Public debt

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The public debt - or government borrowing - is a topic of that raises concerns that go beyond its economic and financial consequences. The economic consequences of public debt are themselves a topic of controversy, but the consensus view is that the ability to borrow to meet an emergency such as war or a severe recession is a legitimate policy objective. It is common practice for governments to borrow in order to pay for the provision of public goods without the use of taxation, but it is customary to limit that borrowing in normal times for political reasons and in order to retain its availability for emergencies.

Definition

The public debt of a particular country is often referred to domestically as "the national debt". The term public debt is used to refer to the borrowings of governments in general. The OECD's broad definition of public debt as "the external obligations of the government and public sector"[1] is in general use, but national definitions [2] differ in detail [3]and produce figures that may not be comparable. The European Union's definition embodied in its Stability and Growth Pact[4] of "General Government Gross Debt"[5] differs in detail from the complete OECD definition.

The debt of the United States over time is documented online at http://www.treasurydirect.gov/govt/reports/pd/histdebt/histdebt.htm.

Overview

It is customary for governments to use borrowing to finance investment, and it is current practice for the main industrialised countries to allow national debt to accumulate to between 40 and 60 per cent of GDP (except Japan and Italy, with percentages of over 100). However, it is generally considered to be prudent to avoid excessive debt in normal times, in order to be able to cope with emergencies such as wars and recessions. It is also normal practice for governments to allow their national debt to rise to between 70 to 100 per cent of GDP during major recessions - as a result, mainly of the operation of their economies' automatic stabilisers, but also from the use of fiscal stimuluses, intended to compensate for reductions in private sector spending.

Such policies are not uncontroversial, however, and even relatively modest levels of national debt, commonly meet with expressions of concern as being "unhealthy" or even dangerous. Such popular concern may be attributable to an instinctive belief that saving is virtuous and borrowing is discreditable, or to the belief that it imposes unfair burdens on future generations, or to the once universal reverence for balanced budgets - but it is also attributable to fears of harmful economic consequences. Public choice theorists oppose government expenditure, even for the purposes of investment, on the grounds that the politicians concerned are mainly motivated by personal gain, rather than a desire to serve the public interest. Austrian School economists argue that fiscal stimulus expenditure is ineffective, partly because of the Ricardian equivalence argument that it is nullified by increases in private sector saving and partly out of scepticism about the ability of politicians to manage the economy. Other economists have argued that government borrowing is bound, if continued long enough, to lead to a debt trap from which a government cannot escape except by defaulting on its obligations, or by expanding the money supply. The 1931 German hyper-inflation, which was caused by the use of monetisation to manage high levels of postwar debt, has come to be seen as a dramatic warning of the dangers of deficit financing , and sovereign defaults such as the 1998 default by the Russian government as a reminder that governments are not immune from the dangers of insolvency. Sovereign default among developing countries is not, in fact, uncommon, and although the danger that it could happen to a major industrialised country is generally considered to be remote, there is fear that a persistent rumour of its possibility might alarm investors to the point of making it self-fulfilling.

The history of public debt

The British experience

In the 18th century and before, it had been the practice of kings to finance their wars by borrowing. It was cheaper than collecting taxes - and it was risk-free because a king could not be called to account for defaulting on his obligation to repay - and "sovereign default" was a frequent occurrence. In England, however, Charles II's "Stop of Exchequer"[6] of 1672 was the last time it happened, because the "Glorious Revolution" of 1688 was followed by the "Financial Revolution"[7] during which Parliament assumed effective control over the national debt. The culmination of that revolution was the creation in 1749 of the "Consolidated Fund" [8], and the issue of undated bonds known as "consols". The economist Martin Wolf has noted that "by wresting political power from the Crown, English property owners created a regime accountable to themselves"[9], and the former investment banker, James MacDonald has noted that, by putting a government in the hands of its creditors , it created a large, stable and reliable market in public debt[10]. The creditworthiness of the British government in the 8th and 19th centuries enabled it to float huge amounts of irredeemable debt at interest rates as low as 2½ per cent, giving it a significant advantage over its rivals.

Between 1743 and 1815, Britain's national debt increased from £245 million to £745 million, which was twice its national income[11]. A debt reduction act [12] reduced the ratio of national debt to national income to less than 50 per cent by 1900 but, after two further wars and the intervening Great Depression, it rose again to over 100 per cent. According to researchers at the Institute of Fiscal Studies [13], it rose to over 150 per cent during the first world war, remained at above that percentage for most of the years between then and the second world war, during which it peaked at 250 percent. After the war it was reduced steadily to about 50 per cent by 1975, and remained at between 45 and 55 per cent between 1975 and 1990 and between 35 and 55 percent through the 1990s. As a result, mainly, of the operation of automatic stabilisers during the recession of 2009 it is expected to rise from 44 per cent of GDP in 2007 to 100 per cent of GPD in 2014 (compared with an average rise from 69 per cent to 120 per cent for the G20 countries)[14]. Despite its historically and internationally modest level, it was a major issue in the election of 2010.

The United States national debt

In 1783, the United States Congress was given the power to raise taxes, but in 1785, it was found that tax revenues were insufficient to meet the government's expenses and Alexander Hamilton argued the case for the raising of public, arguing that "A national debt, if it is not excessive, will be to us a national blessing."[15] In 1789, Congress established The Treasury Department, naming Alexander Hamilton, as its Secretary, in 1790 it passed the first Funding Act, and by February 1792, interest-bearing government bonds were on sale and the national debt rose to $77 million about 25 per cent of national income. However, a strong preference for freedom from debt and the maintenance of a "balanced budget" was evident from the beginning, and in a 1793 message to the House of Representatives, George Washington advised them that  "No pecuniary consideration is more urgent than the regular redemption and discharge of the public debt: on none can delay be more injurious, or an economy of the time more valuable."[15]  , and in 1799 Thomas Jefferson wrote: "I am for a government rigorously frugal & simple, applying all the possible savings of the public revenue to the discharge of the national debt." [16]. Jefferson's Secretary of the Treasury, reduce the public debt to $45 million by 1811, and by 1835 the national debt had been fully repaid. Following the war with Mexico, the national debt rose again to $65 million, and it reached $2.7 billion, or about 30 per cent of national income, by the end of the Civil War. By the beginning of the First World War it had been reduced again to about 10 per cent of national income but rose again to 30 percent during that war, and to $260 billion, or about 120 percent in the course of the Second World War. It was reduced to below 40 per cent in the 1960s but had risen to over 60 per cent by 1982 and by the end of 2008, it had reached $10.3 trillion, or about 60 per cent of GDP. [17] and is expected to rise to 112 per cent of GDP in 2014[18]. According to a 2010 blog by Professor Randall Wray the US federal government has - with one brief exception - been in debt every year since 1776[19]

International developments

The widespread use of borrowing to finance government projects such as the building of railways began in the early 19th century and developed rapidly thereafter. The complexity of the resulting system of international finance increased substantially in the course of the 19th and 20th centuries, as the developing countries made increasing use of loans from the industrialised countries to supplement limited domestic resources. Growth was particularly rapid in the post-war 20th century, and by 1995 the external debt of the developing countries is estimated to have risen to 32 times its 1970 level, to reach a total of $2 trillion. [20]. International markets in financial assets tend to be exceptionally volatile, however, and capital flows between developed and emerging economies were sometimes suddenly reduced or reversed in response to developments in the investing country or to perceptions of the stability of the recipient economies. There were many sovereign defaults in the 19th and 20th centuries as governments in developing countries became unable or unwilling to continue to meet their interest or repayment obligations in face of such shocks.

Attitudes to public debt

The nineteenth century aversion to the creation of public debt may have owed something to earlier attitudes to personal debt. It was reinforced in the twentieth century by the emergence of its popular association with inflation - an association that was generated, first by the German experience of hyperinflation[21], and later by the inflationary consequences of numerous ill-judged attempts to use deficit finance to promote economic growth. A second source of reinforcement was a desire to reduce government activity by a strategy known as "starving the beast", and survey evidence from the United States suggests that it has acquired a significant influence upon group psychology[22]. Also, opposition politicians in many countries have often warned that government policies would lead to "national bankruptcy" or that they would impose a "burden on future generations"[23]. As a result, public concern about national debt has become a matter of electoral importance (for example, an opinion poll in February 2009, reported that it was one of the top two matters of concern to United States voters [24].)

The economics of public debt

Public debt has some economic characteristics in common with a debt agreement between individuals - from which lender and borrower both expect to benefit. Whether the lender does benefit depends, not upon the loan, but upon the use to which it is put; and with the possibilities of gain or loss for both parties, the net economic outcome is indeterminate. The net effect upon a country's economy of domestic borrowing by its government is similarly indeterminate (it may, however, yield benefits when considered as an alternative to the use of taxation, many forms of which have adverse effects upon the economy).

It is to be expected that a government's borrowing will involve transfers from some of its citizens to others, however. The repayment transfer, in particular, is widely supposed to involve a burden on future generations, but economic analysis has demonstrated that cannot happen except under certain narrowly-defined circumstances[25]. There is nevertheless a possibility that those transfers may have economically undesirable consequences.

Government borrowing may have indirect consequences as the result of attitudes to the risk involved on the part of bond market investors. The yield that those investors obtain on an existing fixed-interest government bond is determined from day to day by their sales and purchases on what is effectively an international market, and it is that yield that determines the interest rate that the government in question has to pay when it offers a new bond issue to the market. The difference between the yield on a government bond and the lowest market yield offered by any government security is referred to as its risk premium or spread and is determined by a variety of factors that influence the market's perception of the risk that the issuing government will default on its interest payments or on its repayment when due.

It is conceptually impossible for a representative government to default on a loan to its own citizens since, by definition, a representative government is one that acts solely in its citizens' interests. In reality, the nearest approach to the ideal concept of a representative government is reached by stable democratically-elected governments, such as those of the G7 countries, and no such government has ever defaulted. It is common practice for governments to roll-over at least part of its maturing debt by selling a new bond issue and using the proceeds for repayments to the holders of the maturing debt. As a matter of arithmetic, however, the longer that practice continues, the greater will be the size of the repayment that will eventually have to be made. Although the repayment of domestically-owned loans does not, by definition, have any immediate affect on national income, a stage would eventually be reached at which the amount required would be more than could conceivably be reached by taxation, leaving monetisation as the only alternative to default. (It is generally recognised that the persistent monetisation of public debt may be expected to have inflationary consequences. It has even been suggested that inflation is the inevitable consequence of government borrowing [26], but that proposition has been rejected by Milton Friedman[27] and others [28]). The term sustainability is often used in assessments of the degree to which a government's fiscal policy offers an assurance of avoiding such an outcome, and that is generally taken to be the determinant of the risk premium that the market assigns to that government's bonds.

The presumption that a representative government will not default is obviously weakened if foreign nationals hold a substantial proportion of a government's bond issue, and additional exchange rate risks arise if much of it is denominated in a foreign currency[29]. Those circumstances apply mainly to developing countries and are among the reasons for the risk premiums that they pay. Otherwise the level of a country's debt as a proportion of its GDP is a major consideration, and other factors that may be expected to affect risk premiums include a record of macroeconomic instability, low levels of economic growth, inflationary tendencies and political uncertainties[30].

Circumstances can arise in which an external shock transforms a previously stable fiscal policy into a condition of fiscal instability. An increase in the risk premium applied to a government's borrowing may increase the cost of its borrowing to an extent that increases its perceived risk of default, as a result of which the bond market applies a further increase in its risk premium. Repetition of that sequence could force the government to default by placing the cost of a roll-over of maturing debt beyond its capacity to raise the necessary funds. An alternative form of destructive positive feedback can occur if the public expenditure cuts introduced to reassure the bond market reduce the level of a country's economic activity to the point that the government's tax revenues are insufficient to service its debt. The likelihood of such catastrophes can also be increased by the bond market's awareness that they can happen.

Some commentators believe that the risk of fiscal instability has been increased by the growing influence of the credit rating agencies and the growth in the market for credit default swaps. Despite their frequent failure to provide warning of impending financial crises[31], the credit rating agencies are believed to exert a strong on the attitudes of many bond market investors and it is thought possible that an agency downgrade of a country can provoke a herding response among investors that adds to the risk of default[32]. Although the intended function of credit default swaps is to offer bondholders a means of insuring against the risk of loss, it is known that some operators in the credit default swap market are not bondholders but speculators whose activities are believed to contribute to fiscal instability[33]

Policy implications

References

  1. Public Debt, OECD Glossary of Statistical Terms
  2. For the US definition see the Treasury Department guide [1].
    For the UK definition, see the ONS guide [2]
  3. Understanding Government Debt Statistics, Economicshelp.org
  4. Stability and Growth Pact, OECD Glossary of Statistical Terms
  5. General Government Gross Debt (Maastricht Definition), OECD Glossary of Statistical Terms
  6. Der-Yuan Yang: The Origin of the Bank of England: A Credible Commitment to Sovereign Debt, Department of Economics, Working Paper 198, University of California, Santa Barbara
  7. Colin Nicholson: Financial Revolution (1688-1750), The Literary Encyclopedia, 2001
  8. The Consolidated Fund Bill provides Parliamentary authority for funds requested by the Government, and has been placed before Parliament every year since 1749
  9. Martin Wolf: Fixing Global Finance, page 18, Yale University Press, 2009
  10. James MacDonald: A Free Nation Deep in Debt, Princeton University Press, 2006
  11. Niall Ferguson: The Ascent of Money, Allen Lane, 2008
  12. National Debt Reduction Act 1866, UK Statute Law Database
  13. Tom Clark and Andrew Dilnot Measuring the U½K Fiscal Stance since the Second World War, Fig 3, page 5, Institute of Fiscal Studies,2002
  14. See the addendum subpage
  15. 15.0 15.1 [http://www.publicdebt.treas.gov/history/1700.htm The 18th Century, The United States Bureau of the Public Debt[
  16. Thomas Jefferson's Letter to Elbridge Gerry of 26 January 1799, quoted in Noble Cunningham: Jefferson vs. Hamilton: Confrontations that Shaped a Nation, Palgrave Macmillan, 2000 [3]
  17. Sources The United States Bureau of the Public Debt and National Debt Burden: Full History, The Sceptical Optimist, 2009
  18. See the addendum subpage
  19. L. Randall Wray, The Federal Budget is NOT like a Household Budget – Here’s Why, Naked Capitalism.com, 11th February 2010
  20. Ashish K. Vaidya: "International Indebtedness", in Globalization: encyclopedia of trade, labor and politics, Volume 2, ABC-CLIO, 2005 [4](Google abstract)
  21. The Nightmare German Inflation, Scientific Market Analysis, 1970.
  22. Jonathan Barron and Edward McCaffery: Starving the Beast: The Psychology of Budget Deficits,U of Penn, Inst for Law & Econ Research Paper 04-21; USC Law and Economics Research Paper No. 04-24; and USC CLEO Research Paper No. C04-21 December 2005
  23. Osborne: Brown's borrowing risks run on the pound, Guardian, 15 November 2008
  24. Voters’ Attitudes about America’s Growing Budget Deficit and National Debt, Findings from a Nationwide Survey Among Registered Voters, Conducted by Hart Research Associates and Public Opinion Strategies [5]
  25. For the debate among economists on that issue see James M. Ferguson (ed): Public Debt and Future Generations, University of North Carolina Press, 1964 (available to subscribers to the Questia online library at [6])
  26. Thomas Sargent and Neill Wallace: Some Unpleasant Monetarist Arithmetic, Federal Reserve Bank of Minneapolis
  27. Edward Nelson: Milton Friedman on Inflation, Federal Reserve Bank of St Louis Winter 2007
  28. Allan Meltzer: Monetarist, National Review, Vol. 41, January 27, 1989
  29. Because a fall in its exchange rate could mean having to repay more than had been borrowed
  30. Paolo Manasse, Nouriel Roubini, and Axel Schimmelpfennig: Predicting Sovereign Debt Crises, IMF Working Paper, International Monetary Fund, November 2003
  31. < Frank Partnoy: How and Why Credit Rating Agencies are Not Like Other Gatekeepers, Social Science Research Network, 2006
  32. Amadou N R Sy: The Systemic Regulation of Credit Rating Agencies and Rated Markets, World Economics, October-December 2009
  33. Richard Portes: Ban Naked CDS, EuroIntelligence 18 March 2010