Public debt

The public debt - is a topic of political significance that has often been the subject of controversy. A policy objective of limiting public debt in normal times is often adopted in order to enable it to be used to cope with unforeseen shocks such as wars, recessions and natural disasters.

Definition

The public debt of a particular country is often referred to domestically as "the national debt". The term public debt is used to refer to the borrowings of governments in general. The OECD's broad definition of public debt as "the external obligations of the government and public sector " is in general use, but national definitions differ in detail and produce figures that may not be comparable. The European Union's definition embodied in its Stability and Growth Pact of "General Government Gross Debt" differs in detail from the complete OECD definition.

Overview

It is customary for governments to use borrowing to finance investment, and it is current practice for the main industrialised countries to allow national debt to accumulate to between 40 and 60 per cent of GDP (except Japan and Italy, with percentages of over 100). However, it is generally considered to be prudent to avoid excessive debt in normal times, in order to be able to cope with emergencies such as wars and recessions. It is also normal practice for governments to allow their national debt to rise to between 70 to 100 per cent of GDP during major recessions - as a result, mainly of the operation of their economies' automatic stabilisers, but also from the use of fiscal stimuluses, intended to compensate for reductions in private sector spending.

Such policies are not uncontroversial, however, and even relatively modest levels of national debt, commonly meet with expressions of concern as being "unhealthy" or even dangerous. Such popular concern may be attributable to an instinctive belief that saving is virtuous and borrowing is discreditable, or to the belief that it imposes unfair burdens on future generations, or to the once universal reverence for balanced budgets - but it is also attributable to fears of harmful economic consequences. Public choice theorists oppose government expenditure, even for the purposes of investment, on the grounds that the politicians concerned are mainly motivated by personal gain, rather than a desire to serve the public interest. Austrian School economists argue that fiscal stimulus expenditure is ineffective, partly because of the Ricardian equivalence argument that it is nullified by increases in private sector saving and partly out of scepticism about the ability of politicians to manage the economy. Other economists have demonstrated that the use of deficit financing is bound, if continued long enough, to lead to a debt trap from which a government cannot escape except by defaulting on its obligations, or by expanding the money supply. The 1931 German hyper-inflation, which was caused by the use of monetisation to manage high levels of postwar debt, has come to be seen as a dramatic warning of the dangers of deficit financing , and sovereign defaults such as the 1998 default by the Russian government as a reminder that governments are not immune from the dangers of insolvency. Sovereign default among developing countries is not, in fact, uncommon, and although the danger that it it could happen to a major industrialised country is generally considered to be remote, there is fear that a persistent rumour of its possibility might alarm investors to the point of making it self-fulfilling.

The history of national debt

The British experience

In the 18th century and before, it had been the practice of kings to finance their wars by borrowing. It was cheaper than collecting taxes - and it was risk-free because a king could not be called to account for defaulting on his obligation to repay - and "sovereign default" was a frequent occurrence. In England, however, Charles II's "Stop of Exchequer" of 1672 was the last time it happened, because the "Glorious Revolution" of 1688 was followed by the "Financial Revolution" during which Parliament assumed effective control over the national debt. The culmination of that revolution was the creation in 1749 of the "Consolidated Fund" , and the issue of undated bonds known as "consols". Members of Parliament were concerned from the start to reduce the level of national debt, as evidenced by the passage of the National Debt Reduction Act 1786 . Their intentions were frustrated, however by the need to finance Britain's part in the Napoleonic War, and between 1743 and 1815, Britain's national debt increased from £245 million to £745 million, which was twice its national income. A further attempt signalled by a second debt reduction act was more successful and the ratio of national debt to national income was reduced to less than 50 per cent by 1900. But further two wars and the intervening Great Depression raised it again to over 100 per cent. According to researchers at the Institute of Fiscal Studies , it rose to over 150 per cent during the first world war, remained at above that percentage for most of the years between then and the second world war, during which it peaked at 250 percent. After the war it was reduced steadily to about 50 per cent by 1975, and remained at between 45 and 55 per cent between 1975 and 1990 and between 35 and 55 percent through the 1990s. As a result, mainly, of the operation of automatic stabilisers during the recession of 2009 it is expected to rise from 44 per cent of GDP in 2007 to 100 per cent of GPD in 2014 (compared with an average rise from 69 per cent to 120 per cent for the G20 countries).

The United States national debt

In 1783, the United States Congress was given the power to raise taxes, but in 1785, it was found that tax revenues were insufficient to meet the government's expenses and Alexander Hamilton argued the case for the raising of public, arguing that "A national debt, if it is not excessive,will be to us a national blessing." In 1789, Congress established The Treasury Department, naming Alexander Hamilton, as its Secretary, in 1790 it passed the first Funding Act, and by February 1792, interest-bearing government bonds were on sale and the national debt rose to $77 million about 25 per cent of national income. However, a strong preference for freedom from debt and the maintenance of a "balanced budget" was evident from the beginning, and in a 1793 message to the House of Representatives, George Washington advised them that  "No pecuniary consideration is more urgent than the regular redemption and discharge of the public debt: on none can delay be more injurious, or an economy of the time more valuable." , and in 1799 Thomas Jefferson wrote: "I am for a government rigorously frugal & simple, applying all the possible savings of the public revenue to the discharge of the national debt." . Jefferson's Secretary of the Treasury, reduce the public debt to $45 million by 1811, and by 1835 the national debt had been fully repaid. Following the war with Mexico, the national debt rose again to $65 million, and it reached $2.7 billion, or about 30 per cent of national income, by the end of the Civil War. By the beginning of the First World War it had been reduced again to about 10 per cent of national income but rose again to 30 percent during that war, and to $260 billion, or about 120 percent in the course of the Second World War. It was reduced to below 40 per cent in the 1960s but had risen to over 60 per cent by 1982 and by the end of 2008, it had reached $10.3 trillion, or about 60 per cent of GDP. and is expected to rise to 112 per cent of GDP in 2014. According to a 2010 blog by Professor Randall Wray the US federal government has - with one brief exception - been in debt every year since 1776

International developments

The widespread use of borrowing to finance government projects such as the building of railways began in the early 19th century and developed rapidly thereafter. The complexity of the resulting system of international finance increased substantially in the course of the 19th and 20th centuries, as the developing countries made increasing use of loans from the industrialised countries to supplement limited domestic resources. Growth was particularly rapid in the post-war 20th century, and by 1995 the external debt of the developing countries is estimated to have risen to 32 times its 1970 level, to reach a total of $2 trillion. . International markets in financial assets tend to be exceptionally volatile, however, and capital flows between developed and emerging economies were sometimes suddenly reduced or reversed in response to developments in the investing country or to perceptions of the stability of the recipient economies. There were many sovereign defaults in the 19th and 20th centuries as governments in developing countries became unable or unwilling to continue to meet their interest or repayment obligations in face of such shocks.

Popular attitudes to public debt

The nineteenth aversion to the creation of national debt was reinforced in the twentieth century by the emergence of its popular association with inflation - an association that was generated, first by the German experience of hyperinflation, and later by the inflationary consequences of numerous ill-judged attempts to use deficit finance to promote economic growth. A second source of reinforcement was a desire to reduce government activity by a strategy known as "starving the beast", and survey evidence from the United States suggests that it has acquired a significant influence upon group psychology. Also, opposition politicians in many countries have often warned that government policies would lead to "national bankruptcy" or that they would impose a "burden on future generations". As a result, public concern about national debt has become a matter of electoral importance (for example, an opinion poll in February 2009, reported that it was one of the top two matters of concern to United States voters - awareness of which may have been behind the President's decision to set up a "fiscal responsibility summit").

The economics of public debt

The benefit from debt arises from the avoidance of the costs of financing expenditure by taxation. Governments can normally borrow at lower interest rates than are paid on other loans because they are considered less likely to default on repayment, but investors may be expected to force any government that they consider to pose even the smallest risk of default to offer a "risk premium" above that minimum rate. Risk premia are seldom required of a government of any of the major economies unless it is considered possible that its national debt might eventually rise to a point at which it could not plausibly be repaid out of tax revenues. An example of such an occasion occurred in 2009 when the difference between the yields on Irish and German 10-year bonds reached 2.5 per cent). The circumstances that govern that possibility are considered in the article on fiscal policy. Financial instability could result if the interest rate increase raised the perceived risk of default and prompted a succession of further rate increases. The importance of maintaining investor confidence in the safety of their bonds has led the authorities in the European Union and in the United Kingdom to announce their intention to adopt deficit-limiting rules.

It is generally recognised that the persistent monetisation of the national debt, (as an alternative to reducing it by tax increases or spending cuts) may be expected to have inflationary consequences. Some economists have even suggested that such inflationary consequences are the inevitable consequence of deficit financing , but that proposition has been rejected by Milton Friedman and other monetarist economists, and it is not supported by empirical evidence. An analysis of historical experience has found an association between deficit financing and inflation among developing countries, but none among industrialised countries - a difference that has been attributed to differences in the short-term costs of tax collection.