Rethinking government debt

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This article is the first in our new series on debt, deficits and the role of central banks.  It is cross-posted from Coppola Comment

There is a huge amount of hysteria about government debt and deficits, not just in the UK but throughout much of the world. As I write, Brazil has been downgraded by Standard & Poors because of concerns about rising government debt and weakening commitment to primary fiscal surpluses in a context of political uncertainty and deepening recession. It is the latest in a long line of downgrades and investor flight over the last few years. The global economy is a very stormy place.

The UK, which has halved its fiscal deficit in relation to gdp in the last five years, is embarking on another round of fiscal tightening, with the aim not only of completely eliminating the deficit but running an absolute surplus by 2020 in order to, in the words of the Chancellor, "bear down on debt". The Chancellor's plan enjoys considerable popular support due to a widespread belief that if we do not eliminate the deficit and start paying down debt, we will end up like Greece. "Dealing with the deficit" has become synonymous with good economic management.

But others argue that further austerity to eliminate the deficit and pay down debt is unnecessary and harmful, especially if it means further cuts to investment spending. A growing number of voices call for the UK to increase investment spending even if it means a rise in headline debt/gdp in the short term, because improved growth from the extra investment would result in debt/gdp falling in the longer term. For many of these people (and I admit I am one), deficit phobia is economically illiterate and failing to invest when interest rates are on the floor is irresponsible management of the economy.

Still others say that government debt is unnecessary: a monetarily sovereign government can fund spending through central bank money creation. Jeremy Corbyn's People's QE gives a nod in this direction.

So who is right? How much debt should the UK have? What is the purpose of government debt?

To discuss the purpose of government debt, we must first consider the relationship between debt and money. Ever since the abandonment of the gold standard in 1971, governments have issued their own currencies. A government bond issued by a currency-issuing sovereign is simply a promise to issue an agreed amount of sovereign money at defined points in the future. The only new money issued is the interest: the principal payment at maturity simply re-issues the money withdrawn from circulation when the bond is sold. Thus, buying a government bond is exactly the same as placing money in a government-insured time deposit account in a bank. We should really regard government bonds as certificates of deposit. They are simply money, in another form.

Debt issued by a monetarily sovereign government in its own currency is the safest of safe assets. A monetarily sovereign government cannot be forced into default on debt issued in its own currency, and it does not have to tolerate inflation either. Default is a political decision. So is inflation.

But the power to issue money does not of itself confer monetary sovereignty. Many governments that are not monetarily sovereign issue money. What then do we mean by "monetary sovereignty"?

Monetary sovereignty means that the government  has full control over both the amount and the value of money in circulation, in all its forms (including government debt). Note that fixing a value is not the same as controlling it. We generally say that a government is monetarily sovereign if the following are true:

  • it issues its own currency 
  • it has a freely-floating exchange rate
  • it has an open capital account

But this would also be monetary sovereignty:

  • it issues its own currency
  • it has a fixed exchange rate or the currency is not traded
  • it has strict capital controls

Note that the definition of "monetarily sovereign" would include some failed states. Monetary sovereignty is not a guarantee of responsible economic management. Sovereign governments can trash their economies if they choose.

There are five principal ways in which governments can lose or relinquish sovereignty.

1. Any country in which the currency used to settle debts ((legal tender) and pay taxes is not issued by the government is not monetarily sovereign. So, for example:

  • Ecuador (uses US$)
  • Panama (ditto)
  • Kosovo (uses Euro)
  • San Marino (ditto)
  • Zimbabwe (anything goes except the Zimbabwean dollar)

This category also includes all Eurozone countries except Germany.

2. Any country which fixes the value of its currency in relation to one or more other currencies does not have monetary sovereignty UNLESS it also has strict capital controls. So, for example:

  • Bulgaria (currency board to Euro)
  • China (floating peg to a basket of currencies: leaky capital controls)
  • Denmark (ERM II peg to Euro)

Switzerland regained monetary sovereignty when it released its Euro peg earlier this year,  to the consternation of the financial markets.

3. Any country whose currency's value is explicitly or implicitly determined by the value of a commodity does not have monetary sovereignty.

The most obvious example of this is the inter-war gold standard, whose inflexibility prevented countries such as the US from reflating their economies and thus turned a recession into a Depression. But oil exporters such as  Russia and Kazakhstan also fall into this category. They have now floated their currencies, but their currencies track the oil price.

4. Any country that borrows mainly in another currency does not have monetary sovereignty even if it issues its own currency. This includes high levels of foreign-denominated external debt arising from a large trade deficit. Most hyperinflations involve countries which issue their own currencies but have very high external debt: this was certainly true of the archetypal hyperinflation, that of the Weimar republic. 

5. Any country which is largely dependent on trade links to a more dominant country does not have monetary sovereignty. This is perhaps the least obvious category, but it is crucially important. The small economies of South East Asia are dependent on trade ties with China. As the external value of a currency is largely determined by trade, their currencies therefore fall or rise with the yuan even without explicit pegs.

The five categories listed above cover the majority of countries in the world, including some of the largest economies. Monetary sovereignty is a very rare breed indeed. The vast majority of governments cannot issue either money or debt without limit. For most of the world, deficits (including external ones) and debt DO matter. Though perhaps fiscal rules don't have to be quite as strict as those imposed in the ridiculously-named EU "Stability and Growth Pact", which are slowly squeezing all growth out of the Eurozone and creating social and political instability.

But there seems to be a select group of countries which do have monetary sovereignty. The most prominent of these is the US, but it also includes Japan, Germany (because it is the Eurozone hegemon and the Euro is really a renamed Deutschmark), Switzerland (now), the UK, Canada and possibly Australia. Oddly, all of these violate one or more of the categories above - but they are nonetheless trusted by investors. Why this is, is a mystery. The key criteria appear to be the following:

  • a history of sound economic management and few defaults (ok, so why is Germany in the list?)
  • a dominant economic position (ok, so why isn't China in the list?)
  • a credible independent central bank
  • reserve currency status
  • long-dated government debt stocks mainly owned by own citizens
  • stable government and low political risk

These countries enjoy privileges that other countries do not. Although they have very low interest rates on government debt, they do not need to fund government spending with debt: they can simply issue money to meet commitments, relying on taxation and monetary policy to maintain purchasing power. They even have unlimited access to each other's currencies through central bank swap lines, thus in effect eliminating their external debt liabilities. But these extraordinary privileges do not mean that their own-currency debt has no purpose. On the contrary, they make it more vital than ever - and there is not enough of it.

The debt of this "Premier League" countries has four main uses in the modern global economy: 

  • A safe savings vehicle for  their own citizens (particularly vital in those that have poor demographics, such as Japan)
  • A safe haven for foreign investors fleeing from trouble elsewhere
  • An anchor for investment portfolios
  • An essential lubricant in financial markets

Strictly speaking, only the first of these is "necessary" as far as those governments are concerned. Their primary responsibility is to their own citizens. Enabling those citizens to save safely AND invest productively is a part of that responsibility. For that reason alone, these governments should issue enough debt to meet the saving propensity of the domestic private sector, though they might choose to lean against the pro-cyclicality of saving preferences by issuing money instead of debt in recessions and debt instead of money in booms.

But the other three are also essential, from a global economy perspective. The financial system needs safe assets. The fallout when private sector "safe assets" are exposed as the risky assets they really are is terrible. So too is the fallout when sovereign debt issued by governments that do not have monetary sovereignty is exposed as the risky asset it really is. We have seen both in recent years: the 2008 crisis was a failure of private sector safe assets, and the Eurozone crisis was a failure of government safe assets. We are still paying for the consequences of these failures. To pretend that the financial system can manage without safe assets is folly.

This explains the clampdown on government debt and deficits in "Premier League" countries. There is a terrible fear among financial sector actors that these countries will pursue reckless economic policies that destroy the purchasing power of their currencies and the value of their government debt. This fear has been deliberately communicated to the general public in those countries by captive politicians and media, in order to ensure wide acceptance of the austerity policies that much of the financial sector believes is necessary to maintain the value of safe assets. It is perhaps understandable, but it is economically unjustified. The truth is this:

  • Running a primary fiscal surplus in a recession makes the recession worse, raising debt/gdp and increasing the risk of sovereign default
  • Running a primary fiscal surplus when growth is poor and the private sector highly indebted is likely to cause a recession
  • Running a sustained absolute surplus robs the private sector of its savings
  • Paying off government debt deprives the private sector of a safe store of value
  • Increased growth and prosperity arising from productive investment outweighs the cost to future generations

Sadly such basic economics is lost on credit ratings agencies and investors, who see only rising deficit and debt/gdp and start to panic about getting their money back.

It is indeed necessary that the government debt of the world's "premier" countries should remain "safe". But draining their economies by forcing austerity policies upon them is not the way to keep it safe. On the contrary, it is likely to make it LESS safe. Safety is ensured through investment in the physical and human capital of the country to secure growth and prosperity for the future.

Clearly, even governments of "Premier League" countries can't do entirely as they please. There is bound to be a tipping point at which trust is lost and the country is relegated to the second division. We don't know exactly what that tipping point is. But the message from today's low interest rates is that we are nowhere near that point. For the sake of both their own citizens and the global economy, these countries can, and should, invest.