How much can the government borrow?

In 2020, the impact of the coronavirus and partial economic shutdown will cause a substantial and unprecedented increase in government borrowing. It will severely test the question of how much the government can borrow. There are a few quick points worth bearing in mind.

• Historical precedents. In WWII, the OBR said the UK ran a budget deficit of nearly 27% of GDP. By the early 1950s, UK national debt had risen to 240% of GDP. Yet this was not a significant problem. In the post-war period, the UK enjoyed a long period of economic expansion, where debt to GDP ratios fell. In March 2020, UK debt to GDP ratio was around 80% of GDP, so there is significant room for an increase in government debt.

Source: Reinhart, Camen M. and Kenneth S. Rogoff, “From Financial Crash to Debt Crisis,” NBER Working Paper 15795, March 2010. and OBR from 2010.

• Government's have the ability to create money. Some economists (especially those believing in MMT) argue the only constraint to government borrowing is inflation. In other words, higher government spending financed by printing money is only a problem when it causes inflation. In a severely depressed economy, with inflation falling (and possibly deflation) it maybe desirable for the government to create money and target a positive inflation rate. In 2009/10 recession, US and UK financed some borrowing through quantitative easing.
• In a recession, most economists accept that a rise in government borrowing is necessary to offset the fall in private sector investment and spending. Keynesian economics says expansionary fiscal policy can help an economy recover. But austerity (cutting spending) can make the recession worse, worsening tax revenues and be counter-productive in cutting borrowing.
• During a period of economic growth when the economy is close to full capacity, government borrowing can cause many problems such as crowding out of the private sector, pushing up interest rates, and possible inflationary pressures.

The amount a government can borrow depends on many factors, such as

• Does it print its own currency?
• Do markets trust the government to maintain low inflation and not default?
• What are the interest rate on government bonds?
• What is the state of the economy?
• What is the purpose of government borrowing?
• To what extent is the government borrowing from domestic or foreign investors?

Levels of government debt

At times government debt has been very high:

• US 117% of GDP in 1945 (gross federal debt (1)
• UK 240% of GDP in the early 1950s 
• Japan has national debt over 230% GDP

How does the government finance its debt?

1. Selling government bonds to the private sector - either domestic or foreign. The private sector buy bonds because the security and interest rate on them.
2. The Central Bank can finance shortfall in revenue by increasing the money supply and buying bonds itself. This is sometimes known as quantitative easing.

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. 

This shows that the rise in government borrowing in 2009/10 recession mirrored the rise in private sector savings.

• In a depression, we tend to see a rise in private sector saving (the paradox of thrift) because households fear being made unemployed and firms don't want to invest. Therefore, in a recession, there is often surplus private sector savings. A surplus of unused savings means there is an advantage for the government to borrow, invest, create jobs and make use of these surplus savings. As Greg Mankiw said in March 2020. "There are times to worry about the growing government debt. This is not one of them."

• 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. 

UK bond yields fell during a period of rising debt 

 

This shows that during a period of higher government borrowing 36% of GDP increasing to 80% of GDP - bond yields fell from 9% to 2%

• Lender of last resort. If a country has a Central Bank willing to buy bonds in case of liquidity shortages, investors are less likely to fear a liquidity shortage. If there is no lender of last resort (e.g. in the Euro during 2011/12) then markets have a greater fear of liquidity shortages and so are more reluctant to buy bonds.
• 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 the 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 and it could lead to capital withdrawal.
• 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. A crucial factor is whether inflation is likely. In a recession, inflationary pressures vanish so it is much easier to finance a deficit by borrowing.

Why did Eurozone countries experience more debt problems than UK and US in 2012?

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 (between 2011 and 2013) Italy had no Central bank willing to act as a lender of last resort. See more reasons for Italian Debt Crisis

However, when the ECB agreed to effectively intervene in the bond market, bond yields fell.

Does higher debt lead to higher bond yields?

Related

• EU debt crisis explained
• National debt UK