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Governments aren't Households

23 Aug 2020

As the pandemic persists, the amount of government spending necessary to support the economy has only risen. In fact, government debt has risen over £2 trillion for the first time ever. Inevitably, many are concerned about the state of public finances and whether we are spending beyond our means.

UK National Debt

To understand government debt, it is worth decomposing what it actually is. When governments spend more than they raise in revenue, they run a budget deficit. The national debt is all of the deficits added up over time. Governments are able to run deficits by issuing bonds, which various individuals, firms and governments buy. Bonds are loans - so if I buy a government bond, I’m giving them some money now and in return, they will pay me back the principal with some interest on top at a later date.

But why can governments run perpetual deficits? In a very trivial sense, that’s because people demand government bonds - they want to lend the government money, and based on the prevailing interest rates, they’re willing to do so for very little. But in a more meaningful sense, the reason there is demand for government debt boils down to a few things.

The first is just that governments exist forever. I can’t keep borrowing because I’ll eventually die and so I need pay the money back before that point - but the government doesn’t die, so people are happy to lend it money knowing that it’ll exist and can keep rolling over its debts in perpetuity. The second is because government debt is unlike household or corporate debt - it operates in a general rather than partial equilibrium. That is, the amount of government spending has first-order effects on the growth of the macroeconomy and on interest rates, whereas me taking out student loans would not.

(The third is that in principle, governments should never have to default on their debt, since they issue debt denominated in their own currency. This means they ought to be able to print the debt away. Of course, this doesn’t occur in practice - in part because of the inflationary problems, in part because it leads to a reduction in credibility for the future, and in part because central bank independence means this doesn’t occur.)

The consequence of all of this is that government debt is in demand, and as such, the optimal amount of debt is positive rather than zero. Of course, it isn’t always going to be in demand - historical instances of sovereign debt defaults such as in Greece make it clear that there comes a point where people are no longer willing to lend to governments. And the determinant of whether or not someone is willing to lend to governments is whether they expect to be repaid - as such, a more useful indicator is the debt-to-GDP ratio. As long as the GDP of the country rises in line with the debt, we will be able to pay the interest payments. (An even better measure would be the interest-payments-to-government-revenue ratio, but doing continuity adjustment on time series data from the ONS and BoE was hard enough with debt.)

UK Debt to GDP Ratio

And so the national debt should not be a primary concern right now. By all measures, whether it is in terms of the interest rate at which people are willing to lend to us or the credit rating given to us that measures the riskiness of our debt, people still believe that it is a safe asset and so our costs of borrowing are low. And although spending can’t continue infinitely (despite what MMTers would tell you), the main consideration right now should be about what is necessary to help people survive, not the fiscal constraints that we are far from reaching.

[ economics  takes  ]