Why have national debts been allowed to grow to their present level in the West?

 

National debt refers to all the debt owed by government bodies of any sort within a country. It is owed to the holders of Treasury bonds. These bonds are issued with a return which represents the rate of interest on the bond, and if they are in demand, the interest rate falls; if they are not wanted, because of inflation, a threat of non-payment or from exogenous forces, an existing high level of debt, or a distrust of the government which issues them, the interest rate can be expected to rise.

Most government bonds in developed countries have been a safe investment for financial institutions in the twenty-first century. For some economists, this means that high levels of borrowing by governments could divert funds that could otherwise have gone to investment or lending in the private sector, raising costs and interest for business and placing pressure on productivity. This process was called ‘crowding out’ in the past, though the term has fallen away a little.

Borrowing is not a good way to carry on fiscal policy in the long term, however. This is because the interest payments on the borrowing rise as the borrowing rises, and they need to be paid from the national budget. These payments eat into, and can displace, spending on public and merit goods, public sector investment, and other government activities, and will if not addressed cause tax rises and spending cuts in the future. Fiscal contraction leads to lower aggregate demand, and therefore to falls in gross domestic product and increases in unemployment, which worsen the burden of the debt as a percentage of GDP.

As with everything, the reasons for the fiscal contraction matter. If spending cuts and tax rises are forced on a government with no credible plan to reduce debt, which is just responding to the pressure of debt interest, capital flight and market negativity may follow. If a government is committing to a short- or medium-term contraction to restore the budget and is making targeted cuts and tax rises which help with that aim, there will be a fiscal dividend as interest rates on the debt may fall, and investors might gain confidence and accelerate their plans, leading to more growth and more income for the government from taxes. The ‘right’ stance may thus result in a virtuous fiscal cycle.

The economics of high borrowing are not always fair. Smaller states which are not seen as ‘safe havens’ in risky economic environments, for instance, are often punished more harshly for their borrowing than bigger ones to which capital moves in fear of market instability elsewhere. The size of an internal bond market also matters. So, for instance, Greece found its borrowing reach over 160% of GDP in 2012, but because it was not a ‘safe haven’ and because it had locked itself into the eurozone, it was forced to create competitiveness and to generate savings by internal devaluation. Previously, it would have allowed its currency to depreciate, attracted tourists, and used the boom to lower or close deficits. Markets forced it to pay a high interest on bonds, and when Greece turned to partners in the eurozone and the IMF, it found that they demanded equally harsh terms.

Japan, on the other hand, has been running debt to GDP at ratios of over 200% for some time. It has been able to do this because it is seen as a safe bet to pay back by markets. Two other factors in its favour are that Japan sells many bonds to its own people as investments, which protects it from international factors and which could always lead to Japan accepting the bonds as tax payments, wiping out both deficits and debt, as a last resort. Moreover, Japan pioneered negative real interest rate policy and its internal savers have no other way to save other than to fund government debt at interest rates which, whilst low, are still higher than offered in banks or by many investments.

The United Kingdom is a good example of a state which has in essence benefited from deficits and debt on a cyclical basis. The UK’s debt: GDP ratio in 1975 was running at around 55%. This was one of the reasons why the country endured the ‘IMF crisis’ of the mid-1970s, though debt stabilised and then fell as North Sea Oil allowed it to endure the recession of the early 80s. Strong growth followed, and between 1987 and 1997, even with a recession in the middle of the period, UK debt never reached 40% of GDP and was usually lower. From 1997 to 2008, UK debt was held by prudent fiscal policy and the displacement of borrowing into Private Finance Initiative vehicles to a mid-30% range. Between 2008-19, debt exploded to around 80% of GDP, then stabilised by 2016 and fell slightly, and was then pushed up by the covid crisis above 100%.

The UK has not, however, been punished by financial markets. Instead, debt repayments, though high, currently constitute £45 billions of a budget which is over £1 trillion, with a deficit of £234 billion (17% of GDP) in 2021. The reasons for this are complex, but there are three primary ones. Firstly, the UK is still seen as safer than many other comparable countries, with a stronger underlying growth rate after covid, and is still a centre for investment in financial instruments and property.

Secondly, the UK national debt was significantly reduced up to 2019, and currently is over 100% of GDP, but the ratio is still much lower than many other comparable economies. As growth increases, the ratio will fall.

Thirdly, the UK is pursuing robust policies to exit covid emergency spending, raise taxes and national insurance, and to restrain government spending, before other countries.

A fourth potential effect—the way in which states with reserve currencies attract investment so that creditors can obtain the currency when they get the interest payment—is not great, though the pound is used in around 5% of global transactions.

As states move from deficit and debt accumulation to a balance or surplus and debt reduction, they experience growth after the contraction. As more people are employed and off welfare payments, the proportion of government money spent on pensions to replace lost former incomes (‘the replacement ratio”) falls and people have more disposable income (so long as government does not raise income taxes.)  Governments will be able to use more of the government income to reduce taxes or invest in infrastructure and programmes to improve human capital and productivity.  The marginal efficiency of capital for private investors will rise, and the opportunity cost of hiring workers for businesses will fall, strengthening growth.

The twenty first century has seen several long-term and some short-term reasons for the punctuated growth of national debt. One was the 2008 financial crisis, which placed a great strain on economies, but which did not result in a 1930s-style depression because of the way governments increased borrowing. Another was the covid crisis, which was unprecedented in its scale and in its global nature. Accumulations of debt during the crisis were not met with panic or surprise by markets.

Thirdly, some developed countries have begun to adapt to an accepted demographic change occasioned by the emergence of ageing populations which are shrinking in size, but which have access to accumulated savings. This means to an extent that national debt can be offset against the spectacular growth in asset values which has undermined arguments about inevitable crowding out and lack of investment capital. Deglocalisation has seen the return of investment to developed economies as costs and risk have risen in Asia, and China has turned inwards to its own development after passing a Lewis inflexion point.

Finally, large numbers of economists and opinion formers seem to have accepted, even if only temporarily, the claim of modern monetary theorists and some elected officials that debts no longer matter as they did, and that the liquidity of electronic markets and the ability of governments to raise and taper the quantity of electronic money in circulation has altered the amount of debt that a nation can bear.

It remains to be seen whether this relative complacency about debt a temporary or permanent development is. It is always possible that further exogenous shocks or a slow global recovery will encourage both money printing and one-off state-based debt forgiveness or rescheduling. It is more likely, however, that states will come under pressure not just to reduce their debt: GDP ratio but also the absolute value of their debt. Some may choose inflation, some may attempt to stimulate growth, and some may choose currency depreciation (or have it thrust upon them.)