A number of people,
including the occasional economic journalist, are puzzled about why
government debt at 90% of GDP seemed to cause our new Chancellor and the markets so
little concern when his predecessor saw it as a portent of impending
doom. I always argued that this aspect of austerity had a sell by
date, so let me try to explain what is going on.
The 90% figure comes
from a piece of empirical work which has been thoroughly examined,
and found to be highly problematic. (Others have used rather more
emphatic language.) Part of the problem is a lack of basic thinking.
Why should the markets worry about buying government debt, beyond the
normal assessment of relative returns. The answer is that they worry
about not getting their money back because the government defaults.
If a government
cannot create the currency that it borrows in, then the risk of default
is very real. Typically a large amount of debt will periodically be
rolled over (new debt sold to replace debt that is due to be paid
back). If that debt cannot be rolled over, then the government will probably be
forced to default. Knowing that, potential lenders will worry that
other potential lenders will not lend, allowing self fulfilling beliefs to
cause default even if the public finances are pretty sound.
The situation is
completely different for governments that can create the currency
that the debt they sell is denominated in. They will never be forced
to default, because they can always pay back debt due with created
money. That in turn means that lenders do not need to worry about
forced defaults, or what other lenders may think, so this kind of
self fulfilling default will not happen.
Of course a
government can still choose to default. It may do so if the political
costs of raising taxes or cutting spending is greater than the cost
of defaulting. But for advanced economies there is an easier option
if the burden of the public finances gets too much, which is to start
monetising debt. That is what Japan may end up doing, and what others
may also do if QE turns out to be permanent. But this is a very
different type of concern than the threat of default. And it does
not, in the current environment, lead to the emergence of large
default premiums and market panics.
How can I be so
sure? Because with QE we have had actual money creation, and it has
not worried the markets at all. It seems hard to tell a story where
markets panic today about the possibility of monetisation in the
future, but are quite sanguine about actual monetisation today.
So for economies
that issue debt in currency they can create, there is no obvious upper limit anywhere near to current debt/GDP ratios when economies are depressed and inflation is
low. Japan shows us that, and we must stop treating Japan as some
special case that has no lessons for the rest of us. (How often did we hear of their lost decade in the 1990s that it couldn’t happen
anywhere else.)
It was good that the
IFS suggested Hammond has a look at Labour’s fiscal rule. As I
explained in this post, Hammond’s new ‘rule’ is pretty
worthless. But one key part of Labour’s rule that keeps being
ignored but is crucial in today's environment is the knockout if interest rates hit their
zero lower bound. It is for the reasons described above that this
knockout is there and is perfectly safe: when interest rate policy fails you can completely and safely forget the
deficit and debt and use fiscal policy to ensure the recovery. It is
the basic macro lesson of the last 6 years that is fairly well
understood among academic economists but still remains to be learnt
by most people who talk about these things. Whether senior economists
in the UK Treasury need to learn it or just keep quiet about it for
other reasons I do not know.
