As government borrowing takes the ratio of public debt in Britain to national income above 100%, listen out for the alarms raised by fiscal conservatives that our profligacy is perpetuating debts that your children will have to pay. The alarms will be found most commonly in Conservative circles where fiscal austerity plays on fear of personal debt, and underpins the fundamental Conservative values of hard work and thrift (unless you have private income). These were expressed in very large figures for Government debt (£2 trillion!) announced by the Chancellor of the Exchequer in his Autumn Statement today.
The usual (Keynesian) answer is that government debt doesn’t matter, since a government deficit activates a fiscal multiplier to allow debt to be repaid out of the resulting economic growth. However, recent evidence has cast doubt on the idea that the fiscal multiplier will be sufficiently high to generate sufficient economic growth. It turns out that the fiscal multiplier (the ratio of the fiscal deficit to the resulting economic expansion) itself may be ‘endogenous’, in the sense of being too low in recessions, or periods of low growth (secular stagnation).
The first step towards understanding government debt is the realisation that government debt is not like the mortgage that takes a large chunk of working life to pay off. Looking at how debt structures affect the circulation of money shows up the differences. To start with a distinction emerges between borrowing abroad, ‘outside’ debt, and domestic borrowing, or ‘inside’ debt. ‘Outside’ debt is indeed pernicious, because it commits to the future transfer of resources to persons or institutions outside the economy. Such was the problem of British governments in the two World Wars of the last century, when Britain had to borrow abroad to secure supplies for the war effort and to feed, clothe and fuel the population at home. A similar problem is faced by governments of developing countries today which are encouraged to borrow abroad, when international money markets are liquid. The repayment effort then requires either refinancing (‘kicking the can down the road’ as it is called in banking circles), or a drain on foreign currency reserves, augmented by a deflationary squeeze on imports.
Domestic borrowing, or ‘inside’ debt is, however, different. It commits to the future transfer of resources to persons or institutions within the economy. So, unlike ‘outside’ debt, it keeps resources within the economy, merely redistributing them. Whereas ‘outside’ debt is a burden on our children and grandchildren, ‘inside’ debt is merely a commitment to make our children pay taxes to defray the interest and repayments to our children who hold government debt. In other words, domestic borrowing commits future generations to pay money to future generations. This is a promise to transfer money within the same generation, rather than, as fiscal conservatives argue, between generations. External debt indebts our children to outsiders. Internal debt indebts our children to our children.
This leads to a first principle of government debt management, namely that government borrowing should be domestic, rather than external, in order to keep financial resources within the economy.
It is at this point that debt management and the incidence of taxation come into play. If we assume, for the sake of simplicity, that government borrowing is done through the sale of bonds, then those bonds will end up in the financial portfolios of those persons who are wealthy enough, or have sufficiently high incomes, to have savings backed by those bonds. However, payment of taxes is much more widely distributed. Government borrowing in domestic markets commits tax-payers in general to provide interest income to bondholders who are usually in rather more favourable financial circumstances than tax-payers. The outcome of this redistribution is therefore regressive, although the degree of regression depends on the structure of the tax system. Supposing that the costs of servicing government debt are paid for by an increase in Value Added Tax. Since this is a tax that is paid mostly by people on average or below average incomes, the result will be to transfer income from persons of modest incomes to those on higher incomes. The freezing of public service salaries announced in the Autumn Statement, represents a similar kind of regressive transfer.
This therefore leads to a second principle of government debt management, namely that in societies characterised by inequality of incomes and wealth, government debt requires tax rates to be made more progressive as the debt rises, in order to avoid increasing that inequality. This is where the propaganda about government debt as a burden on our children is used for regressive purposes in persuading people of modest means that it is either them or their children who should pay off the debt. There is an alternative: people with higher incomes and owners of wealth should pay.
There is a very sound economic reason for making wealthy people with high incomes pay the costs of government debt. These are people with savings. When their taxes are increased, this may affect their savings. But it usually has no effect on their expenditure. People with savings are also the principal holders (directly or indirectly) of government bonds. Higher taxes to pay for those bonds therefore take money away from the wealthy classes, and returns it to them in the form of payments of interest and principal on the bonds. The overall cash position of the wealthy classes remains unaffected by the higher taxes.
By contrast, if taxes to service the government debt are raised on households and small businesses whose incomes are too low for them to be able to save, then their expenditures are in effect squeezed. What amounts to the same thing occurs if government employees find their salaries frozen in order to service the debt. The squeeze on household expenditure then tends to reinforce deflationary pressures in the economy, not so much because consumption is reduced, but because people who might not otherwise do so enter the labour market to earn additional income, and the added competition drives down wages.
The third principle of debt management is therefore that, to avoid detrimental effects on economic activity, higher taxes to service government debt are best levied on higher incomes and wealth. This assures financial stability by maintaining a stable cash position among the wealthy, and has minimal effect on aggregate demand and economic growth.
This should reassure prudential parents about the security of their childrens’ futures. However, the anxious parent will also wish to know whether there is any upper limit on this kind of ‘internal’ borrowing. This was suggested by Carmen Reinhart and Raghuram Rajan a few years ago, in a study that claimed to show that government borrowing in excess of 90% of GDP was usually followed by financial crisis. It turned out that the Reinhart and Rajan study was marred by some methodological flaws. But the principal reason why it should be dismissed by prudential parents today is because it muddled up ‘inside’ and ‘outside’ borrowing: The ruin of Florentine bankers by the default on King Richard the Lionheart’s borrowing to finance his crusades, like the Third World debt crisis of the 1980s, was clearly a case of ‘outside’ borrowing, whose dangers are not diminished here. A more relevant historical example is the British government debt after the Second World War, which reached 250% of Gross Domestic Product: far larger than any possible British government debt today. It was eventually brought down not by draining the resources of taxpayers with fiscal surpluses and public servants with penury, but by inflation and economic growth.
The provident parent should therefore put away the piggy bank, reject Conservative alarums about public debt, and assist their children into a profession whose pension will be soundly backed by government bonds serviced by taxes on the rich.
Jan Toporowski is Professor of Economics and Finance at SOAS University of London and a member of the Council of the Progressive Economy Forum. He has worked in international banking, finance and central banking, and has published ‘Why the World Economy Needs a Financial Crash’ and other Critical Essays on Finance and Financial Economics (London: Anthem Press, 2010).
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