I’ll keep this article deliberately short and simple for two reasons. Firstly because it’s a five-minute read (apparently), and secondly because I’m not an economist.
How governments borrow money
Governments spend money on “public goods” – things like roads, schools, pensions and benefits. If they don’t have enough money coming in from tax receipts, they will have to borrow the money. They do this by issuing government bonds. A typical bond is a piece of paper saying “I will pay the bearer £1000 in 5 years’ time, and I will pay an annual “coupon” interest rate of 2%, ie £20 in the meantime”. The potential investor – who might be an individual or a pension fund manager – will do his calculations and might be happy to buy this for say £850. So his outlay will be £850 but he will recoup £1000 down the road and will enjoy some interest payments along the way. The government will be happy too since it now has £850 in pocket to spend.
The problem for the government in issuing such a bond is two-fold. Firstly it will have to find the money for the coupon payments every year, and secondly it will need to stump up £1000 down the road . Ordinarily this isn’t a problem – after the 5 years are up it might just issue another government bond for the same amount, thereby kicking the full repayment further into the future.
When to borrow money
At times of a domestic or global recession – most recently during the covid years – there is a case for public borrowing as the government spends money to support businesses and prop up demand. This is “countercyclical” fiscal policy. During this spending spree they will be shelling out more than they earn, and that means borrowing money.
The problem with a big debt
If the government keeps spending more money than it takes in, it will have to keep borrowing more and more and the total “government debt” – the money that it has promised to pay back to these bond investors over the coming years – will continue to climb.
The problem with this is obvious (since we can relate to this situation in our own lives). Even if the government keeps issuing new bonds each time the old bonds reach maturity, it can’t avoid forking out the interest payments! And these can become a real drain on the public finances.
One sometimes hears the figure of extra borrowing a government issues over one calendar year, eg 5% of GDP, but the more important figure is the total accumulated debt. As an example, the UK government debt currently stands at around 95% of GDP. This translates into an eye-watering £111b of interest payments each year, or around 3,7% of GDP!!
A debt of 100% of GDP seems to be a psychological threshold where the general public really start to take note, but any % of debt is a drag on the economy. Japan’s debt stands today at 250% of GDP!
How does Japan manage then?
It’s not managing. After the boom years of the late ‘80s, the Japanese economy has never been the same again. And with debt so high, it’s painted itself into a corner with its economic choices severely curtailed. It can’t raise taxes or cut public expenditure in order to cut the debt for fear of depressing the economy even further, and it can’t try to spend its way out of trouble either – that’s what Abenomics was partly about – for fear of pushing its finances further into the red.
But how can it even survive at all with such an astronomical level of debt? Because Japanese interest rates are very low and it’s therefore not so expensive for the government to keep servicing the interest. A second reason is that most of its debt is held domestically. In fact half of it is actually held by the central bank! This sounds rather circular – but just remember that central banks trade in and out of bonds in order to manage short term interest rates (ie we’re not talking about anything dodgy like “quantitative easing” here…). Other countries like the US, especially if their currency serves as a reserve currency, can borrow easily and cheaply, but they run the risk that investors have a change of heart and sell the debt (ie the bonds) on the open market causing yields to rise. Yields (ie effective interest rates) means that the next time the government issues bonds to the public it will get less money for them. In our example above it will only get perhaps £700 (or if you like 700 yen) for a bond that pays out 1000 when it matures. At least if Japanese investors get spooked, the’ll probably pass their bond portfolio onto someone else based in the same country. By the way, how can a government appeal to domestic investors when it issues its bonds? By issuing them in the local currency and by incentivising (through reserve requirements and capital rules) their local banks and insurers to hold them.
The problem with a big surplus
This is a nicer problem to have, but it can’t be optimal. We know intuitively and historically that no panacea exists in economics. For starters, it’s not really fair for a government to levy taxes on the people and then hoard the money. And secondly, if every government ran large persistent surpluses, global demand would be depressed – and all these wealth funds running after the same assets to invest in would probably drive prices up and dampen returns too!
It has to be said though that many of the surplus nations are in surplus for a very specific reason – windfall returns from oil and gas! This is the case for many of the Gulf states and even Norway which funnels its proceeds from North Sea oil and gas into its “Oil Fund”, currently standing way in excess of its GDP. This is a common practice: when a government’s stash gets really sizable it sets up a “sovereign wealth fund” to invest the money, and this constitutes a source of revenue for future generations.
Many oil nations are aware that these riches are ephemeral and are starting to spend their accumulated wealth on “diversification projects”, as is the case with Saudi Arabia’s “Vision 2030”.
The ideal is to balance the books
Unless the government is blessed with fossil fuels, it should aim to be neither too much in debt nor in credit. In the tough times it should borrow money to support and boost the economy, and in the good times it should be putting money away for a rainy day. This is exactly what Keynes proposed, but this is not what happens in practice…
Deficits are built into the system
High deficits are structural and the reason is a very simple one – it’s called “political economy”. The fact is that incentives of the political class drive policy towards deficit. Elected governments want to please their electorate, and voters prefer spending and punish austerity! This is indeed why most countries adopt fiscal rules, and ensure institutions like soverign wealth funds and the central bank are independent, in order to constrain these short-term political pressures. But voters are short-sighted and the pressure from them is overwhelming. Only if it gets close to collapse – like Greece in 2008 – can a country implement the really extreme measures necessary to bring its finances back from the brink.