When is public debt unsustainable?

There’s much confusion around today about huge budget deficits and ‘unsustainable’ public sector debt, confusion which helps right-wing deficit hawks to push through drastic deficit reduction programmes. Part of that confusion arises from the fact that for the non-economist, it is difficult to make the distinction between the need to ‘balance the books’ for a household or for the corner grocer on the one hand, and for government on the other. This distinction becomes particularly important when the general public knows that households have been spending more than their income; ie, that net private domestic savings is negative—-as it has been until quite recently in the UK and the USA. It cannot be said too often: the government books don’t work the same way as those of the household or even of the firm.

Today, when both firms and households in the private sector are reducing their spending (saving more) in order to restore their finances, the public sector needs to spend more if national income is not to fall. Otherwise, aggregate demand is lower than aggregate supply, which implies unemployment. Moreover, if national income does fall, this entails a spiral of more job losses, less spending, lower tax receipts and an even bigger ‘hole in government finances’. To paraphrase Keynes’s contemporary, Michal Kalecki, if government is to earn what it spends, workers must spend what they earn.

Adding to the confusion is the distinction between the ‘budget deficit’ and the ‘sustainability’ of the national debt. In essence, the key point here is that if the budget deficit continues to grow too quickly, the debt-to-GDP ratio grows. At some point—so the conservative argument goes—servicing (ie, paying interest on) the national debt becomes too great a burden. When the financial market believes this point has been reached, it will cease lending the government money and government will ‘go broke’.

Now in practice, a government that borrows in its own currency can’t go broke because it can print money; when it does this to push down government bond yields, the process is called quantitative easing or QE. Of course governments can’t do this forever without running the risk of inflation, but inflation is not much of a risk under present conditions of high unemployment and less-than-full capacity output. Just look at Japan where the public debt-GDP ratio is 200% and the general price level is still falling, not rising.

In essence, where one places the limit for a ‘sustainable public debt ratio’ depends on time and circumstance. If, like Greece, your central bank can’t issue the currency, you can’t devalue and you rely exclusively on overseas markets to buy your bonds, your sustainable debt ratio may be low. But Britain is not at all like Greece: its current net debt-to-GDP ratio is low (just over 60%), it can issue its own currency, it borrows mainly at home and the average maturity of the existing debt stock is 13 years. Moreover, unlike Greece, Britain’s medium and long term bond yields are falling.

To simplify the argument, let us assume that Britain doesn’t want to exceed the figure of 100% for the debt-GDP ratio (about the level of the USA today); ie, if today’s GDP is £100bn, its stock of public debt should not exceed £100bn (these numbers are arbitrary). The key concept is that as long as Britain’s GDP grows at a rate equal to or greater than the real rate of interest on debt, the cost of debt service, the debt-GDP ratio will not rise. For example, if we grow at 2% and the cost of debt service is 2% in real terms, our GDP next year will be 102 while our stock of debt (assuming interest is rolled over) is also 102: the debt-GDP ratio remains unchanged. Note that in this case the government is not having to borrow for public expenditure; rather, it is borrowing 2% of GDP to cover the interest on existing debt. This means that the primary current deficit will be zero, but the headline deficit will be 2% of GDP.[1]

The good news is that if we pay the interest, the debt-GDP ratio falls. And of course, if we grow faster than 2% in real terms, we can increase public expenditure and pay back interest while keeping the debt-GDP rate constant. The bad news is that if we grow more slowly than 2%, or if the interest rate rises above GDP growth, the debt-GDP ratio rises.

The practical implications of this hypothetical illustrative example for Britain are far from being trivial. First of all, cutting government spending at a time when the private sector is spending less will almost certainly result in a fall in GDP and a rise in the debt-GDP ratio. Indeed, it would be much more sensible to spend more—particularly on the sort of green public infrastructure investment which will stimulate private investment—thus raising the rate of growth. There is no reason why we should not accept an 80% debt-GDP ratio as the cost of achieving more jobs and higher sustainable economic growth.

Crucially, monetary policy must not be tightened in the immediate future; indeed, further quantitative easing via the Band of England’s Asset Purchase Facility (APF) will be needed to keep medium term bond yields low even if this slightly shortens the term structure.

Finally, once renewed growth has been achieved together with low interest rates, as long as growth is higher than debt service, cuts are unnecessary to pay down debt; the debt-GDP ratio will pay itself down at zero cost. If growth or interest rates are less favourable then there will be a cost, but it will be modest – we would have to pay not the interest, but the difference between growth and the interest, to stabilize the debt ratio.

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[1] See P Segal, ‘So, how much debt is too much? More than the government admits’, guardian.co.uk, Friday 3 Sep 2010.

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