Wednesday, 9 February 2011

National Debts are a farce. Governments should cease borrowing.

There are four main reasons, or excuses for national debts, as far as I can see. They are all nonsense.

Number one: buying votes.

The first and most feeble reason for borrowing is that it enables politicians to buy or win votes by not collecting enough tax to cover government spending. Instead, expenditure is covered by borrowing.

This works because voters are more aware of tax increases than increased borrowing. Hence the temptation for politicians to borrow.

The ACTUAL EFFECT of this borrowing is pretty much the same as tax, or rather it has to be arranged so that the macroeconomic effect is the same. That is government spending which is not covered by tax is stimulatory, even inflationary. This has to be countered by some sort of deflationary measure: e.g. extra borrowing. (The word deflation is used in the “aggregate demand reducing” sense here.)

(Incidentally, this article is written only with countries that issue their own currency in mind. Thus the points made are relevant for a common currency area like the Eurozone. But care should be taken in applying the points to INDIVIDUAL COUNTRIES in the Eurozone.)

Borrowing from abroad.

In addition to borrowing from natives, governments normally fund deficits to some extent by borrowing from abroad. This activity is a farce and for the following reasons.

The real purpose of government borrowing, to repeat, is to counter the reflationary or stimulatory effect of government spending which is not covered by tax.

Incidentally, there are of course a large number of economic illiterates who have not grasped the difference between macro and microeconomics, and who think that governments borrow for reasons similar to a household borrowing when the household’s expenditure exceeds its income. These illiterates need to go away and work their way through a basic economics text book.

At any rate, where a government borrows from abroad, demand from domestic sources is NOT constrained as a result. To that extent, nothing is achieved by borrowing from abroad. Indeed, the relevant government WILL STILL HAVE TO BORROW from its own private sector in order to rein in demand (or implement some other deflationary measure). But assuming such a government goes for domestic borrowing in addition to borrowing from abroad it will end up paying twice as much by way of interest!

A total farce!

So what to do? On the face of it, there is no simple solution because it is administratively difficult for a government to issue bonds, while ensuring that those bonds are bought only by natives rather than foreigners. Well the solution is to abolish government borrowing!

Number two: borrowing with a view to stimulus.

Government borrowing also takes place with a view to stimulus. This is the classic Keynsian solution for a recession: governments “borrow and spend”. But there is a huge nonsense here, as follows.

Borrowing, at least to some extent, raises interest rates, which is deflationary. This means governments have to nullify this deflationary effect by the usual interest rate reducing ploy: creating new money and buying government debt. Which raises a big question: what was the point of borrowing in the first place? That is, where is the sense in government borrowing and then buying back the relevant debt?

Or to put it another way, why not just create new money and spend it and forget all about borrowing? Keynes was actually aware that the latter policy was the best and simplest. But he also knew he was surrounded by economic illiterates who would chant “inflation” in reaction to the idea. So he went for the more convoluted borrowing option and kept relatively quiet about the “create new money” option.

Incidentally Milton Friedman regarded the “create new money” policy as a perfectly viable option.

Number three: borrowing to purchase assets.

Governments frequently borrow in order to purchase assets, e.g. build infrastructure. But this makes no sense, and for the following reasons.

Borrowing makes sense (for a household, firm or any other microeconomic entity) where there is absolutely no other way of funding the relevant expenditure. For example when a family buys a house, the capital sum is normally so large relative to the family’s income and total assets, that borrowing is the only option. In contrast, when someone buys a pack of cigarettes, there is no need to borrow.

Now when the government of an average size country spends a hundred million on a new road or some bridges, a hundred million might sound like a big sum. But it’s small change compared to the government’s TOTAL budget. It’s the equivalent of someone buying a bottle of whiskey. There is thus no need for governments to borrow to fund infrastructure projects.

Put that another way, if a government DOES borrow for such projects and gradually pay back the capital sums involved, it will simply pay out each year almost exactly the same total sum as if it funds infrastructure projects out of income. The only difference is that under the “borrow” option it will have to pay interest as well!

Number four: spreading costs across generations.

A plausible sounding argument for government borrowing to fund capital projects is that this spreads the burden across generations because future generations ostensibly have to repay some capital and/or pay some interest. The flaw in this argument is that while various members of the next generation inherit the above liability, others inherit a corresponding asset, namely government debt or bonds. These two net to nothing.

Put another way, the brute physical reality is that it is impossible to build a road this year (2011) without diverting concrete, steel and so on from other uses in 2011 (assuming constant aggregate demand). That is, people living in 2011 have to sacrifice the consumption of other products to have the road built. Or put a third way, it is a physical impossibility to build a road in 2011 with concrete produced in 2050. It is also very difficult to have new born babies, or the as yet unborn build roads and bridges!

The only way for a government to “spread costs across generations” is for it to borrow from abroad, and gradually pay the debt back, as pointed out by Richard Musgrave (no relation) in the American Economic Review*. But if EVERY country does this, the ploy descends to farce.

* Musgrave, R.A. (1939). ‘The Nature of Budgetary Balance and the Case for the Capital Budget’. The American Economic Review, 29 (2): 260-271.


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