Friday, January 7, 2011

How Much Can the Government Borrow?

With public sector debt increasing around the world (list of National Debt by country), an important issue to consider is how much can governments borrow?

There is no easy answer. Japanese public sector debt is over 220% of GDP, yet bond yields are low. Countries in the Eurozone, such as Ireland, Portugal and Italy saw rapid increases in bond yields despite having lower debt levels. The amount governments can borrow depends upon many factors such as the level of private sector savings, confidence and expectations of future growth.

Levels of Government Debt

At times government debt has been very high:
  • US 117% of GDP in 1945 (gross federal debt (1)

    national debt
  • During WWII, UK national debt increased from £7.1 billion to £21 billion. In the early 1950s, UK public sector debt increased to over 200% of GDP much higher than in the financial crisis 2008-11. See: Could the UK borrow 200% of GDP again?
  • Japan has national debt over 230% GDP

Governments can Finance Their Debt in Two Main Ways

  1. Selling Bonds to the private sector - either domestic or foreign
  2. The Central Bank can finance shortfall in revenue by increasing the money supply and buying bonds.

Factors Which Influence How Much a Government Can Borrow

  • Domestic Savings. If consumers have a high savings ratio, there will be a greater ability for the private sector to buy bonds. Japan has very high levels of public sector debt, but with high domestic savings, there has been a willingness by the private sector to buy the government debt. Similarly, during the Second World War, the government was able to tap into the high levels of domestic savings to finance UK debt.
  • Relative Interest rates. If government bonds pay a relatively high interest rate compared to other investments, then ceteris paribus, it should be easier for the government to borrow. Sometimes, the government can borrow large amounts, even with low interest rates because government bonds are seen as more attractive than other investments. (e.g. in a recession government bonds are often preferred to buying shares (which are more vulnerable in a recession). This is why US bond yields fell 2008-11, despite growth in US government borrowing.
  • Lender of Last Resort. If a country has a Central Bank willing to buy bonds in case of a liquidity shortages, investors are less likely to fear a liquidity shortage. If there is no lender of last resort (e.g. in the Euro) then markets have a greater fear of liquidity shortages and so are more reluctant to buy bonds.
  • Prospects for Economic Growth. If one country faces prospect of recession, then tax revenues will fall, the debt to GDP ratio will rise. Markets will be much more reluctant to buy bonds. If there is forecast for higher growth. This will make it much easier to reduce debt to GDP ratios. The irony is that cutting government spending to reduce deficits, can lead to lower economic growth and increase debt to GDP ratios.
  • Confidence and Security. Usually, governments are seen as a safe investment. Many governments have never defaulted on debt payments so people are willing to buy bonds because at least they are safe. However, if investors feel a government is too stretched and could default, then it will be more difficult to borrow. Therefore, some countries like Argentina with bad credit histories would find it more difficult to borrow more. Political uncertainty can make investors more concerned.
  • Foreign Purchase. A country like the US attracts substantial foreign buyers for its debt (Japan, China, UK). This foreign demand makes it easier for government to borrow. However, if investors feared a country could experience inflation and a rapid devaluation, foreigners would not want to hold securities in that country.
  • Inflation. Financing the debt by increasing the money supply is risky because of the inflationary effect. Inflation reduces the real value of the government debt, but, that means people will be less willing to hold government bonds. Inflation will require higher interest rates to attract people to keep bonds. In theory, the government can print money to reduce the real value of debt; but existing savers will lose out. If the government creates inflation, it will be more difficult to attract savings in the future.

Why Did Eurozone Countries Experience More debt Problems Than UK and US

debt

Bond yields in Italy, increased despite Italy having a primary budget surplus. This was a similar story for other countries in the Euro. One issue is that Italy has no Central bank willing to act as a lender of last resort (ECB won't buy bonds). See more reasons for Italian Debt Crisis

Related

5 comments:

clive said...

Hi
How far can the pound fall before the government has to protect its citizens from the effects of a worthless currency? Surely joining the € and effectively fixing the exchange forever seem to make more sense now than ever before. The argument about interest rates do not, seem as valid as before, now we know the banks have their own inter bank rates, also the “toilet paper currency as the Tories once described the € seem to have back fired. Which is the toilet paper currency now? This debate will not go away Britain is coming to the cross roads, and as I see it what point is there in being part of Europe if its citizens can not afford even to holiday there? That alone do business which is not on an even playing field?

Regards

Clive Cargill

clive said...

Hi
How far can the pound fall before the government has to protect its citizens from the effects of a worthless currency? Surely joining the € and effectively fixing the exchange forever seem to make more sense now than ever before. The argument about interest rates do not, seem as valid as before, now we know the banks have their own inter bank rates, also the “toilet paper currency as the Tories once described the € seem to have back fired. Which is the toilet paper currency now? This debate will not go away Britain is coming to the cross roads, and as I see it what point is there in being part of Europe if its citizens can not afford even to holiday there? That alone do business which is not on an even playing field?

Regards

Clive Cargill

Musgrave said...

Both the above article and Mr Blanchard of the IMF make the totally false assumption that stimulus necessarily involves extra debt.

As Keynes, Milton Friedman and a string of other Nobel prize winning economists have periodically pointed out over the last 80 years (e.g. William Vickrey), STIMULUS DOES NOT NECESSITATE EXTRA DEBT.

Re Friedman, see ; http://nb.vse.cz/~BARTONP/mae911/friedman.pdf
Re Keyes see: http://www.scribd.com/doc/33886843/Keynes-NYT-Dec-31-1933 and search for the passage starting “Individuals must be induced….”

For advocates of Modern Monetary Theory (Google it), the idea that stimulus requires extra debt is just a sick joke. If Economics Blog wants to get with it, I suggest it gets to grips with Modern Monetary Theory (also known as Functional Finance).

Gavin Cooke (author) said...

What none of these figures take any account of is the debt associated with more than three million permanent immigrants to the UK since 1997 and access to the welfare state. The NHS, education sector and housing sector have been drained of billions of pounds of resources not accounted for in aNY GOVERNMENT STATISTICS which make the rest of the statistics presented here meaningless.

Anonymous said...

ALL money is created as debt and destroyed when repaid.97% of the money we use is Private(digital)Bank loan money.Checkout positivemoney.org [the UK monetary reform group]for detail.