The bleak future of public debt
Public debt levels are rising throughout the developed world, with economies bordering on stagflation as politicians prefer short-term giveaways to long-term fixes. Since the turn of the century, the amount of public debt relative to gross domestic product (GDP) in developed economies has surged to highwater marks not seen since the turmoil of World War II. During peacetime, such extreme levels of indebtedness are unprecedented. This raises the question whether record debt levels pose a risk to economic performance and development over the coming decades. Economists are divided.
The proponents of Modern Monetary Theory, such as Stephanie Kelton (The Deficit Myth) in the United States, are convinced that public debt as such is not a problem. Governments that issue their own currencies can, in principle, finance any deficit. As long as they control their own fiat currency, governments can run out of money only if there are self-imposed restrictions in place. But these are by no means necessary.
The thinking goes that if artificial restrictions are alleviated, there is no nominal limit to financing government deficits. From the vantage point of Modern Monetary Theory, the only natural restriction to deficit finance is set by price inflation. Deficits should not exceed the point at which inflation is pushed too high. And, if such an eventuality is avoided, public debt is a boon rather than a bane, and governments should stimulate the economy rather than stifle growth with excessive fiscal discipline.
It seems that, in reality, debt levels truly can be too high.
The massive deficits that governments ran during the Covid-19 pandemic were indeed followed by higher price inflation that caused strife across the developed world. Central banks were forced to increase interest rates in response, further deepening public indebtedness. This has now started to slow Modern Monetary Theory’s rise in popularity. It seems that, in reality, debt levels truly can be too high. Yet putting inflation aside, there are other equally important reasons why public debt is costly and potentially dangerous to society.
Private debt is functional
A credit transaction is an intertemporal exchange of goods based on an expected return at a subsequent point in time. This means that goods in the present are exchanged for goods in the future. We typically have a present sum of money (a “present good”) given from a creditor to a debtor, exchanged against a claim on a larger sum of money in the future (a “future good”) given to the creditor.
Private credit transactions are based on two factors: a matching of the beneficiary (of the present good) and the payer (of the future good), and second, on the side of the creditor, a congruency of the risk taker and the provider of capital. These features set appropriate economic incentives to prevent structural over-indebtedness while enabling growth in an unhampered market economy.
The providers of capital have an incentive to lend at low risk to private debtors who are likely to remain capable of timely repayment. The debtors, on the other hand, face strong incentives to keep their borrowing under control, knowing full well that they will have to carry the burden of repayment themselves.
The inherent risk of public debt
The congruency that enables sustainable private credit transactions breaks down when it comes to public debt: The receiver of the present good is the current government, along with recipients of additional government spending that the public debt enables. The burden of indebtedness, however, is not carried by the current elected officials and those who immediately benefit from the cash influx, but by taxpayers at large. This is a textbook case of a moral hazard. The costs of the credit transaction are imposed on third parties.
The congruency on the creditor side persists, at least in principle. However, there is an artificial reduction of risk due to government privileges, namely control over the issuance of a fiat currency and the right to tax citizens. Historically, holders of government debt could position themselves at the receiving end of tax redistribution. For example, when interest rates were higher than the inflation rate, a holder of government bonds could expect to see a profit at the conclusion of the term. Nowadays, as real interest rates (the effective rate for borrowing after adjusting for inflation) are often below zero, incentives to hold government debt have decreased significantly. Individuals and institutional investors, such as pension funds, are often forced to hold government debt through regulations. They would not do so of their own accord.
The people making decisions to run public deficits and benefit from them are not the same people that will carry the burden of repayment. What is more, the providers of capital do not enter into the relationship fully voluntarily. The natural economic incentives to keep debt within economically viable bounds are undermined when it comes to governments. This is why we have fiscal rules and debt brakes for governments. But such rules and mechanisms have their flaws.
Facts & figures
Among the best-known fiscal rules are the Maastricht criteria for entry into the eurozone. The criteria include, among other things, a maximum level of debt at 60 percent relative to annual GDP and a maximum annual fiscal deficit of 3 percent of GDP. The chart above shows that eurozone countries on average have exceeded the maximum debt level for decades now. The largest economies of the eurozone still fail to adhere to the rules. In many respects, this is only the tip of the iceberg. The debt levels depicted only reveal explicit government debt. However, there are significant amounts of implicit or shadow debts (payments governments have already promised to make in the future but for which repayment is not accounted for in the official debt statistics).
Do we owe ourselves?
One common claim as to why public debt is unproblematic is that we, the general public, are borrowing and owe the repayment primarily to ourselves. From this point of view, the debt level does not really matter. However, even in cases where public debt is held exclusively by domestic institutions and individuals, this is an illusion. Why? Because different individuals are standing behind the collective terms “we” and “ourselves.”
Not all people hold government debt in the exact proportion to what they must pay in taxes to make it possible for the government to pay back the debt. If that were so, one could indeed just delete the debt – voila! But there are net beneficiaries and net payers of government debt. Public debt has always and everywhere been a tool for redistribution. It creates winners and losers. In times of extremely low and even negative interest rates, the general public that is forced to hold government debt must be counted among the losers.
Public debt as a building block for future capital
Another very common but misguided view is that some individuals or institutions necessarily must go into debt if others want to build up capital for the future. On one side of each credit transaction is a claim on a future good, that is, an asset. If some people want to accumulate such assets, the thinking goes, others must go into debt. Without debt there would be no savings, some economists argue. But then savings are required for long-term growth and prosperity.
It is thus argued that if too few private individuals and institutions are willing to take on debt, the government needs to step in. While a credit transaction does indeed require savings to lend, it is not true that saving requires debt. Saving is a necessary condition for credit, but it alone is not sufficient. One can save part of one’s income and buy assets that are entirely unrelated to credit and debt. One could acquire, for example, stocks, precious metals, natural resources, cryptocurrencies, machines, real estate and more. These assets in principle are unrelated to debt. They are real assets and represent real savings in the economy.
The truth that debt is a burden
That public debt is a burden on future generations is often denied or ignored. Politicians argue that future generations do not only inherit the debt, but they inherit the asset attached to the debt, that is, the claim on future payments. This, however, is true only under very specific circumstances that are not generally met.
For example, if parents pass on to their children government bonds that they held in their portfolio, the children indeed inherit both, the burden to pay back government debt through taxes, but also the claim on future payments. But the younger generation typically does not simply inherit the assets. They usually have to buy them from the older generation. Take for example pension systems in many developed countries. Pension funds often hold significant amounts of public debt. The younger generation pays for their claims on future payments through their ongoing contributions into the system. Hence, they inherit the burden and must pay for the asset.
Scenarios
Highly unlikely: The repudiation of public debt
One way out of the debt cycle would be to repudiate the public debt. At a minimum, the share of public debt that is directly held by government institutions, most notably central banks, could be canceled. But one could go even further than that and delete all public debt.
Such a measure would send a strong signal to future investors who would be very hesitant to buy government debt. Government spending would be primarily limited to what they can finance directly through ongoing taxation. Public debt would be kept at an absolute minimum from then on.
Such a drastic approach to solving the public debt problem would create many direct short-term losers. The long-term gains from such measures – preservation of wealth, monetary value and prosperity, among others – are probably too heavily discounted in today’s democratic systems. The likelihood that such measures will be taken is thus close to zero.
Unlikely: Economies outgrow the public debt burden
The most convenient way of coping with large debt levels economically is to outgrow them in real terms. This scenario, however, seems very unlikely for Europe and much of the developed world. Real economic growth has been low for decades and the policies implemented do not favor economic growth.
In Germany, for example, the green transition promoted by successive governments has led to a strongly decreasing trend in industrial output. The German government is thus undermining one of the most important pillars of its economy. Without fundamentally changing the course of its economic policy, Europe will not be able to outgrow its debt levels. It is highly questionable whether such a change is politically desired or even possible.
Most likely: Continued ‘fiscalization’ of monetary policy
For quite some time monetary policy in the eurozone has been (mis)used in the pursuit of goals that fall within the realm of fiscal policy. This trend is called the “fiscalization” of monetary policy. The EU taxonomy for sustainable activities makes room for such a case. Favorable financing conditions through the central and commercial banking system are granted to businesses in accordance with the European Green Deal and similar criteria. It is very likely that Europe continues down this path. This makes it possible for governments to achieve fiscal policy goals through discriminatory financing conditions set by the central bank.
In this way, governments and today’s elected officials do not have to take on credit and subsidize certain businesses directly and thereby run even higher deficits. That job is done by the banking system and through monetary policy. The burden of such policies is imposed on the general public not through higher explicit government debt and taxation, but through inflationary redistribution, a loss of wealth and gradual declines in prosperity. Yet the costs are not immediately visible to the general public, making such a strategy particularly appealing to short-sighted governments.
This report was originally published here: https://www.gisreportsonline.com/r/future-public-debt-2/
Our Partners
