Funding Expenditures
As Britain enters a severe recession that will lead to large fiscal deficits and growing public debt, a question presents itself – when are deficits and debt too large? The question has an apparently simple answer. The fiscal deficit is too large when it results in the government finding it cannot sustain its servicing (interest charges plus repayment of principle). That answer opens a further question, when is debt service unsustainable?
This question begins with the recent arguments that if governments have control of national currencies — sometimes called sovereign currencies — they can fund their expenditures through money creation. This view derives from the argument that taxes do not directly fund spending. This approach to public expenditure has limited applicability. While possession of a national currency provides the necessary condition for governments to auto-finance their expenditures, it is not a sufficient condition as a moment’s reflection shows.
The International Monetary Fund has 189 members, 145 of which have national currencies. Of those 145 no more than a dozen governments could safely and effectively fund their expenditures by money creation. The ability to do so requires that the currency be safe from speculation against the exchange rate. That requires either that the national currency serve as an international medium of exchange (reserve currency) or that the government possesses substantial foreign exchange reserves. Both serve as protection against exchange rate speculation.
Inspecting the Special Case
Among large countries only the United States and to a much less extent the United Kingdom have reserve currencies. The Chinese and Japanese governments represent hybrid cases of partial reserve currencies, due to their large trade volumes and substantial foreign exchange reserves. The Chinese government holds the world’s largest stock of reserves with Japan second, $3.1 and 1.4 trillion, respectively. No other government holds as much as a trillion.
A few governments of medium-sized and small countries possess reserves sufficient to protect against speculation, Norway, Saudi Arabia and Switzerland are among the few. As I pointed out in my recent book, The Debt Delusion, the principle that governments with national currencies can borrow from themselves has such limited applicability that it does not involve theory. Rather, it involves an empirical relationship of considerable importance but a special case.
The vast majority of governments would invite fiscal disaster by borrowing from themselves. Because of the structural characteristics of developing economies monetization of borrowing via selling bonds to the central bank or creation of credit lines in the central bank would provoke excess demand and inflation leading to exchange rate depreciation. For that reason the vast majority of governments with national currencies borrow in financial markets, nationally and internationally.
Even for the handful of special cases a caveat applies, the sustainability of the debt service. Further analytical discussion requires that we abandon generality and go directly to specific cases. The British government can and has engaged in considerable deficit monetization because of two specific characteristics of the economy. First, the large financial sector encourages capital inflow that weakens the destabilizing effect of exchange rate speculation. Second, the lingering function of the pound as a currency of international exchange fosters holding of sterling as a reserve by many governments.
Even in the case of Britain, the sustainability of debt service requires the continuation of low interest rates on public bonds, now 0.5% for two year gilts, and a long maturity structure of UK bonds. The latter at 15.4 years is the longest among OECD countries, all of which have an average of less than ten except for Britain. The Debt Management Office in the Treasury maintains the stability provided by long maturity borrowing.
However, interest rates at the present low level are not sustainable. The British government can avoid speculation that would elevate interest rates because the Bank of England sets rates. Public bonds serve as a major element in private pension funds, for wealthy and also for the middle class. If interest rates remained permanently low, that would require a substantial restructuring of pension funds and private portfolios in general.
As a policy rule, the Bank of England should aim to sustain gilt rates in the long term near the economy’s sustainable expansion rate, about 2.5%. Public debt service is manageable if it declines or maintains a steady share of public spending. Calculating whether debt service is sustainable involves several key numbers: 1) the level of debt, 2) average interest rate on the debt, 3) fiscal deficit (which adds to the debt), 4) the size and growth of public expenditure, and 5) expansion rate of the economy.
As guidelines we set the economy’s expansion equal to the target gilt rate (2.5%) and set a guideline for public expenditure at 40% of GDP, the share for much of the post-WWII years. Sustainability of public debt service then depends on two numbers, the fiscal deficit and the initial size of the public debt. Should the covid-19 depression result in a debt to GDP ratio well over 100% and fiscal deficits to GDP in double figures, debt service sustainability could become a concern.
Summary
In principle governments with national currencies can fund expenditures through money creation. In practice very few should do so, one of which is the United Kingdom. We have an empirical possibility to consider, not a theoretical generalization. At the beginning of 2020 the possibility of the British government incurring an unsustainable debt or deficit remained remote. The covid-19 economic depression changes that.
Economic recovery will occur from an initial condition with a quite large public debt to GDP and double digit deficits. When that recovery brings interest rates back to their historically typical level debt sustainability could become a concern. This does not imply restraining expenditure but quite the contrary. As shown when George Osborne was Chancellor, budget cuts reduce the Treasury’s tax take by slowing the growth of the economy. Sustained recovery will require continued management of the maturity the debt and achieving a steady recovery, unlike the near stagnation during 2010-2020 abortive recovery.
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