Few aspects of our economy are as gravely misunderstood among politicians, media pundits and the general public as our public finances. Indeed, public discourse on the national debt is luxuriant with myths and fallacies. This piece offers a rebuttal to three widely held beliefs regarding public debt which, I hope, will lead to greater honesty in discussions, and debates, on the state’s finances.
1. The Public debt is very large
“£2 trillion – the terrifying total of our national debt” – Mail Online, 20th February 2009
I suspect to a great many people, when discussing the national debt the figures involved are quite large, there seems to be something intuitively wrong – after all £1.8 trillion is a huge number which contains a lot of zeros! Unfortunately, most individuals tend only to be concerned with one half of the country’s balance sheet: the liability side. Yes, our national debt is growing but so is our national income – and at a faster rate. And yet individuals seldom celebrate the size of our national income, which currently amounts to £2.6 trillion.
It’s disingenuous to discuss the significance of the national debt in absolute terms. The nominal value of the debt is largely unimportant. Instead, it is the level of debt relative to the economy’s earning capacity that is the critical figure. For example, an individual with very little or no income (and assets) may consider a debt of £50,000 impossible to repay, but an individual that earns £1 million a year would consider the same level of debt an infinitesimal sum. A nation’s earning capacity or income can be represented by Gross Domestic Product (GDP), and hence it is the ratio of government debt to GDP which is the important measure because it reflects the ability of the government to repay.
The following chart illustrates the ratio of government debt to GDP, for every year beginning in 1800. At current, the ratio of government debt to GDP stands at 85.8%, which is significantly smaller than the debt to output ratio experienced by the post-war generation of over 250% of GDP. It becomes obvious to the reader that the level of public debt, measured properly, as a proportion of national income is not large at all.
2. The UK will ‘run out of money’, and go bankrupt.
“The British Government has run out of money” – George Osborne, 26th February 2012
An elementary truth, which you will not hear from politicians, is that in an economy which has a flexible exchange rate and an independent currency managed by a domestic central bank, the government can never be forced to go bankrupt. This is because the central bank (in this case the Bank of England) can always act as a lender of last resort. That is to say, the Bank of England can always purchase the government’s debt, if need be. For instance, there may be some months when the government fails to sell sufficient bonds and faces a shortfall. A consequence of this is that bond investors would panic and demand higher interest rates. But, the Bank of England can intervene and overcome this liquidity shortage, keep interest rates low and ensure confidence among investors.
So, the UK can never ‘run out of money’ because, as established above, the Bank of England can always prevent a liquidity crisis from turning into a solvency crisis. De Grauwe (2011) provides a detailed explanation on this issue, stating that:
“If investors were to fear that the UK government might be defaulting on its debt… [then] they would sell their UK government bonds, driving up the interest rate. After selling these bonds, these investors would have pounds that most probably they would want to get rid of by selling them in the foreign exchange market. The price of the pound would drop until somebody else would be willing to buy these pounds.
The effect of this mechanism is that the pounds would remain bottled up in the UK money market to be invested in UK assets. Put differently, the UK money stock would remain unchanged. Part of that stock of money would probably be re-invested in UK government securities. But even if that were not the case so that the UK government cannot find the funds to roll over its debt at reasonable interest rates, it would certainly force the Bank of England to buy up the government securities. Thus the UK government is ensured that the liquidity is around to fund its debt. This means that investors cannot precipitate a liquidity crisis in the UK that could force the UK government into default. There is a superior force of last resort, the Bank of England.” (p. 2)
Furthermore, the validity of the assertion that the UK could ‘run out of money’, or go bankrupt, has been conclusively debunked by the market reaction to, both, the Great recession, and the associated substantial increase in the public debt to GDP ratio. The (below) chart illustrates this very well: long-term government bond yields are at historic lows, and in real terms they are negative.
3. Government debt imposes a burden on future generations.
“You talk about austerity but it’s actually about not saddling our children or grandchildren with significant debts to come” – Theresa May, 20th July 2016
An argument often invoked by members of parliament and the general electorate goes as follows: if the present generation spends more than it earns (and, hence, increases the national debt), the next generations will have to pay for their borrowing needs in the form of higher taxes. Thus, the national debt places a burden on future generations.
But, this is not true. The national debt does not burden future generations (at least, not in the conventional sense of paying higher future taxes).
There are two objections to the above argument. Firstly, the government very rarely pays off its debts. Instead, it refinances it by issuing new bonds to pay for the old maturing ones – assuming investors are happy to purchase them (which has been the case for the last three centuries). It is the interest payments, not the principal amount, which costs the government. Presently, the interest payments on the public debt costs the government £46 billion, or 2.4% of GDP. But even this does not accurately reflect the burden of debt.
This brings us on to the second counter-argument: to the extent that public debt is held or owned, the debt (or the majority of it) is money we owe to ourselves – to each other.
The Bank of England owns about 25% of the national debt and the government pays the interest on this part of the debt to itself. Thus, one-quarter of the debt and the associated interest payments are not a burden. Furthermore, half of the public debt is held by UK financial institutions: primarily pension funds and insurance companies. The interest paid on debt held by these institutions is income to households. Thus, the national debt provides a source of income to households: a benefit, not a burden. It is important to understand that one person’s debt is another person’s asset. The UK’s public sector debt is always someone else’s asset; in this case it is, primarily, the domestic private sector’s asset. Thus, there is simply no net debt burden to domestic holders of government debt. The effect of the debt, held by the domestic private sector, amounts to a tax cut.
As for the public debt which is held by foreigners, that is a potential problem. Currently, the stock of debt held by foreign creditors amounts to £13 billion, or equivalently 0.7% of GDP. Aside from this being a very small, inconsequential sum, under current circumstances we are able to borrow from foreigners at a negative real rate of interest, suggesting that there is no real debt burden.
Of course, there may be a negative effect on the distribution of income and wealth, because the domestic recipients of the debt interest payments and the current taxpayers are not one and the same. But, if this is the cause of concern then this is not an issue about your children and grandchildren being burdened by debt, instead it is an issue of inequality and distribution. In a sense, government debt could (for the most part) be viewed as a transfer of resources and wealth from one part of the economy to another.