less than the growth rate, positive shocks to debt caused by recessions will gradually unwind of their own accord.

I have, however, to end with one final myth. This is

Deficits don’t matter as long as they don’t create excess inflation.

This is just not true when independent central banks (ICBs) control interest rates, because central banks will vary interest rates to control inflation. ICBs have been very successful at bringing inflation right down to low levels, which is why no government or opposition is going to abandon them anytime soon. In that situation, deficits that are too large or small will lead to changes in interest rates rather than inflation. (ICB’s are not so good at preventing recessions when inflation is low, which is why we need a state dependent assignment.)

Once recessions, caused by whatever means, are over then it makes sense to have targets for the government deficit (excluding investment) as a share of GDP. What that target should be will depend on a view of what the ideal debt to GDP ratio should be. (For more detail see here.) These targets are there not because high deficits will be the end of the world - far from it. Instead they are a disciplining device for governments. In the past it was thought they were needed to stop left wing governments spending too much, but in the UK and US the more likely problem is of right wing governments taxing too little.

Which brings us to why so many people think government debt and deficits are much more important than they actually are. In the past spurious concern about deficits has been seen by many to be an essential way of keeping a lid on government spending when a left wing government is in power, or even as a way to shrink the state when a right wing government is in power. It is ironic that in a era when there is an imperative to reduce climate change, the importance of deficit targets may be to stop right wing governments cutting taxes.  

How the lessons from austerity have not been learned

The UK and the Eurozone are both vulnerable to the next recession, but both politicians and central bankers think each other should deal with it.

I don’t want to talk about the likelihood of a recession in the UK, US or Eurozone. Forecasting is a (necessary) mug’s game, where there are just too many variables to make anything like an accurate prediction. It is worth outlining the risk factors, and Grace Blakeley does an excellent job here. Instead my concern is the vulnerability in both the UK and the Eurozone to the impact of a recession if it happens. This vulnerability was clearly illustrated by the mistakes made after the Global Financial Crisis, yet in many ways the lessons of that failure have not been learnt.

Most people know the story of austerity after the Global Financial Crisis (GFC). In the UK the negative impact of the GFC was so severe that even cutting interest rates from around 5% to 0.5% was not sufficient to counteract its impact. As a result the Labour government in 2009 undertook various fiscal stimulus measures. They, together with lower interest rates, succeeded in stopping the fall in output, but by 2010 the signs of a recovery were still fragile. The new Coalition (Conservative and Liberal Democrat) government decided to focus on the rising budget deficit rather than the recovery, and undertook a large fiscal contraction in what became known as austerity.

The consequence of UK austerity was the slowest recovery from a recession in centuries. Here is a nice chart from a recent report by James Smith of the Resolution Foundation, which clearly illustrates the extent of the weak recovery.

Employment eventually recovered, but at the cost of an unprecedented fall in real wages. James Smith gives some evidence to suggest that the reason employment got off comparatively lightly but wages suffered by much more than we might expect was the 2008 sharp depreciation in sterling. This allowed firms to respond to the recession by keeping wages low, whereas in recessions in which sterling did not fall firms resisted nominal wage cuts and so had to resort to cutting jobs.

The idea that austerity was essential to reduce the deficit is simply wrong. It undoubtedly was a large factor in the weakness of the UK recovery. The tightening of fiscal policy has continued until today, with the consequence that interest rates have had to stay low to offset this fiscal tightening. The net result is that instead of rates being near 5% as they were before the GFC, they are below 1%. As James Smith points out, interest rate cuts in previous recessions have ranged from three to ten percent. This means that conventional monetary policy has almost no room to counteract a new economic downturn if one came.

The Eurozone is in an even worse position. Their history is of two recessions since the GFC, the second of which was largely caused by fiscal tightening as a result of the Eurozone crisis of 2010-12. The last time core inflation in the Eurozone touched 2% was in 2008, and it is currently around 1%. (More details from Frances Coppola here.) Interest rates set by the European Central Bank (ECB) remain at their lower bound. If a new recession happened, caused for example by a disruption in trade due to Donald Trump, conventional monetary policy would be unable to do anything about it.

Of course central banks in the UK and Eurozone still have various unconventional monetary policy tools. But the clue to their reliability at ending a recession is in their name. They are unconventional because they have only been used since the GFC, so we have limited evidence on their impact. It is like having an accelerator on a car where how far you have to push your foot down varies from second to second. You will end up driving slowly, which in economic terms means a prolonged recession.

All this is now largely understood by central bankers. All have said in one place or another that they will be relying on fiscal stimulus to help counteract the next recession. The ECB needs fiscal stimulus right now to get out of the last one. Yet fiscal stimulus is in the hands of politicians and not central bankers, and many of the politicians and political parties that were crucial in implementing the austerity that hit the post-GFC recovery are still in power.

There is therefore a danger that the policy of fighting the next recession will fall between two stools. Central bankers will say, in their own quiet and politically sensitive way, that they are not equipped for the task, but politicians may be deaf to these messages and will once again start worrying about deficits that inevitably rise in an economic downturn. To say more, we need to differentiate between the UK and the Eurozone.

In the UK some may think that with a new Prime Minister the problem of austerity has disappeared. In order to get elected both candidates have promised all kinds of tax cuts or spending increases. But as I have argued recently, what we are seeing here is what economists call deficit bias: the tendency to borrow just for political gain. Worse still, if the borrowing is mainly for tax cuts (including tax cuts for the rich), there is a danger that it is part of a strategy called ‘starve the beast’, which involves increasing the deficit with tax cuts and then demanding spending cuts to bring the deficit under control.

The upshot is that a Tory leader wanting to spend and cut taxes to please party members provides no guarantee that they will undertake effective fiscal expansion in any future recession. Neither of the Coalition partners has apologised for the mistake of austerity, and we have no reason to believe that they wouldn’t do it again in any future recession. The only major party that has a fiscal framework that would automatically move to fiscal expansion when interest rates hit their lower bound is Labour.

In the Eurozone there is also too little recognition among senior politicians that fiscal stimulus is required when ECB interest rates are at the lower bound. This is why Eurozone inflation is still below target. The OECD point to a crying need for more fiscal stimulus. Germany in particular has a great need for additional public investment, but is restrained by a fiscal rule that is worthy of an economic stone age. Efforts to create a Eurozone budget that could act in a countercyclical way have also been blocked by politicians, despite support from the ECB.

We can hope for a change of political attitudes in both the UK and Eurozone, but central bankers should not be content with hope. They have been delegated the task of stabilising the economy, and if they fail to complete this task in economic downturn after downturn many will come to believe that delegating monetary policy to central banks was a huge mistake. In addition, it is not the case that all central banks can do when interest rates hit their floor is unreliable types of unconventional monetary policy.

A fail safe way for a central bank to bring a recession to an end when interest rates are at the lower bound is to create money and give it directly to citizens. It could also create money and give it to borrowers by subsidising borrowing rates. The former is called helicopter money, a term due to Milton Friedman, and would require cooperation from government. The latter has been undertaken by the ECB in the past (see Eric Lonergan here), and so could be done to a greater extent without involving government. In essence it involves cutting interest rates on borrowing to well below the lower bound, but keeping rates for savers at the lower bound, and funding the difference by creating money.

Central banks in most of the major economies have been happy to create money during a recession, but nearly always this money has been used by central banks to buy assets. The impact on the economy is then difficult to predict, because no one's income has increased and the interest rate for borrowing has not fallen significantly. Giving the money directy to people rather than buying assets would have a direct and more predictable impact in stimulating the economy, as Frances Coppola argues in her new book.

So why do central banks not do this? There are two major reasons. First, they worry that increasing people's income is the job of elected governments, although I would argue that it is central bank's job to stabilise the economy if the government does not. (See my article with Mark Blyth and Eric Lonergan for more on helicopter money.) Second, if they create money to buy assets, when the economy recovers they can if necessary take money out of the economy by selling those assets. If they give that money away they wil not have those assets to sell. However this problem could be dealt with by governments guaranteeing the supply of assets a central bank needs.

Besides these arguments, I think there is a third argument why most central banks have not proposed doing these types of measures in a major way, and that is conservatism with a small c. The problem is that, if politicians unprepared to undertake fiscal expansion in a recession remain in power, that conservatism may be very costly both to us and to central banks themselves.