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.  

Do politicians need to pander to myths?

About UK politics, but raising some general issues about politicians and popular prejudices

Paul Bernal has a powerful post (HT Chris Dillow) where he says Labour lost the election long before 2015, by pandering towards three big myths: the myth that Labour created a huge deficit which required austerity in the midst of a recession, the myth of the ‘scrounger’, and the myth that Labour made a mistake in allowing excessive immigration. I obviously agree about deficits, I’m appalled at the hostility to welfare recipients stoked by the right wing tabloids and the harm done by inept reform, and I’m dismayed that politicians shy away from putting the positive case for immigration. For that reason I should agree that in England at least one of the three major parties should be standing up against all these myths. The Conservatives and Liberal Democrats helped manufacture the first myth, and the Conservatives contributed to the second and pander to the third (although some of their supporters would not favour costly immigration controls). Labour failed to combat all three.

The media have, predictably, reached a consensus about why Labour lost: it was too left wing, it was anti-business, it failed to be aspirational (it wanted to raise some taxes on the rich) blah blah blah. But as Peter Kellner and others have pointed out, there is no clear evidence for these assertions. Instead, they just happen to represent the things that much of the media dislike about Labour’s policies. Watching at least some of Labour’s potential future leaders, who the media as a whole describe as ‘modernisers’, fall in line with the media’s diagnosis makes the Parliamentary Labour Party look pathetic. Perhaps it is?

And yet, Peter Kellner also points out that being tough on scroungers and immigration is very popular. And these issues mattered for many voters. In a tweet about Bernal’s post, I asked was it better to lose telling the truth than lose being complicit in a lie? But it would be better still if a political party could tell the truth and win! Yet that seems a hopeless task. Jonathan Portes has championed the evidence on immigration, but as the BBC’s Nick Robinson put it, he would not get elected in any constituency as a result.

It is tempting at this point to blame the media for this state of affairs. In one sense I agree: I think newspapers should have a responsibility to tell the truth, rather than pander to prejudice when it suits their owners to do so. But in terms of practical politics this does not get you very far. One of the depressing conclusions that will be drawn from the election result is that it is fatal to stand up to Rupert Murdoch. [1]

Is it also true that cutting the deficit is widely popular? Here I think the evidence is less clear. I agree with John McDermott that perceived competence is vitally important, and not only in relation to self-interest. That is why Labour made a strategic mistake in not challenging with more force the coalition’s blatant myth making on the deficit issue. As Jonathan Hopkin and Mark Blyth point out, it is incredible how the blame for our current problems has so easily been transferred from the finance sector to fiscal profligacy, and not just in the UK. (But not so incredible if you follow the money, and take media power seriously.) 

Perhaps I can also make a very personal point here. As one of only a few academics who have written an academic paper on the Labour government’s fiscal record, which concluded that Labour profligacy was a myth, you might have expected Labour at some stage to have used some of the many words I have written on this to support their case. As far as I know they did not. Perhaps they were put off by some of the my criticism of other aspects of Labour’s programme. But this didn’t put off Alex Salmond, who was happy to quote my support of the SNP’s line on austerity, suggesting it had all the more force because I was not an SNP supporter.

Talking of which, I think there is one more piece of received wisdom that needs exposing, and that is Scottish exceptionalism. As I hinted at the beginning, there was one major UK party that did campaign against austerity, was pro-immigration and supportive of welfare. No doubt other factors also led to the huge success of the Scottish national party, but their position on these three issues didn’t seem to do them any harm, and in some cases probably helped a lot. This example suggests the answer to the question posed in the title is a clear no. 

It is generally presumed by the media, both sides of the border, that this is all because Scots are inherently more left wing than the English. But the evidence suggests differences in social attitudes between Scotland and England is not that great. The question Labour (or at least somebody) should be asking is why the SNP can avoid pandering to these three myths and win decisively, when the consensus is that doing the same in England would be electoral suicide.   

[1] Some people who comment on this blog say that when I voice concerns like this I’m being a bit passé, but on other occasions I’m accused of being anti-democratic! Somehow a politician choosing to delegate macro policy to experts reduces democracy, but allowing rich media barons to control the information that much of the electorate receives, and as a result have a considerable influence on politicians, is just fine.

Myths: a reply to Tony Yates

In this post Tony was responding to both my mediamacro series and Paul Krugman’s Guardian article, but I’m going to focus on the former. That is because I think Tony only really has a problem with the first in the series, which was about the 2010 ‘crisis’. So his ‘third way’ is really 7/8th my way! He also argues that 2010 austerity was not a major problem because of developments in consumer price inflation, but that is an argument that I did not cover in the myth series, because it is not part of the narrative I was criticising. I will address it here.

First the 2010 crisis. Tony agrees that there were no signs of a crisis in the markets, but he rightly says that a crisis could have subsequently happened. If I wanted to be pedantic, I would say that this means he agrees with my criticism of the mediamacro narrative, which at the very least allows politicians to pretend that there was an actual crisis. There is rather a big difference between “we saved the economy from a firestorm”, and “we took prudent action because bad things might have happened”. So maybe 15/16th my way.

As there was no actual crisis, what were the chances of one happening? Eric Lonergan has written a very good response to Tony on this, but he makes an additional point which I have made in the past but which I can too easily forget. Because austerity damages the real economy, it increases domestic credit risks. To the extent that governments stand behind those extending the credit (banks), then austerity can actually increase government default risk. So austerity as a precautionary policy can actually make the outcome you are trying to prevent more likely.

I also think I take a different view to Tony on what might have happened if markets had suddenly taken fright on the deficit and stopped buying UK debt. We agree that the Bank could have just bought the debt - as it was doing anyway under QE. But could it control inflation at the same time? At first sight it seems obvious that printing more money to buy government debt would compromise the inflation target. But that will not be true if you are at the Zero Lower Bound (ZLB), and austerity is only a problem at the ZLB. Paul Krugman has written a paper on this, but it becomes irrelevant because of our second disagreement.

This is that although the lack of recovery from 2010 to 2012 was regrettable, it was also inevitable given that inflation was way above target. Tony sees the MPC as trying - and largely succeeding - in getting the optimal balance between inflation being too high and output being too low. If that is the case, the ZLB was not actually a constraint during that period - interest rates combined with QE were doing just what the MPC would have wanted. This view is also a position that I think most MPC members hold.

Here I think we need to take a step back and think about what good policymaking is. A good policy is one that allows for what might happen, and not just what eventually did happen. In a sense this is a trivial observation: we do not want policies that are OK 51% of the time, but really screw up 49% of the time. However I think, after the event when we know how the world did turn out, it is so easy to forget this key point. We do not want to take taxis that generally get us there a bit quicker by taking risks, but occasionally crash. If we are unlikely enough to take such a taxi, and we do not crash, we do not say to ourselves ‘good choice’.

As Paul emphasises in his reply to Tony, you wait until you are well clear of the Zero Lower Bound (ZLB) before embarking on fiscal tightening. You are about to hit the economy hard, so you want to be pretty sure that someone else will be able to make sure it can absorb that blow. In the case of Osborne in June 2010, we do not know if he even understood the risk, because his keynote speech on macroeconomic policy ignores the ZLB issue. But if he did, he certainly did not think to himself that inflation was going to rise to 5% in 2011 so austerity is OK. (The OBR forecast for inflation was below 3%.)

While on that subject, Martin Sandbu says that as Danish and Swiss rates are now negative, 0.5% was not the ZLB anyway. This is completely beside the point. It was absolutely clear in 2010 that the Bank regarded 0.5% as the lower bound, so they were not going to cut rates further. The Bank was independent, so the Chancellor had to work around what the Bank was actually going to do (and not what five years later we might wonder what it might have done). 

What this all means is that Tony’s argument about inflation is not an excuse for austerity, but an argument about how much in practice it cost. I addressed this argument in detail here. I will not repeat what I said, because I do not want to detract from the more fundamental point above, but the upshot is that the £4000 per household figure that I often quote for the cost of austerity already incorporates some monetary policy reaction to fiscal decisions, so could well include any raising of rates in 2011 if austerity had not happened. But whatever the cost, 2010 austerity was a first order policy mistake, because it took unnecessary and large risks with the economy. 

Mediamacro myth 3: the 2007 boom

The only way you can sustain the myth that Labour was fiscally profligate is by suggesting that immediately before the recession the UK was experiencing a massive boom. In an economic boom tax receipts are high and spending on transfers low, so the budget should be in surplus. If it is in fact in significant deficit, that indicates serious fiscal laxity.

There are two half-truths here. First, everyone remembers talk of a housing boom, and a housing boom sounds pretty similar to a more general economic boom. But more seriously, the idea that there was a huge boom in 2007 appears to be backed up by data from the IMF and OECD. Let us take each in turn.

This chart of house prices clearly shows a housing boom in the middle of the last decade. But does it indicate a general economic boom in 2007? There are two problems: there is clearly an underlying trend in the data, and house prices rose most rapidly at the beginning of the decade. When you take any trend into account, the middle years of that decade look like a plateau.

The upward trend in house prices is likely to be due to two factors: a growing mismatch between demand (encouraged in part by inward migration) and supply (very few new houses being built), and lower real interest rates. (The reason why low rates are important is explained here, and the link with demand and supply here.) As all these factors can also vary in the short term, this indicates that the house price cycle need not always be correlated with the more general economic cycle. The clearest indication of this is what has happened to London and South East house prices over the last two years, which are now well above 2007 levels. Does that mean the region is in the middle of an even more massive boom? Of course not.

If you look at both the OECD and IMF’s current measures of the output gap (the difference between actual output and the level that would keep inflation constant), they suggest a large positive gap for the UK in 2007. (3.5% in the latest OECD Economic Outlook.) That is a pretty large boom. The problem here is that in 2007, the OECD only thought the output gap at the time was less than 0.5%, which is no boom at all. Why the change in view? The answer is the recession, and the UK’s slow recovery. To cut a long story short, the OECD in effect retrospectively fit a gradually moving trend through the data (for productivity rather than output, but it comes to the same thing), so the longer the UK fails to catch up with its pre-recession trend, the more the OECD has to bend that trend over the past. The more it bends the trend, the more 2007 looks like a boom.

Could the OECD be right now and wrong back in 2007? The big problem here is that none of the more reliable measures behaved in 2007 as you would expect in a large boom. Inflation was happily bobbing around the Bank’s 2% target. Interest rates were rising, but not rapidly. Unemployment was a little higher than a couple of years before. Consumer debt was rising, but mainly because of rising house prices and mortgages. As the Bank’s Ben Broadbent points out, in the subsequent recession “losses on most domestic loans have actually been unexceptional. Instead, it is UK banks’ substantial overseas assets that caused much of the damage.”

This gets us to the key point as far as Labour profligacy is concerned. What is relevant to this issue is not what we think about the 2007 UK economy today, but what the general consensus was at the time. As we have already noted, the 2007 OECD Economic Outlook thought at the time that the UK economy was pretty close to trend. As far as I can see, this was a consensus view. The IFS Green Budget for 2007 had an output gap of effectively zero. The IMF’s Article IV assessment published around Budget time in 2007 came to a similar conclusion. The reason this was the consensus view is the data noted in the previous paragraph.

One final look at the numbers. If we assume real growth of 2.5% (again a consensus view at the time) and 2% inflation, then a debt to GDP ratio of 40% would imply that the sustainable deficit was 1.8% of GDP. As the estimate of the output gap at the time was around zero, there was no reason to adjust this for the state of the cycle. The actual deficits for financial years 2006-7 and 2007-8 were slightly over 2.5% of GDP. The difference is what I call mild imprudence, and would have been fairly easily to correct in subsequent budgets. By 2009-10 the deficit had risen to 10.2% of GDP because of the recession. So the deficit in 2010 was a consequence of the recession, not Labour profligacy before the recession.

And if you cannot shake off that idea that Gordon Brown was profligate, one final set of figures. Between financial years 1979 to 1996 (the 18 years of Conservative government), the deficit averaged 3.2% of GDP. From 1997 to 2007 it was 1.3%. Now maybe the Conservatives were a bit unlucky with having two recessions on their watch, so the equivalent cyclically adjusted figures are 2.6% and 2.1%. One last time: Labour fiscal profligacy is as mythical as the unicorn.

Previous posts in this series

(0) UK mediamacro myths: an introduction

(1) 2010 Britain faced a financial crisis

(2) Labour profligacy

My New Statesman article that provides a summary of this series is also now available online.

Mediamacro myth 2: Labour profligacy

As I noted in my previous post, the very big government budget deficit in 2010 was largely the result of the recession. That fact is difficult to square with the myth that the coalition government rescued the economy from an impending financial crisis, so it is important to push another explanation for the large deficit: that it reflected the profligacy of the previous government.

Economic journalists know full well this is a myth. Yet it is a myth repeated on countless occasions by the coalition parties, and by journalists working for the partisan press. On one occasion one of these journalists tried to rubbish a post where I wrote it was a myth, and I hope learnt to regret the experience.

Just inspecting the chart in my last post shows this myth is nonsense. But the political commentators that are central to mediamacro seldom look at economic data. What they do remember of the pre-recession budgets of Gordon Brown was some criticism that he was not being as prudent as he might be. That memory is both correct (both the IFS and NIESR made that criticism) and the criticism is valid, as I set out in my study of this period. (To read the study free before the election, go here.) This is the half-truth that sustains the myth.

But mild imprudence is not profligacy. We can see that by looking at another chart, for the debt to GDP ratio. Profligacy would imply a rapidly rising ratio, but this ratio before the recession (37% in 2008) was below the level Labour inherited (42% in 1997), and below its fiscal rule figure of 40%. No profligacy there.

So the Labour profligacy argument on its own would fall apart, if it was not itself buttressed by another myth: the argument that the government should have been running large surpluses in 2007, because we were in the midst of a major boom. That myth is important and widespread enough to deserve a post of its own tomorrow.

One final point. There was no impending financial crisis in 2010, but there was a very real financial collapse in 2008. Even though Labour was not profligate, if it had been more prudent wouldn't that have given it more ammunition to fight the recession caused by the financial collapse? To the extent that Labour's countercyclical fiscal policy in 2009 was moderated by a worry about debt (which I suspect it was), this is a half-truth. But as Vicky Pryce, Andy Ross and Peter Unwin state in their book 'Its the Economy Stupid: Economics for Voters' (which I happily recommend, and which in its initial chapters covers much of the ground of this series):

"The elimination of the UK's structural deficit [under Labour before the recession] would not have been even a sticking plaster in the face of the haemorrhaging of the finance sector's jugular"

I would also add that the Conservatives not only argued for even less financial regulation before the financial collapse, but opposed Labour's measures to moderate the recession in 2009.

Previous posts in this series

(0) UK mediamacro myths: an introduction

(1) 2010 Britain faced a financial crisis

Mediamacro myth 1: 2010 Britain faced a financial crisis

The idea that the Coalition rescued Britain from a crisis is routinely put forward as fact by both the Conservatives and Nick Clegg. Every time the media let such statements pass (as they invariably do), the language seems to get more florid: Clegg’s latest is that the coalition was born in the “midst of an economic firestorm”. [1]

The facts say this is pure nonsense. The economy had begun to recover from the recession, and this recovery might have continued if it had not been hit on the head by domestic and Eurozone austerity. As Larry Elliott makes clear (see also here), there was no sign of any market panic, either in the markets for Sterling or government debt. 

But the government’s budget deficit was very large, and debt as a proportion of GDP was therefore growing. If, through a separate myth, you have created the idea that the major (perhaps only) goal of aggregate fiscal policy is to reduce deficits, this seems like a serious problem. But the deficit was rising because of the recession. It always does rise in a recession and fall in a boom, as the chart below shows. It was particularly high in 2010 because this recession was particularly deep.

Any economist would cringe at the idea that policy should try and eliminate deficits and surpluses created by the economic cycle, because that would mean destabilising the economy. This is sufficiently well known (cyclical deficits and surplus are called ‘the automatic stabiliser’) that it could undermine the idea that the high deficit was an immediate problem. This is one reason why it is important to push another mediamacro myth - the idea of Labour profligacy, which we debunk tomorrow. [2]

So where is the half-truth that gives the ‘firestorm’ myth some credence? It is of course the Eurozone crisis, and the idea that the UK could suffer a similar fate to the Eurozone periphery. But academic macroeconomists understand that the situation of a country with its own central bank, like the UK, is quite different from a country without, because the central bank can (and in the UK will) act as a lender of last resort, so the government will never ‘run out of money’. That simple fact is sufficient to prevent any crisis happening for an economy like the UK. Greece was profligate, and had to default, but the crisis in the rest of the Eurozone ended the moment the European Central Bank agreed to act as a lender of last resort in 2012.

Why is it so important to keep up the pretence that in 2010 the UK economy was ‘on the brink’ of a financial crisis? Because only then can the pain of the subsequent few years be excused. The truth is that the failure to recover until 2013 was not the inevitable cost of rescuing the economy from crisis, but an avoidable choice by the Coalition government. The delayed recovery, and the damage that did to living standards, was at least in part a direct consequence of attempts to reduce the deficit far too early, and there was no impending crisis that forced the government's hand. [3]

Previous posts in this series

(0) UK mediamacro myths: an introduction

[1] There is something about Clegg that wants me to see him in the best possible light. So I imagine that, when confronted just after the 2010 election by briefings from the Treasury and the Bank about the dire economic situation, he really believed what he was reading. He did not realise that, from the Treasury at least, it is standard practice to say this to any incoming government. (One of the interesting untold stories of austerity is the extent to which it was encouraged by senior Treasury civil servants.) But I suspect my imagine of 'Clegg the naive' is, well, imaginary.

[2] If the financial crisis had permanently lowered UK GDP, or the tax potential of GDP, then that would also imply the need to reduce government spending at some point. But, as most economists agree, you do that when monetary policy can offset the impact of these cuts on demand. You do not choose to undertake austerity when short term interest rates cannot fall any further.

[3] The clear majority of macroeconomists agree that austerity when short term interest rates cannot fall any further will reduce output. The OBR calculate that austerity cut growth in financial years 2010-11 and 2011-12 by 1%, but there are good reasons for thinking this may be an underestimate.