Thursday, November 27, 2014

Does Debt Matter?

LONDON – Europe is now haunted by the specter of debt. All European leaders quail before it. To exorcise the demon, they are putting their economies through the wringer.

It doesn’t seem to be helping. Their economies are still tumbling, and the debt continues to grow. The credit ratings agency Standard & Poor’s has just downgraded the sovereign-debt ratings of nine eurozone countries, including France. The United Kingdom is likely to follow.

To anyone not blinded by folly, the explanation for this mass downgrade is obvious. If you deliberately aim to shrink your GDP, your debt-to-GDP ratio is bound to grow. The only way to cut your debt (other than by default) is to get your economy to grow.

Fear of debt is rooted in human nature; so the extinction of it as a policy aim seems right to the average citizen. Everyone knows what financial debt means: money owed, often borrowed. To be in debt can produce anxiety if one is uncertain whether, when the time comes, one will be able to repay what one owes.

This anxiety is readily transferred to national debt – the debt owed by a government to its creditors. How, people ask, will governments repay all of the hundreds of billions of dollars that they owe? As British Prime Minister David Cameron put it: “Government debt is the same as credit-card debt; it’s got to be paid back.”

The next step readily follows: in order to repay, or at least reduce, the national debt, the government must eliminate its budget deficit, because the excess of spending over revenue continually adds to the national debt. Indeed, if the government fails to act, the national debt will become, in today’s jargon, “unsustainable.”

Again, an analogy with household debt readily suggests itself. My death does not extinguish my debt, reasons the sensible citizen. My creditors will have the first claim on my estate – everything that I wanted to leave to my children. Similarly, a debt left unpaid too long by a government is a burden on future generations: I may enjoy the benefits of government extravagance, but my children will have to foot the bill.

That is why deficit reduction is at the center of most governments’ fiscal policy today. A government with a “credible” plan for “fiscal consolidation” supposedly is less likely to default on its debt, or leave it for the future to pay. This will, it is thought, enable the government to borrow money more cheaply than it would otherwise be able to do, in turn lowering interest rates for private borrowers, which should boost economic activity. So fiscal consolidation is the royal road to economic recovery.

This, the official doctrine of most developed countries today, contains at least five major fallacies, which pass largely unnoticed, because the narrative is so plausible.

First, governments, unlike private individuals, do not have to “repay” their debts. A government of a country with its own central bank and its own currency can simply continue to borrow by printing the money which is lent to it. This is not true of countries in the eurozone. But their governments do not have to repay their debts, either. If their (foreign) creditors put too much pressure on them, they simply default. Default is bad. But life after default goes on much as before.

Second, deliberately cutting the deficit is not the best way for a government to balance its books. Deficit reduction in a depressed economy is the road not to recovery, but to contraction, because it means cutting the national income on which the government’s revenues depend. This will make it harder, not easier, for it to cut the deficit. The British government already must borrow £112 billion ($172 billion) more than it had planned when it announced its deficit-reduction plan in June 2010.

Third, the national debt is not a net burden on future generations. Even if it gives rise to future tax liabilities (and some of it will), these will be transfers from taxpayers to bond holders. This may have disagreeable distributional consequences. But trying to reduce it now will be a net burden on future generations: income will be lowered immediately, profits will fall, pension funds will be diminished, investment projects will be canceled or postponed, and houses, hospitals, and schools will not be built. Future generations will be worse off, having been deprived of assets that they might otherwise have had.

Fourth, there is no connection between the size of national debt and the price that a government must pay to finance it. The interest rates that Japan, the United States, the UK, and Germany pay on their national debt are equally low, despite vast differences in their debt levels and fiscal policies.

Finally, low borrowing costs for governments do not automatically reduce the cost of capital for the private sector. After all, corporate borrowers do not borrow at the “risk-free” yield of, say, US Treasury bonds, and evidence shows that monetary expansion can push down the interest rate on government debt, but have hardly any effect on new bank lending to firms or households. In fact, the causality is the reverse: the reason why government interest rates in the UK and elsewhere are so low is that interest rates for private-sector loans are so high.

As with “the specter of Communism” that haunted Europe in Karl Marx’s famous manifesto, so today “[a]ll the powers of old Europe have entered into a holy alliance to exorcise” the specter of national debt. But statesmen who aim to liquidate the debt should recall another famous specter – the specter of revolution.

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    1. Commentedjan andreassen

      You forget the practical route. Europe has always beeen about lofty ideals followed by a d-mark revaluation. Germany is strong and has gotten that way through the trials of history. No this is not a PIGS problem, but an issue for france,netherlands and sweden. No chance against der mittelstand.

    2. CommentedEnrique Woll Battistini

      It does matter who spends the money and on what, whether government or individuals, friends or foes, just as much as it matters that debt be repaid no matter whose it is or to whom it is owed; breaking the faith in government financial commitments sows the seeds of economic failure, social injustice, political disorder, and dissolves the trust on which society and the future iare built. That is why default by government is crassly immoral, much more so than impoverishment through uncontrolled inflation, by central banks, and must never allowed to become state policy.

    3. CommentedShane Beck

      Does national debt matter? Only in the current international economic, political and legal framework where the international bondholders expect to get their dividend ahead of any other national interest. For example, if the United States decided to default upon their national debt for some insane reason, there would be very little that international investors could do other than the obvious actions of seizing overseas US assets and withholding future credit. This has happened in the past in revolutionary situations such as Revolutionary Era France and the Bolshevik revolution. In a climate where polities "break the rules", the rules no longer apply. Not saying that it will happen in this case in either US or Europe but simply noting that it has happened in the past with debt being one of the causes of such revolutionary conditions and repudiation of such debt being one of the outcomes

    4. CommentedGordon Roberts

      You throw up one linear graph and proclaim that MMT is true ( with this you sound like you have left no avenue of thought unexplored. Well how about this avenue Mr Arrogant: how about wealth distribution?? Did you ever think that the national debt payments going to people who already have money on being paid at least partially by the taxes of those who scrap by day to day and have no surplus money to benefit from the money their government pays in debt maintenance? Rather than getting the complete government services they deserve they are financing the growth of wealth of those who are already better off than they are and they have no choice about it. And as the debt burden gets worse and the population ages with more debt to be paid by fewer and fewer (portportionally) working younger people, fewer and fewer government services will be provided for the increasing taxes paid.

      I merely have a bachelor of mathematics,.. but even i know that you have no idea what the word 'proof' means. You speak as one who has knowledge, yet you only misleads others. Please be silent.

    5. CommentedMATTHEW M

      Most of the comments herein are more worthy than the article. Particularly, debt just used to finance current non investment consumption is problematic. If debt is indeed incurred to finance investment, infrastructure, emerging technologies and related job training etc then it ultimately has a return or stimulative effect on growth, which correspondingly reduces the debt position. The problem is in most "advanced" societies, they have lost the sense of what to invest in. And the entanglement with too powerful of bankers and Wall Street is blinding them to see this reality.

    6. CommentedNick Marshall

      This is getting the cart before the horse. Who are these future generations and what is their population? It is just too glib to assume that we know the size and wherewithal of any future generation to assume anything about the wealth or output in the future. Economic forecasts are never more than a projection of the present trend i.e.they tell you what has happened but nothing about the future.
      Adding further debt now (money creation from thin air) is not actually doing anything for the economy because the multiplier effect is not happening. It is not happening because banks are reluctant to lend and people are reluctant to borrow. Economists regard this as irrational because they look at the world in terms of numbers. Real people have limited lifespans and families to take care of. People are far more sensible than the so called experts. They will take their lumps now and probably revolt later to take their revenge on those who allowed such economic distortions to happen. The final sentence "Future generations will be worse off, having been deprived of assets that they might otherwise have had." is about as stupid an idea as I can imagine. Essentially, it is saying that experts like Robert Skidelsky know the future. There was hardly an economist alive who predicted the downturn from late October 2007. Common sense tells me that in the end, despite government/central bank manipulations, there will be defaults on an unprecedented scale. In such a deflationary period only those who have paid off all debt will be in a position to flourish - hence the common sense of the common people to reject taking on more debt.

    7. CommentedNick Marshall

      The global economy has been falsely supercharged over the last decade or two by rampant credit/money creation. In the mid sixties every dollar created added a dollar to GDP but today it takes five or more times as many to add each dollar of improvement. The reason is pretty simple - each new dollar has less purchasing power than the previous one. Economists and those highly paid people who run corporations may not notice this but ordinary people do. The whole system needs re-calibrating and the only way to do that is by honest accounting which will, of course, result in a very high level of default. Default is not bad, it is what happens in a well functioning system, because it clears out the financial arteries and passes assets from debt laden weak hands to strong hands which can nurture and grow the asset. The nineteenth century saw several crashes and bank runs of short duration. None were a risk to the system as a whole because no bank or business was "too big to fail". That is not the situation now, which is all the more reason to let those businesses fail which are supposedly crucial to the system. If they are so crucial, how come they got us into this global mess? The longer it goes on with the taxpayer's burden being increased with bailouts and quantitive easing, the greater and more damaging the eventual crash. I do not pretend that it will be bloody awful for a while but better to take our lumps now than later.
      The idea that "governments, unlike private individuals, do not have to "repay" their debts" is so stupid and dishonest that it could only be uttered by an economist. It is an exercise in semantics. It may be true that the government, per se, can avoid its obligations by printing but that is only to pass on the burden of the obligation to the citizens of that country and their descendants by way of falling purchasing power and utterley distorted market signals. The only true thing that can be said is that those in government, the zombies who are supposed to represent the interests of the people, now only serve their own ends. There will, no doubt, be a period of reckoning.

        Commentedparthasarathy Shakkottai

        The household net worth of USA is $58.5 Trillion. The national debt is $14 T. GDP is about the same, $14T/yr.The ratio of GDP/yr to govt spending/yr has been about 5 over the years. The same ratio holds for household net worth to national debt.
        "The currency issuer is the monopoly producer of money and, just as every asset has a liability, also results in government liabilities. The issuer's liabilities, or "debt", is a digital account of the currency supply used by the currency users. To a fiat currency issuer, the currency supply is a digital accounting tool, not an asset in and of itself. The currency supply is simply the bookkeeping records corresponding to all the currency users’ savings in banknotes, deposits, and treasuries.
        Money functions as both a store of value and a medium of exchange. When users acquire dollars they can spend them for items in the marketplace or choose to "save" them as banknotes, deposits, and treasuries.
        The more users choose to save the more "debt" the issuer takes on. A common misconception is that currency issuers "borrow" money. The issuer does not borrow because it is the monopoly producer of the currency - the money that currency users spend or save. This is simply double entry accounting.
        Savings by currency users, domestic or foreign, is a straightforward concept on an individual level but becomes counter intuitive on a macro level." from”

    8. CommentedProcyon Mukherjee

      The price mark-up over unit labor cost, a measure of business power, has been rising sharply in recent times (Source: Bureau of Economic Analysis, National Income and Product Accounts; Bureau of Labor Statistics, Productivity and Costs; CEA calculations); I do not know if even a fraction of this could be invested to increase the marginal productivity of labor and its proceeds shared in a proportion that could lead to consumption increment.

      We all know that the marginal propensity to consume is higher at the base and that is where the debt burden pinches severely.

      Procyon Mukherjee

    9. CommentedPaul A. Myers

      The distribution of the proceeds of national debt matters a lot. Debt used to finance infrastructure and social investment in education and research (1) moves today's economy towards full employment, (2) increases the future income of the country, and (3) increases the long-run marginal productivity of labor, thus raising real wages over time.

      In contrast, debt used to finance current consumption only achieves the first of the above three objectives: current employment is improved.

      So public debt that builds public assets is actually a prerequisite of achieving advanced economic status. Private sector economics, no matter how "free," will not take you there.

      Most of the advanced economies are under-investing in public assets and productivity-building infrastructure. So their productivity of labor is stagnating at a time when emerging market economies, incorporating the latest technology, and rapidly improving their productivity.

      So the emerging countries start to "eat the lunches" of the advanced economies.

      And politicians do not want to give up on public consumption regardless of impact on long-term income. So we get slower growth and higher unemployment and a sense of a stagnating future.

    10. CommentedDuncan Hume

      Of course debt matters! The casual approach to debt evidenced in this article is exactly why we have a problem. Any entity that borrows money to meet its ongoing expenses is creating an untenable situation. We now have many countries that are meeting day to day expenses using borrowed money. It may be the easiest path for those elected to positions of responsibility but it is not responsible governance. Debt works when it is being used for investment with a reasonable expectation of a return but that is not what has been happening, and assuming that the problem is going to be fixed by devaluing the currency is a joke, how is that going to affect your constituents? and eventually the lenders will wake up and then interest rates will be set to match your cavalier attitude.

        Commentedparthasarathy Shakkottai

        This applies to a monetarily sovereign economy, say USA. Government creates money and the economy uses it.
        a) Federal Deficits – Net Imports = Net Private Savings is strictly true. Govt “debt” is the sum of all deficits and appears on one side of the equation whereas the private sector “debt” means negative savings. Govt deficit is the source of money.
        Income taxes play a minor role in macroeconomics. It has a role in income inequality and inflation control. Govt "debt" is the same as private wealth. These are in the form of the govt bonds held by citizens, grandmothers, pension funds and so on. The interest also flows into the private sector. Two key equations in economics which apply to any system of govt which creates its own money:
        A numerical proof of (a) is shown in figure 4 of
        b) Gross Domestic Product = Federal Spending + Private Investment + Private Consumption + Net exports.
        The GDP is equal to approximately 5 times govt spending.
        Actual data is in
        Deficits have been quite common in the US economy.

    11. CommentedDerrick Wilkinson

      If he thinks the printing press can be used to repay debt he has clearly not understood the fact that money is not merely a means of exchange but also - and equally important - it is a store of value. Printing money is one of the quickest ways of devaluing a currency - by undermining the confidence of savers and investors in that government

    12. CommentedDerrick Wilkinson

      So debt is not a burden on future generations and does not need to be repaid. Perhaps then the government could just assume all private debts as well, since the resulting higher government debts are neither a burden nor need repayment. Arrant nonsense!!!

        CommentedAnthony Juan Bautista

        Excellent point. Also, the future taxpayers (now children) don't get ANYTHING in adulthood in return for their tax dollars servicing inherited debt (because these govt goods/services were consumed by their forbears). So SOMETHING has indeed been transferred from old to young. Mr. Skidelsky apparently reads Krugman--both possess an utter absence of morality on this matter (the very definition of rationalization).

    13. CommentedHelena Hessel

      Indeed it does. Investors' memory is surprisingly short. Argentina is an excellent example.

    14. CommentedProcyon Mukherjee

      Debt to GDP ratio is passe, what now counts is the ratio of government debt to government revenue, which has been mounting and this is a clear indicator that we are drawing from the future without a credible plan on how to bring some semblance of balance. Austerity actually is a double whammy, but if it is directed towards bringing a balance in those areas where restructuring is necessary, it is actually a step in the right direction. Procyon Mukherjee

        Commentedparthasarathy Shakkottai

        Myths about debt/GDP still persist. Please see

    15. CommentedLuke Ho-Hyung Lee

      Could I suggest you see this letter? "An Open Letter to the Economic Leaders of the West -- especially the United States"

      I wrote this letter about a year ago on December 21, 2010, but I think it is still effective.