Public debt after the pandemic

by John Quiggin on December 30, 2020

Another extract from my book-in-progress, Economic Consequences of the Pandemic

Over the course of the Covid-19 pandemic, governments around the world have issued huge amounts of public debt, much of which has been purchased by central banks. In the US, for example, Federal public debt increased by $3 trillion over the course of 2020 (this is about 15 per cent of US national income)

while the monetary base (money created directly by the Federal Reserve) increased by around $1.6 trillion. This money was used to buy government bonds along with corporate securities in open market operations (what is now called Quantitative Easing)

These policies represent a complete repudiation of assumptions which were considered unquestionable by the political class until relatively recently: that budgets should be balanced, and that public debt is always undesirable.

Even the most widely-accepted modifications of these assumptions are now problematic. A standard view is that budget balances should be stable over the course of the economic cycle. If measured appropriately, this entails a stable ratio of public debt to national income.

But where should this ratio be set?

Back in the 1990s, the European union set a target rate of 60 per cent of national income. At the time, with bond interest rates around 5 per cent, that implied annual interest payments equal to 3 per cent of national income. Taking account of inflation at 2 per cent, the value of payments required to hold debt constant in real terms was about 2 per cent of national income. That’s easily manageable, but still a significant component of government budgets (it’s more than most spend on defence, for example).

Repeating the same calculation today causes some problems. The real rate of interest on high grade sovereign bonds is now negative [That’s true even distressed borrowers like Greece. That is, bondholders are paying governments for the privilege. So, the more debt governments issue, the more they receive.

And there is, it appears, no real limit. Japanese government debt is equal to more than 200 per cent of national income. But 5-year government bonds yield negative returns, just as they do in Germany. Even bonds with a term of 30 years offer interest rates below 1 per cent, below the current rate of inflation.

The bigger question is: in the absence of any apparent constraint on our ability to finance current spending with long-term debt, what policy approach should replace the now-discredited goals of balanced budgets and zero debt. The answer is to consider fiscal policy in terms of the need to match aggregate demand (public and private) with the productive capacity of the economy, taking account of the appropriate balance between consumption and investment.

This way of thinking about things comes naturally to old-school Keynesians,

This suggests a policy of matching the maturity of financing public spending with the effective duration of that spending. Current expenditure, such as transfer payments, should, under normal conditions, be financed by taxation. Long-term investments in physical, human or social capital should be financed by bonds with a maturity similar to that of the investment’s lifetime. This approach is broadly consistent with the accrual accounting framework introduced in the 1990s, but left to languish as governments returned to a focus on misleading, but seemingly more comprehensible cash-based measures.

If this approach is adopted consistently, the long-term equilibrium will be one in which the ratio of public debt to GDP will be determined by the stock of public investments in physical and human capital.

{ 13 comments }

1

nastywoman 12.30.20 at 3:39 pm

”But where should this ratio be set”?

please not again at the different Credit Worthiness of different States –
or we have to deal with the Speculators again…
(and Paul Krugman – again – will call for Greece to get out of the Euro?)

2

steven t johnson 12.30.20 at 3:54 pm

“Current expenditure, such as transfer payments, should, under normal conditions, be financed by taxation. Long-term investments in physical, human or social capital should be financed by bonds with a maturity similar to that of the investment’s lifetime. ..If this approach is adopted consistently, the long-term equilibrium will be one in which the ratio of public debt to GDP will be determined by the stock of public investments in physical and human capital.”

Is long-term equilibrium a thing in capitalism? This strikes me as a kind of plot hole, like assuming libertarian/neoclassical/Henry Hazlitt style economics are totally correct given “full employment,” when not explaining what full employment is and how we know when we have it. Given the absence of any accepted/acceptable theory of profit, the amount of revenue to finance current expenditures is determined by unknown causes. Thus it is hard to imagine what “normal” conditions might be. In practical terms, the role of public debt as a refuge for capital demands fiscal austerity and cash-basis accounting, near as I can tell.

3

Rapier 12.30.20 at 4:22 pm

It’s not debt if it never has to be paid back and US, Japanese and EU debt will not be paid back to the central banks. When the notes and bonds are redeemed, that is the principal is paid to the central banks, they will turn around and buy the newly issued debt that was used to pay off the old debt.. Simply rolling over the debt. So it isn’t really debt. Yes, technically it is paid back but it’s all just a polite fiction.

The whole thing of the Fed funding 85% to 100% of the monthly deficits goes against the first rule of central banking dating to the Bank of England. That is central banks are not supposed to fund most or all of government debt. Well that rule isn’t even a polite fiction anymore. As long as the currencies don’t collapse no need to worry is the thinking, if anyone actually thinks about it which few do.

Besides inflation is low they say. They say that because exploding asset prices are not called inflation. It is called increasing value.
https://pbs.twimg.com/media/Epw4fv8XYAQ20ev?format=jpg&name=large

So while GDP will decline this year our ‘wealth’ is exploding. The conclusion? The previous 100,000 years of human history was a tale of mostly poverty and much misery because there wasn’t enough money.

4

Anders 12.30.20 at 8:16 pm

“ratio of public debt to GDP will be determined by the stock of public investments in physical and human capital”

Why not view govt debt / GDP simply as a not terribly interesting ratio which is emergent in a complex way from the cumulative deficits run by a state in the modern era, along with cumulative GDP growth?

I think the rule of only borrowing to finance capital investment (which I think the UK Labour Party may maintain) requires more argument. It seems quite problematic to me, not least because
(a) the distinction between current and capital spending is often arbitrary when you look closely (esp in anything relating to intellectual property / R&D), and
(b) in a sharp downturn such as Covid lockdowns, it may be compelling for a govt to cut taxes hugely (or allow taxes naturally to drop off), so that taxes are less than what would be considered normal ‘current’ govt expenditure. (Not sure whether such a scenario actually transpired in any OECD countries in 2020.) It would be odd for an arbitrary “don’t borrow to finance current expenditure” rule to mean that taxes should be increased, or spending cut, in such a scenario.

You might like Toby Nangle’s fiscal rule proposal (https://principlesandinterest.wordpress.com/2020/03/05/a-better-fiscal-rule/) if only to dismiss it. I tend to prefer your functional finance approach.

5

Tim Worstall 12.31.20 at 2:42 pm

You are arguing from a manipulated price. Don’t think that works.

“The real rate of interest on high grade sovereign bonds is now negative [That’s true even distressed borrowers like Greece. That is, bondholders are paying governments for the privilege.”

That price is hugely dependent upon this:

“Over the course of the Covid-19 pandemic, governments around the world have issued huge amounts of public debt, much of which has been purchased by central banks. In the US, for example, Federal public debt increased by $3 trillion over the course of 2020 (this is about 15 per cent of US national income)

while the monetary base (money created directly by the Federal Reserve) increased by around $1.6 trillion. This money was used to buy government bonds along with corporate securities in open market operations (what is now called Quantitative Easing)”

That we’ve deliberately – and rightly – manipulated the interest rate on government debt down makes it, I think, difficult to draw useful conclusions about what next from the price of government debt.

6

John Quiggin 01.03.21 at 4:12 am

Tim @5 Rates at or near zero (real) apply for maturities up to 100 years. If this is a manipulated price, then we can conclude that governments can set interest rates at whatever level they like, forever. If not, then it is an equilibrium market outcome.

7

nastywoman 01.03.21 at 8:49 am

and there is this theory that the only purpose of these non existing interest rates –
IS –
to get EVERYBODY into ”gambling” –
and the height’s of the different ”Casinos”
(Stock Markets)
proves that this ”purpose”? worked very well –
and now even German Retirees – who used to have all of their savings in safe interest paying saving accounts –
are speculating with ”Aktien”…

8

Tim Worstall 01.03.21 at 2:41 pm

“If this is a manipulated price, then we can conclude that governments can set interest rates at whatever level they like, forever.”

Not really. The forever part that is. I think we can agree, given this evidence, that governments can set interest rates for some period of time. If – or as and when as I would put it – the inflation arrives from that vast expansion of the money supply to set those interest rates then perhaps not so much.

9

steven t johnson 01.03.21 at 6:44 pm

Tim Worstall seems to have gone from public debt, as in treasury bonds, to all creation of money (it’s unclear whether a commitment to gold as the only real money is implied) by central banks like the Federal Reserve. Except that the money created by the Fed is shoveled into banks and the stock market, so I’m not clear in what sense this counts as public debt. As near as I can tell, if it’s private debt, MMT, er, QE and such will be continued indefinitely…at least they’ve promised to.

Thus as near as I can tell, Tim Worstall’s objection is that t-bill can only count as productive assets and safe heavens for wealth in a depression so long as government spending is austerely controlled. As for when the inflation arrives? Like von Hayek or Henry Hazlitt or J.B. Say or number of defunct economists, Milton Friedman still rules the minds of economists, if nothing else. Thus the supply of money is held to determine inflation regardless of the “velocity of money.”

In practice, so far as I can see, the inflationary effect of money supply increases seems to depend on the intensity of deflationary pressures on prices, decreases in new investment in capital, decreases in real output, the dearth of profits in productive enterprises (even if economics can’t identify them,) the intensity of the need for assets that will keep their value (which does include gold, but gold prices are strongly manipulated plus gold is relatively scarce plus gold is simply not necessarily going to grow in value during a recovery, like real estate is supposed to.)

tl;dr? $2 000 stimulus checks will not cause inflation because most people will simply retire as many bills they already owe. Eighty-five billion dollars a month will inflate stocks and bank profits but since they count as assets this is a Good Thing. Tim Worstall as near as I can tell only sees things from the creditor standpoint. (Seeing things from the debtor standpoint is the original programmatic meaning of economic populism, dating back to the Roman Republic. Wanting to get out of a rigged game is the left-wing viewpoint, in my opinion.)

10

Tim Worstall 01.04.21 at 12:36 pm

Err, no:

“Thus the supply of money is held to determine inflation regardless of the “velocity of money.””

I have a – slightly – firmer grasp on the subject than that. MV=PQ, something that despite Friedman liking it is, at a certain level, an obviousness. The amount of money times the number of times it is used is equal to the things we use money for times the amount of money we use for each thing.

We can also say – not entirely and wholly accurately but usefully enough – that M is base, narrow, or M0 money. We’ve created a lot of that with QE, righteously and justly. Can’t recall the actual figures but it’s something like £70 billion for the UK economy in 2007 and £800 billion and change today (that might be M1). Given that we’ve not seen a boom in P or Q then we must have had a fall in V.

OK. The inflation worry about the future is that V recovers. If it does – please note the if – then something else has to change to make our identity work. It’s unlikely to be Q as there’s a likely limit on how fast a mature economy can grow. 3%? 5% maybe? So, we might – if, note, if V recovers – that P does, we get inflation. Unless, that is, we sell those QE bonds back to the market, collect the cash and cancel the increase in M0 (or M1 maybe).

Far from my concerns being regardless of V they’re based upon it.

Or, if you prefer, it is M4, maybe M3, but at least the wide money supply, the narrow times velocity, which is the concern. Not the narrow supply sans any reference to velocity.

11

steven t johnson 01.04.21 at 11:36 pm

Tim Worstall@10 wrote “The inflation worry about the future is that V recovers. If it does – please note the if – then something else has to change to make our identity work.”

Noting the “if,” it is still unclear to me how a hypothetical recovery in V (that is, a recovery in new investment, increased profitability of enterprises, increased employment, growth in real wage, all of which is growth) can reasonably be expected to occur when 1) economic growth after 2008 never returned to the previous trend 2)the emergency regime of the Fed put into place had to be reaffirmed in December 2019, before the pandemic 3)the Fed has promised to continue the flood of money/credit indefinitely 4)the failures of zombie companies, which surely cannot be delayed forever and 5)there is no generally accepted theory of profit that offers any arguments, much less evidence, for a V-shaped recovery (pun not intended,)

This unmotivated “if” cannot I think be reasonably imagined as a compelling argument for fiscal/budget austerity now. Plus, this still seems to be focusing on public debt while supporting unlimited Fed Reserve debt to support banks and stocks. We are in this situation partly because those who knew better lied and said that government was the problem, when government most certainly sometimes is the solution to problems created by businessmen, including bankers and stock brokers. Even with the “if” noted, I don’t understand how only public debt can be an inflationary problem, except in the sense that public debt must be austerely minimized so that public debt instruments are safe havens. Or at the least officially productive enough to count as assets so that a profit can be reported.

I keep thinking a VAT is in the making sooner or later but surely if zombie companies can go on forever so can a zombie government that can tell its creditors to go to hell. Venezuela can’t (which I think is the fundamental reason their approach isn’t working very well,) but the US dollar is fundamentally based on blood. Which is why the rand or the ruble, despite being the currency of gold-producing countries, aren’t going to become the world’s reserve currency. (And the RMB isn’t even fully convertible, though no doubt there are those in China who live in hope.)

12

steven t johnson 01.05.21 at 1:50 pm

Proofreading skills fail again. The failures of zombie companies will eventually stress the financial system, constituting either a monstrous drag on recovery—the optimistic scenario!—or another global financial collapse to be met with even greater subsidies to wealth (and austerity in budgets, when a VAT is apt to be designated necessity.)

13

Tim Worstall 01.06.21 at 9:40 am

“This unmotivated “if” cannot I think be reasonably imagined as a compelling argument for fiscal/budget austerity now.”

I haven’t said that it is. The claim is rather narrow.

Here’s the US V:

https://fred.stlouisfed.org/series/M1V

From some 3.8 (doesn’t matter 3.8 of what for my argument) in 1960 to 10.6 in 2008 to 3.9 today. The claim is only that if – if – that V returns to the levels of a decade (or two, three, four) back then there’s significant inflation baked into the current money supply/QE etc.

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