Government debt is not debt in any meaningful sense of the word.
Well, actually that's not quite true. Let me clarify. The debt of genuinely sovereign governments that issue their own currencies, have properly functioning central banks and full control of monetary policy is not debt in any meaningful sense of the word.
This all stems from the nature of our fiat money system. In a fiat money system, governments create money. More accurately, money is created by private banks as agents of the state, backed and supported by the central bank which is part of government. The "independence" of central banks is pure fiction. Central banks may operate independently of political control - if politicians allow them to - but they are part of the government machine just as much as government treasury departments are.
Most central banks - with the notable exception of the Federal Reserves - were originally created to fund governments, but their role has changed over the centuries and we have now reached the interesting position where central banks are not allowed to fund governments directly, though they can and do fund them indirectly via the banking system. But there is no reason under a fiat money system why a sovereign government could not simply instruct its central bank to issue money to meet spending commitments, rather than issuing debt. When governments do this it is known as monetization, or "printing money" - although these days not much printing would be involved. It is NOT the same as QE, which exchanges various forms of government debt for money.
Monetization has historically been associated with hyperinflation, and it is fair to say that the fear of inflation is the principal reason why governments don't simply issue money to meet spending commitments. But leaving aside voluntary (and sometimes legal) constraints on monetization, sovereign governments that issue their own currencies do not need to borrow to meet spending commitments.
So if government could in theory meet its spending commitments entirely through money issuance, why do we need government debt at all? Many people would argue that we don't. But I disagree. You see, debt serves a useful purpose which money does not adequately meet because of its primary function as a medium of exchange.
In the past, when governments did not have control of their own currencies because they were tied to gold, governments had to borrow to fund their spending, because they could not simply issue money. And those countries that today don't have control of their own currencies also have to borrow. So for Eurozone countries - including the mighty Germany - debt is indeed debt. They cannot issue their own currencies, and therefore they have to borrow to meet spending commitments. But for everyone else, debt is not debt, it is savings. The trouble is that we have not yet really understood the nature of our fiat money system. We are still trying to treat it like a gold standard. Thus we insist that governments must borrow to meet spending commitments. And if they borrow what we consider "too much", we start to worry about over-commitment and the debt burden on future generations and the cost of interest service and what on earth the markets will think and will people stop buying our debt and oh my goodness we had better cut back and get this deficit under control. This panic spiral is completely unnecessary and in my view stems from a fundamental misunderstanding of the role of government debt in a fiat money system.
Debt provides a safe store of value for the citizens of the country. It is similar to insured deposits at banks. Like deposits, debt is interest-bearing. And at the moment, debt benefits from a 100% guarantee from government, whereas the insurance on deposits is capped. It is also highly liquid, and therefore the funds are rather more accessible than they are in many time deposit accounts. Debt is also fully transferrable: you can give your son gilts for his 21st birthday, but you can't give him a deposit account. Well, actually, you can if you are a UK resident. You could open a National Savings account in his name, deposit funds in it and give him a National Savings certificate of deposit representing those funds. You would have done EXACTLY the same as buying him gilts to the same value. Effectively, gilts are certificates of deposit. When you buy government securities, you are depositing your money in a 100% government-insured interest-bearing deposit account. Governments really are banks.
But what about the interest on debt? Well, it used to be that government securities were interest-bearing whereas money was not, and this reflected the slightly higher risk of debt. This is because unlike money, debt is time-limited: when it matures it has to be redeemed or refinanced, and there is always the risk that government won't be able to find the money to do that. Or at least that's what people think. They are wrong, of course: sovereign currency-issuing governments can ALWAYS find the money to refinance their debts, because they can issue it. There is effectively zero duration risk on the debt of sovereign currency-issuing governments.
But now that banks pay interest on government-insured deposit accounts, and central banks pay interest on excess reserves, most money is interest-bearing. And interest rates on government debt for highly-regarded currency-issuing sovereigns are at an all-time low. As I've noted before, the liquid nature of government debt means that any real difference between the interest rates on deposits and the yields on debt is arbitraged away. Therefore the interest cost of money and debt are pretty much the same. Governments are free to choose which to issue depending on the saving versus spending needs of the economy.
At present, when the preference is for saving over spending and this has caused a nasty drop in aggregate demand, arguably the preference should be for issuing money rather than debt, since money is the medium of exchange in the real economy and we wish to encourage spending - though of course as money is also an interest-bearing safe asset, adding money may just encourage people to stash it away if their preference is to save. But when the problem is too much spending and government wishes to encourage saving, government may choose to issue more debt and less money, which reduces the money stock in the real economy while maintaining liquidity in the financial system (since interest-bearing money and government debt are near-substitutes). It's a balance. Note that this dynamic balancing of monetary and fiscal instruments requires cooperation of central bank and treasury. It is not possible for them genuinely to be independent of each other for this to work, though if the central bank is responsible for inflation targeting it would probably be sensible for it to be in the driving seat. Perhaps it is time to recognise that the central bank needs to have the right to TELL the Treasury to issue debt!
Note also that I am still not talking about QE. No asset purchases are involved. The money is what Friedman called "helicopter money" - money issued by the central bank and spent directly into the economy. And on the Treasury side, debt should similarly be issued primarily to residents, not to foreigners. This is because of the nature of interest on debt.
Most people who call for government to stop issuing debt - whether because they want government to meet spending commitments through money issuance, or simply want a severe fiscal contraction to "get the deficit under control" - do so because they believe that the interest payments are a deadweight cost. They are wrong. When government debt is held by residents, interest paid is not a cost. It is a tax credit - and if government wanted to, it could recover that by imposition of offsetting taxes.
So ideally, a sovereign currency-issuing government meets its spending commitments by issuing both money, which is used as the medium of exchange in the real economy, AND sufficient interest-bearing debt of various tenors to enable its citizens to save safely in something other than the medium of exchange. It pays interest on that debt from tax receipts, and it taxes away any interest tax credits that it doesn't want certain people (say high earners) to receive. So far, so good. It's a lovely closed system, and provided government is responsible it should not be inflationary. Where it all goes wrong is when foreigners get involved. Because that's when safe government debt becomes risky, and maintaining it, a cost.
Foreign holders of government debt have no direct stay in the way governments manage their economies. They have no vote. So for them the fact that they have no control means risk. The citizens of the country could elect a government that repudiates overseas holdings of its debt or manages the economy so ineptly that the value of the debt is eroded. Therefore foreign debt holders use indirect means of influencing the way governments manage their economies. They demand fiscal austerity measures to hold down government spending for fear of default, and rejection of monetization for fear of inflation. And they threaten to sell their holdings if governments don't comply. For governments who do not issue their currencies, this is a real problem - as we are seeing in the Eurozone. If they can't raise enough from tax income to meet their spending commitments, a buyer's strike can cause them to go bust. But this can't happen to a sovereign currency-issuing government, because it can always print money to pay its debts or buy them back. The threat is empty - but we all still listen to it. How often to we hear people saying that the UK must get its debt under control or it will end up like Greece? No it won't . The UK has a central bank and its own currency. Greece doesn't. That is why Greece really can go bust and the UK can't. That's not to say that the UK can't have serious economic problems, and I am certainly not advocating fiscal profligacy. But for currency issuers the risk is inflation, not insolvency.
In addition to dilution of fiscal and monetary control, foreign holdings of debt cause another problem. Interest paid to foreign debt-holders is a real cost - it leaves the domestic economy. Yes, it comes back eventually in the form of export purchases, but that can take years. In the meantime, it is not available for productive investment in the issuing country. And because it is paid from tax receipts, it is a fiscal transfer from domestic taxpayers to foreign residents. The more government debt is held by foreigners, the less real control it has of fiscal and monetary policy and the greater the real cost to taxpayers.
So why do currency-issuing governments issue debt to foreigners at all? The simple answer is: trade. Overseas residents need foreign currency in order to purchase exports, but just like domestic residents, they prefer to hold their foreign currency savings as something other than the medium of exchange - and indeed if they don't there can be problems with liquidity in international trade finance. So there does need to be some "leakage" of government debt to overseas residents. Problems arise when the holdings of government debt by overseas residents overwhelm the ability of the national economy to support them, and the interests of overseas residents trump those of national citizens. To my mind this is a dangerous imbalance which can lead to all manner of dysfunctional economic policies and eventually to nationalism, balkanisation and political unrest. We do not know what level of overseas holdings of government debt creates this imbalance, but it is notable that Japan, which has the highest debt/GDP level in the world yet is widely regarded as a "safe haven" for investment, has very low foreign holdings of its debt. The vast majority is owned by its own citizens.
This brings me neatly back to that safe asset proposal that I've been talking about recently. Since the failure of private sector "safe" assets in 2008 and the subsequent failure of Eurozone "safe" sovereign debt, the financial system has relied on the debt of sovereign currency-issuing governments for collateral and safe investments. But there is a serious shortage of safe government debt. I've argued already that it is unreasonable to expect one or two countries to provide sufficient safe assets for the entire global financial system. The unequal burden of producing sufficient safe assets for the entire system would eventually overwhelm them. But why should governments provide safe assets for this system at all?
Keeping the global financial system going is essential for the smooth operation of international trade. There is much the global financial system does that is self-serving and, to quote Adair Turner, "socially useless". But not everything is, and to the extent that safe collateral and liquidity are needed to support trade finance and capital flows, it would be reasonable for governments to provide these as a last resort. I don't think it should be a first resort, though. The quest for absolute safety is doomed to fail and is a distraction from the real purpose of investment, which is to finance the productive development of the real economy. The financial sector should try a lot harder to produce assets that, while not completely safe, are acceptable as collateral with a reasonable haircut. And governments and regulators should rethink regulatory rules that increase demands for sovereign debt by global banks and investors. But above all, investors need to come out of their bunkers and start accepting risk. Until they do, the world will be stuck in a deflationary slump.
Liquidity trap heralds fundamental change - Coppola Comment
When governments become banks - Coppola Comment
Safe assets and Triffin's dilemma - Coppola Comment
The illusion of safety - Coppola Comment
All Your Dorks Are Belong To This - Pragmatic Capitalism
In fact for the wonkish among you I recommend a read of the entire "dork debate" posts. Waldman's post contains links to most of them:
A confederacy of dorks - Interfluidity
I'm also adding a link to a subsequent post in which I address concerns that I did not discuss taxation in this post and so (according to some) gave the impression that governments can simply issue unlimited money without consequences. They can't. And as debt is simply a future money claim, that means they can't issue unlimited debt either.
So what is the catch? - Coppola Comment
I haven't finished with this subject by any means. There will be further posts on external borrowing constraints and the role of currency, the equivalence of monetary and fiscal policy, and supranational safe assets. That's all I've thought of so far but there will no doubt be others.