Public debt

A country's national debt - also known as its public debt - is a matter of economic and political significance that has often been the subject of controversy. A policy objective of limiting public debt in normal times is often adopted in order to enable it to be used to cope with unforeseen shocks such as wars, recessions and natural disasters.

(terms shown in italics in this article are defined in the glossary on the Related Articles subpage)

Definition

The OECD's broad definition of public debt as "the external obligations of the government and public sector " is in general use, but national definitions differ in detail and produce figures that may not be comparable. The European Union's definition embodied in its Stability and Growth Pact of "General Government Gross Debt" differs in detail from the complete OECD definition.

Overview

Template:TOC-left 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 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 demonstrated that the use of deficit financing 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 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 national 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" of 1672 was the last time it happened, because the "Glorious Revolution" of 1688 was followed by the "Financial Revolution" during which Parliament assumed effective control over the national debt. The culmination of that revolution was the creation in 1749 of the "Consolidated Fund" , and the issue of undated bonds known as "consols". Members of Parliament were concerned from the start to reduce the level of national debt, as evidenced by the passage of the National Debt Reduction Act 1786 . Their intentions were frustrated, however by the need to finance Britain's part in the Napoleonic War, and between 1743 and 1815, Britain's national debt increased from £245 million to £745 million, which was twice its national income. A further attempt signalled by a second debt reduction act was more successful and the ratio of national debt to national income was reduced to less than 50 per cent by 1900. But further two wars and the intervening Great Depression raised it again to over 100 per cent. According to researchers at the Institute of Fiscal Studies , 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 1955. After then 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.

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." 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." , 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." . 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.

Economic consequences

Fiscal sustainability

The ultimate limit upon the size of the national debt is reached when more money is required for its repayment than the government can raise from taxation - at which point, the only alternative to a default amounting to national bankruptcy is repayment with money created for the purpose by the central bank . Money creation aside, national bankruptcy is, in fact, an inevitable long-term outcome if national debt persistently grows faster than gdp. That is known as the debt trap, and its avoidance is the economic policy objective known as "fiscal sustainability". Fiscal sustainability normally requires the maintenance of a surplus of tax revenue over public expenditure, when averaged over a period of five to ten years, and the average size of that surplus, when expressed as fraction of the national debt, has to be at least equal to the difference between the interest rate payable and the gdp growth rate.

Although that identity-based criterion would ensure fiscal sustainability in a stable, risk-free environment, it is generally accepted that a more stringent criterion is needed in order to guard against operating risks. A government's ability to market bonds offering any particular rate of return depends upon the willingness of operators in the bond market to accept that rate of return, and that willingness is influenced by market expectations. A comparatively recent development is the availability of credit default swaps that enable market operators to insure against the risk of sovereign default. Operators in the bond market may be expected to require an increase in the rate of return on a government's bonds sufficient to offset the premium (or sovereign spread} on such insurance. Sovereign spreads tend to be greater, the greater the level of national debt as a percentage of gdp, but they are also influenced by expectations of increases in that level, and by other factors, including expectations of gdp growth or decline. Most of the sovereign defaults of recent years have been due to banking and currency crises rather than to a previously excessive level of public debt

Prudent policy-makers tend in normal times to keep the level of national debt below the level required for sustainability in order to guard against market risks, and in order to preserve the option of using it to cope with unforeseen shocks such as wars, natural disasters and recessions.

Intergenerational effects

It often claimed that the national debt places a burden upon future generations. William Baumol and Alan Blinder have pointed out that such claims are often based upon fallacious reasoning, and that, since it is impossible for repayments to be made to anyone not alive at the time, the repayment is necessarily a transfer of resources within the existing population . It is nevertheless true that debt repayments normally involve an intergenerational transfer within the existing population because they are partly paid for by taxes paid by a new generation of people who tend not to be holders of government bonds. Also - to the extent that government bonds are subsequently passed by inheritance to a succeeding generation - similar transfers can be expected to affect future generations . Concern about that issue has led to the adaptation of "overlapping generation models" to its analysis, and the development of techniques of "generational accounting". However, generational accounts require both economic forecasts and assumptions about future policy, and are consequently controversial and subject to wide margins of uncertainty.

Inflationary consequences

It is generally recognised that the persistent monetisation the national debt, (as an alternative to reducing it by tax increases or spending cuts) may be expected to have inflationary consequences. Some economists have even suggested that such inflationary consequences are the inevitable consequence of deficit financing , but that proposition has been rejected by Milton Friedman and other monetarist economists, and it is not supported by empirical evidence. An analysis of historical experience has found an association between deficit financing and inflation among developing countries, but none among industrialised countries - a difference that has been attributed to differences in the short-term costs of tax collection.

Crowding-out and crowding-in

Under normal circumstances, private sector spending on government bonds is to some extent at the expense of spending on private sector bonds, with the consequence that some private-sector investment is "crowded out". To the extent that government bonds are used to finance consumption rather than investment, the total of the country's investment is diminished, leading in time to a loss of potential output. Crowding-out is seldom complete, however, but depends upon a range of factors including elasticities of demand for investment and for money . During a recession, crowding-out may to some extent be offset by "crowding-in" as government spending makes up for the deficiency in private sector spending, leading to a recovery of demand and an increase in private-sector investment. The balance between crowding out under particular circumstances is a matter of controversy .

Political attitudes

The nineteenth aversion to the creation of national debt 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, 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. 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". 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 - awareness of which may have been behind the President's decision to set up a "fiscal responsibility summit").

Debt-limiting rules

Overview

National legislatures have, from time to time, sought to impose constitutional limits upon government borrowing, often with the objective of limiting government activity, and sometimes in order to avert the danger of default. In some countries, notably the United States, there have even been attempts at "balanced budget amendments" that would forbid all borrowing, even for the purpose of investment. In recent years, the practice of accepting self-imposed limits has also been adopted by governments - a practice which, besides being electorally popular, serves the purpose of promoting investor confidence in the integrity of their bonds. Among developing countries, the development of international capital mobility has made the maintenance of investor confidence a policy imperative because panics among investors and anticipations of default by speculators have been a common cause of sovereign default - as explained by Paul Krugman . Paul Krugman explains the International Monetary Fund's apparently perverse interpretation of the Washington Consensus as requiring the avoidance of deficits, even in periods of recession as a confidence-building tactic.

The maintenance of investor confidence is a matter of mutual concern among governments because crises that can lead to sovereign defaults can be contagious, in much the same way that bank runs can generate banking panics. That consideration has prompted currency unions such as the European Monetary Union to set up deficit-limiting rules and monitoring systems.

The UK's Code for Fiscal Stability

In November 1997 the British government announced its adoption of two rules of fiscal conduct:

- a "golden rule":that over the economic cycle, the government would only borrow to invest and not for public consumption, and

- a "sustainable investment rule": that over the economic cycle, the government would ensure the level of public debt as a proportion of national income is held at a stable and prudent level (subsequently interpreted as 40 per cent of gdp);

and an analysis published by the Treasury in 2008 concluded that:

- the average surplus on the current budget over the previous economic cycle was positive, thus meeting the golden rule; and,

- public sector net debt remained below the 40 per cent of GDP limit of the sustainable investment rule over the cycle.

But in November 2008 the government announced the replacement of those rules by a "temporary operating rule" under which it would set policies to improve the cyclically adjusted current budget each year, once the economy emerges from the downturn, so that it would reach balance with debt falling as a proportion of GDP once the global shocks had worked their way through the economy in full.

The EU's Growth and Stability Pact

The Growth and Stability Pact that was introduced as part of the Maastricht Treaty in 1992, set arbitrary limits upon member countries' budget deficits and levels of national debt at 3 per cent and 60 per cent of gdp respectively. Following multiple breaches of those limits, the pact has since been renegotiated to introduce the flexibility necessary to take account of changing economic conditions.