“The boom, not the slump, is the right time for austerity.”
– John Maynard Keynes
Should fiscal policymakers try to reduce government debt?
As with many of the debates surrounding Macroeconomics, there is no consensus among the different economists regarding this question.
The proponents of reducing government debt argue that debts place a burden on future generations of taxpayers, crowd out private investment and drag down the economy’s growth prospects. Those who believe government debt should not be reduced argue that spending the money on education, infrastructure etc instead would be better for the future prospects of the economy. This side also suggests that excess funds could be used to cut taxes, thus reducing deadweight losses and spurring consumption to boost the GDP.
The experiments of Macroeconomics can only be observed, not conducted, in the natural laboratory that we call economy. Therefore in this article, we analyze the debt levels of some of the major economies in the world, in an attempt to form an objective view of the role of debt and
the nature of policy response suited to it.
With a national debt of well over 200% of its GDP, Japan is the most indebted nation in the world. This debt can be traced to several factors. Post the 1990s bubble burst, the Government of Japan spent a lot of money to bail out many banks and other institutions. Rising social security costs due to the country’s ageing population has exacerbated the matter. While a major chunk of its debt being owed domestically is a mitigating factor, its low productivity and population ageing cast serious shadows over its long term future.
Even with such gargantuan levels of debt, Japan continues to be a stable and creditworthy nation that attracts investors. Since the interest rate has been at zero for over 2 decades, servicing the debt is cheap for the government. But if another global crisis were to strike, the government lacks sufficient monetary and fiscal space to provide a policy buffer, with interest rates close to zero and fiscal deficits continuing. Yet there’s a view that fiscal tightening due to fears of imminent crisis will end up straggling economic recovery. Higher inflation could gradually erode debt, but in a country full of price conscious pensioners, destroying their savings might not be a good idea.
The accumulation of federal budget deficits on account of new programs and tax cuts, borrowing from Social Security Trust Funds, buying of bonds by China and Japan to depreciate their currencies against the dollar, low interest rates on account of trust in the US economy have all been reasons why US national debt has ballooned to current levels. China and Japan each own over 1 trillion dollars worth of US securities.
Around 30% of the debt is intragovernmental holdings, with agencies like the Social Security Trust Fund buying US treasuries with the excess revenues they generate. If you add up the debt held by the Social Security and all the retirement and pension funds, almost half of the US Treasury debt is held in trust for retirement. Thus if the United States defaults on its debt, current and future retirees would be hurt the most. There is a gnawing fear that the heavy burden of interest payments could make it harder for the government to repair ageing infrastructure, spend on Medicaid, allocate more funds to Defense Budget etc. When rates went down to record lows, it allowed the government to take on more debt without paying more interest – but that’s not possible anymore with rising interest rates that make borrowing even more expensive.
In China, the problem is not the government's direct debt (which is less than 40% of GDP), or the reasonable 3% deficit. The issue is the debt being carried by the State-Owned Enterprises(SOEs) and local governments. China’s officials tend to use a combination of local
government financing and the lending policies of state-owned banks to channel a lot of central government actions through the accounts of local government, leading to a significant amount of hidden public debt.
After the recession, the country spent trillions on infrastructure projects, with many banks, including unregulated or "shadow" banks, loaning money to companies that have been unable to pay back their debts. Shadow banking, a 10 trillion dollar network of unregulated lending and risky investment products, is a major problem for China. The government has recently started clamping down on the bad loans problem, but it still has a long way to go.
Optimists say concerns about China’s debt are overblown, that companies and local governments can simply grow their way out of the problem as an expanding economy supports borrowers and creates inflation, which erodes the burden of debt repayments. China’s high savings rate helps, as does a long run of current-account surpluses, which makes the country a net lender to other nations rather than a net borrower. But on the other hand, there’s a risk that China’s debt could at best be a drag on global growth for decades or at worst trigger a new financial crisis. As happened with US in 2008, a financial meltdown in China could have severe ripple implications around the world. Don’t reach for the panic button, though – any potential day of reckoning is far far away yet.
At close to 70% of its GDP, India’s gross general government debt is higher than that of most other major Asian economies, except for Japan. Credit rating agencies like S&P and Moody’s have said that government debt is a major factor in India’s low ratings. This means that India’s interest outflow is high as well.
Typically, emerging markets do have high debt since government spending is higher, but the debt problem makes it crucial that the GDP growth be steady in the future. The ultimate use of the borrowed funds is critical. One aspect in which India and other major Asian economies have done remarkably well is the low household debt to GDP ratio in comparison to credit fueled economies like USA where the
value is astronomical. The IMF has recently said that India’s combined gross debt is set to decline by almost 9 percentage points by 2023-24, creating the basis for a lower interest rate regime and possibly a sovereign rating upgrade.
When it comes to dealing with public debt, perhaps Keynes expressed it best. In times of prosperity, governments have to restrain their spending and gradually cut down on any accumulated debt from lean times. On the other hand, in times of difficulty, governments must
stop looking at their balance sheets and spend freely to lift the economy. In an era of booming economic prosperity, then, perhaps it is slightly alarming that governments around the world continue to accrue debt. No doubt the effects of the Financial Crisis are still being felt. Developing countries must spend more to build their nation, of course, but not at the expense of credit rating downgrades leading to borrowing becoming more expensive. The phenomenon of debt has a huge psychological factor as well. So long as creditors continue
to consider Japan and US as safe havens, any levels of debt on paper wouldn’t matter. China provides an intriguing case study of the benefits/risks of aggressive deficit spending to boost the economy. India and US provide a glimpse of the politics of debt as well, with politicians conveniently choosing to portray debt as a boon or a bane depending on whether their party is in power or in the opposition. The picture looks rosy for now, but if the economy slows, governments around the world would be left with very little room for policy maneuver. Keep really quiet, and you can almost hear Keynes rolling over in his grave.