Today, let's delve into a topic that lies at the heart of the financial universe: national debt. It's a fascinating and complex subject, making it perfect for me to dissect.
The Global Debt Landscape
Looking at the past 25 years, the trajectory of U.S. national debt as a percentage of GDP has been one of relentless growth, a testament to aggressive borrowing. Today, it has surpassed 120%. Similarly, other major economies such as the UK, the Eurozone, and China are all witnessing a seemingly inexplicable surge in their national debt.
The most remarkable case belongs to Japan, the world's most indebted nation. With a staggering debt-to-GDP ratio of 260%, Japan paints a stark picture of fiscal imbalance. This means that it would take 2.6 years of Japan's entire economic output just to pay off its government's debt. Based on Japan's 2022 fiscal revenue, it would take 18 years of stringent saving, without spending a single yen, to settle these debts.
The Logic Behind Government Borrowing
A natural question arises: are these governments acting irrationally by accumulating such massive debts? What is the underlying logic? Could the U.S. face a debt default? And why do some economists argue that the more a government borrows, the better?
This article aims to provide a comprehensive yet accessible explanation of these complex issues.
Why Governments Spend More Than They Earn
Every government collects revenue and incurs expenses. In the case of the U.S., over the past three decades, 95% of its revenue has come from tax collection. On the expenditure side, the government allocates funds to public services, national defense, infrastructure projects, and more.
A closer examination reveals that, for a significant period, U.S. government spending has exceeded its revenue, resulting in persistent fiscal deficits. This begs the question: how is this deficit financed? The answer lies in issuing national debt, essentially borrowing from the public to bridge the funding gap.
A similar pattern of persistent deficits is evident in the fiscal situations of China, Japan, the UK, and the Eurozone. While an individual with such spending habits might be labeled fiscally irresponsible, the same logic doesn't necessarily apply to governments.
The Symbolic Nature of the Debt Ceiling
The recent buzz surrounding the U.S. debt ceiling has brought this mechanism into sharp focus. It serves as a symbolic limit on government spending, a line in the sand drawn by Congress through voting that the Treasury Department cannot cross when borrowing.
While it sounds like a reasonable constraint promoting fiscal discipline, I use the term "symbolic" for a reason. As the national debt inches closer to this ceiling, Congress readily convenes to raise it. This cycle has repeated itself numerous times, with the debt ceiling being raised 42 times between 1981 and today, averaging one increase per year.
The reality is that a U.S. debt default would have catastrophic repercussions on the entire American economy. The White House itself has projected that a sustained debt default lasting several weeks could trigger a 45% plunge in the stock market and cost over 8 million jobs.
Therefore, the debt ceiling serves primarily as a political battleground for the two major parties. Currently, with Biden and the Democrats at the helm, and the Republicans holding a majority in the House of Representatives, House Speaker Kevin McCarthy sees this as leverage to pressure Biden into curbing future government spending.
This dynamic highlights a certain incongruity in the U.S. fiscal system. While there was no significant debate when Biden injected trillions into the economy during his first two years, negotiations only arise when the debt ceiling looms large.
The Global Rise of Government Debt and its Rationale
The U.S. isn't alone in employing a debt ceiling. Denmark has one too, although set at such a high level (three times its current debt) that it's essentially ornamental. Globally, no country has ever been genuinely constrained from issuing debt due to a debt ceiling.
Over the past five decades, global government debt has been steadily climbing. Why are they borrowing so much? What's their thinking?
A Mini Economics Lesson
To grasp this, we need to clarify the problem at hand. Governments borrow to fund their spending. Thus, the crux of the matter lies in understanding why these governments feel compelled to spend so much.
Adam Smith, the father of modern economics who introduced the concept of the "invisible hand," was a staunch opponent of government intervention. He believed that free-market competition fosters optimal efficiency and that governments should minimize their role, keeping their size in check. Borrowing and spending excessively were deemed irresponsible.
The U.S. largely adhered to this laissez-faire approach during the 18th and 19th centuries, encouraging competition and minimizing government involvement. However, problems surfaced as this approach led to periodic economic downturns.
The most severe of these, the Great Depression of 1929, tested the limits of this hands-off ideology. Despite the prolonged economic slump, the U.S. government initially refrained from significant intervention, clinging to the belief in minimal interference with economic cycles. The Depression lingered for over a decade, leading many economists to conclude that the government's inaction contributed to its severity and duration.
This backdrop set the stage for the emergence of another economic giant, John Maynard Keynes. He proposed a new theory that gained traction among governments worldwide. In essence, Keynes argued that markets are not infallible and that governments have a crucial role to play, especially during economic downturns.
When individuals and businesses are reluctant to spend, causing demand to dwindle, Keynes advocated for governments to step in, borrow money, and stimulate demand to prevent or mitigate economic crises.
While Keynesian economics has faced criticism, its core principles have been embraced by governments globally. During crises or recessions, governments are now expected to leverage borrowing and spending to stimulate their economies.
This explains why governments resort to stimulus packages during economic turmoil, such as the 2008 financial crisis and the 2020 pandemic in the U.S., Japan's responses to the 1998 financial crisis, the 2008 crisis, and the 2011 earthquake, and Europe's handling of the Eurozone debt crisis.
This pattern has contributed to the accumulation of substantial government debt. It's important to note that government spending doesn't guarantee success. Japan's persistent borrowing over the past three decades, coupled with stagnant GDP growth, serves as a cautionary tale.
A Controversial New Theory: MMT
Building upon these existing theories, a more recent and radical economic theory called Modern Monetary Theory (MMT) has gained traction. It posits that governments should embrace debt without reservation, as their spending directly translates into income for the private sector.
MMT proponents argue that government credit essentially represents money itself and that as long as inflation remains in check, governments should maximize their borrowing and spending to bolster the economy. However, this theory remains outside the realm of mainstream economic thought, despite its growing popularity.
The True Limits of Government Borrowing
The question then becomes, assuming governments have the capacity to borrow and stimulate the economy, is there no limit to this approach? Of course, there are boundaries, although these differ significantly from those faced by individuals or businesses.
Governments possess a unique ability: they can print money. While it's true that central banks, not governments, hold the authority to print money, governments can influence this process. Central banks can purchase government bonds from the market, effectively engaging in quantitative easing, which indirectly channels printed money to the government.
This distinction highlights the difference between domestic and external debt. Domestic debt refers to a country's borrowing in its own currency, while external debt is denominated in foreign currencies, often the U.S. dollar.
With the exception of the U.S., governments cannot print foreign currencies. Therefore, if they encounter cash flow issues with their external debt, they must borrow from external sources, increasing the risk of default.
Domestic debt serves as a buffer during economic fluctuations, while external debt acts as an amplifier. Debt, by its very nature, is leverage. In prosperous times, when capital flows freely, borrowing can amplify a country's advantages. However, when problems arise, capital flight can exacerbate a downturn.
Historically, many national economic collapses and debt crises have stemmed from external debt defaults. For instance, the Latin American debt crisis of the 1980s showcases this dynamic. The region, experiencing rapid growth, attracted substantial foreign investment. However, the oil crises of the 1970s, coupled with rising U.S. interest rates, forced Latin American countries to raise their own rates, exacerbating their debt burdens. Eventually, Argentina, Brazil, and Mexico all defaulted on their external debt, leading to significant losses for U.S. investors.
The Eurozone debt crisis further illustrates the risks of external debt. The Eurozone's structure, where a single central bank manages monetary policy while member states retain control over fiscal policy, inadvertently transforms domestic debt into external debt. When countries like Greece, Italy, and Spain faced debt crises and potential defaults, the European Central Bank was constrained in its ability to purchase their bonds without jeopardizing its principles. This left these struggling nations with limited options but to seek external assistance, leading to austerity measures that exacerbated their economic woes.
Other examples of crises triggered by external debt defaults include the 1997 Asian financial crisis, the 1998 defaults of Russia and Ukraine, the 2001 Argentine crisis, and the recent crisis in Sri Lanka.
While the saying "domestic debt isn't real debt" might be an oversimplification, it highlights the greater control governments have over their domestic debt. They can borrow more freely during emergencies without the immediate threat of default.
In contrast, the U.S. enjoys a unique position as the issuer of the world's reserve currency, effectively treating both its domestic and external debt as domestic.
The Real Constraints: Interest Rates and Inflation
If money printing isn't a constraint, what truly limits a government's ability to issue debt? Analysis of major debt crises reveals two primary factors: interest rates and inflation.
Interest Rates: Interest rates form the bedrock of financial markets, and government bonds play a pivotal role in determining risk-free interest rates. The price of government bonds influences the interest rates of all other debt instruments, including corporate bonds issued by companies like Microsoft, Amazon, and PetroChina.
Increased government borrowing leads to a greater supply of bonds, driving down their prices and pushing interest rates up. This produces an effect similar to an interest rate hike by the central bank, ultimately curbing consumption, investment, and overall economic activity.
While central banks control short-term interest rates, long-term rates are influenced by government bonds. Rising interest rates not only dampen economic activity but also directly impact the government's borrowing costs. As rates increase, issuing new debt becomes more expensive for the government, creating a vicious cycle.
If interest rates climb to a point where tax revenue falls short of covering interest payments, the government essentially becomes a fund provider for global creditors, trapped in a debt spiral.
This scenario isn't merely hypothetical. If Japan's average interest rate on its debt were to reach 5%, its entire government revenue would be consumed by interest payments alone. Fortunately, this is not the current situation. Despite its massive debt, Japan only allocates 11% of its fiscal revenue to interest payments, and this share has been decreasing in recent years, even as the debt has grown.
This is possible because governments have a tool to counter rising interest rates: quantitative easing (QE). When Japan embarked on Abenomics in 2013, characterized by massive borrowing to stimulate the economy, it feared that excessive bond issuance would drive up interest rates.
The solution: the central bank intervened by printing money to purchase government bonds. This increased demand, propped up bond prices, and kept interest rates suppressed, ideally near zero. This allowed the government to continue borrowing without the fear of escalating interest costs.
By 2020, Japan abandoned any pretense and openly declared its policy of unlimited QE, aiming to keep 10-year bond yields below 0.25%, a target that has since been raised to 0.5% after market pushback.
The surge in the Bank of Japan's bond holdings since 2013 underscores its commitment to suppressing interest rates through continuous bond purchases, enabling the government to sustain its borrowing spree while minimizing interest expenses.
Inflation: While central banks often cite boosting money supply as a reason for QE, a crucial objective is to suppress long-term interest rates. This pattern holds true not just for Japan but also for the U.S. and Europe. Every time concerns arise about excessive U.S. debt, Treasury Secretary Yellen reassures the public, pointing to low interest rates and emphasizing that current interest payments are lower than in the 1990s.
The message is clear: with borrowing costs at historic lows and the added benefit of economic stimulus, why not borrow? Therefore, interest rate manipulation, achieved through government and central bank coordination, can be used to circumvent one of the constraints on government borrowing.
However, there is no free lunch in economics. One constraint governments cannot evade is inflation, a dreaded phenomenon among policymakers and economists alike.
The Inflation Headache: Governments can address insufficient demand and stimulate employment through spending, but inflation poses a unique and formidable challenge. It demands immediate attention, pushing all other economic concerns to the sidelines. Central banks can no longer artificially suppress interest rates, rendering conventional policy tools ineffective.
History repeatedly demonstrates that the only remedy for runaway inflation is tightening monetary policy, akin to chemotherapy for an ailing economy. It involves curbing demand through higher interest rates, often leading to economic contraction. Some governments, hesitant to endure this painful cure, may opt to persist with borrowing and stimulus, risking a descent into hyperinflation, as witnessed in Venezuela in recent years.
The U.S. Dilemma: Given the current high inflation in the U.S., why raise the debt ceiling? The simple answer is that the money has already been spent, leaving no other option.
Hindsight is 20/20. Had the U.S. government anticipated the inflationary consequences of its 2021 stimulus package and the subsequent aggressive interest rate hikes by the Federal Reserve, perhaps it wouldn't have pursued such a course.
Finding the Right Balance: A Delicate Balancing Act
Understanding these constraints allows us to assess the appropriate level of government debt. As long as a country steers clear of the red lines of excessive interest rates and inflation, the level of debt becomes a balancing act between growth and stability, allowing for different strategies and styles.
Some countries, like Denmark, prioritize fiscal prudence, maintaining debt-to-GDP ratios below 50%, even with an essentially unused debt ceiling. Others, like Sweden, the Netherlands, and Switzerland, follow a similar path, prioritizing stability over rapid growth.
The U.S. and Japan, on the other hand, have historically favored high growth strategies. China presents a unique case with its centralized system, where the central government maintains relative fiscal discipline while local government debt and corporate debt pose greater concerns.
Regardless of the chosen approach, the ultimate boundaries remain the same: excessive interest rates that stifle the economy or render debt unsustainable, and runaway inflation. These red lines are not defined by absolute numbers or fixed debt-to-GDP ratios; they are contextual, depending on each country's economic circumstances.
In environments characterized by low interest rates, controlled inflation, and high government credibility, even substantial debt levels might not pose significant risks. Prior to the pandemic, this held true for the U.S., Europe, and Japan, where markets remained relatively stable despite Japan's massive debt.
However, the landscape has shifted. The U.S. 10-year bond yield has surged from 0.6% three years ago to 3.7% today, and inflation, once negligible, now stands at 4.9%. This pattern is mirrored in Japan and Europe.
Therefore, Japan's 260% debt-to-GDP ratio, which might have been considered manageable a few years ago, now raises concerns in the current environment.
Navigating a Debt Crisis: Three Potential Paths
What options are available to governments facing a debt crisis? Imagine the UK government realizes that excessive money printing has fueled inflation, leaving it with limited room to maneuver. It essentially faces three choices:
1. Austerity: This seemingly straightforward approach involves reducing spending and borrowing to curb debt. The U.S. government occasionally resorts to shutdowns due to budget impasses, as witnessed in 2019 when a record 35-day shutdown left 800,000 federal employees without pay for over a month.
However, minor cuts rarely solve deep-rooted debt problems. Large-scale austerity measures can have a swift and often severe impact on the economy, requiring immense political will and often facing significant public resistance. Forcing 800,000 people to work without pay is not a decision taken lightly.
Countries like Greece, Italy, Spain (during the Eurozone crisis), and South Korea (during the 1997 Asian financial crisis) implemented harsh austerity measures to address their debt woes, often at the behest of international lenders like the IMF, who demanded fiscal restraint in exchange for financial assistance.
2. Default or Restructuring: This more radical approach involves either outright defaulting on debt obligations or restructuring them on more favorable terms. While not as catastrophic as corporate defaults that can lead to asset liquidation and closure, sovereign defaults carry severe consequences.
The primary impact is a loss of credibility, resulting in higher future borrowing costs and difficulty accessing credit markets. This can be particularly damaging for developed economies that rely heavily on credit markets for their functioning.
A sovereign default can trigger a collapse of the entire credit market within a country, rendering its currency undesirable and leading to a sharp decline in its exchange rate. Recovering from such a blow can take a decade or more. This explains why a potential U.S. default, even for a short period, could lead to massive job losses and economic turmoil.
However, domestic debt defaults are not unheard of. Between 1980 and 2022, there have been 84 instances of such defaults globally. Interestingly, major economies have typically defaulted on their domestic debt alongside external debt defaults, as seen in Russia (1998), Argentina (2001), and Greece (2012). Faced with the inevitable credit rating downgrade from an external default, governments might see little reason to honor domestic debt obligations.
Argentina, for instance, has defaulted three times in the past two decades, highlighting the allure of this option when the going gets tough.
3. Procrastination: This is the most common path chosen by governments facing debt challenges, despite its inherent flaws. It involves either borrowing more to repay existing debt or resorting to money printing, or a combination of both.
Debt crises often coincide with economic stagnation and high inflation. Governments, hoping to stimulate growth and inflate their way out of trouble, might increase spending. While there's a slim chance that this could ignite technological breakthroughs or productivity gains, leading to economic expansion that outpaces inflation and eventually eases the debt burden, the more likely scenario is continued deterioration.
While economically irrational, procrastination often aligns with political incentives. Elected officials facing regular elections are unlikely to champion unpopular austerity measures or risk the consequences of default, especially when the alternative – procrastination – offers a less painful short-term solution.
The Greek debt crisis serves as a stark reminder of the dangers of relying on public opinion when making critical economic decisions.
Conclusion
This deep dive into national debt has revealed the complexities and interconnectedness of government finances. We've explored the motivations behind government borrowing, the distinctions between domestic and external debt, the true constraints on borrowing (interest rates and inflation), and the potential consequences of excessive debt.
The key takeaway is that there are no easy answers or one-size-fits-all solutions. Managing government debt is a delicate balancing act, requiring careful consideration of economic realities, political pressures, and long-term consequences. While procrastination might seem tempting in the short run, it often exacerbates the problem, leaving future generations to grapple with the consequences.