Tuesday, 1 February 2011

Reducing the national debt does not involve much austerity.


A proper analysis of the national debt is impossible without splitting it into its component parts, e.g. foreign owned and domestically owned debt. There is also an important distinction between the structural debt, and in contrast, the part of the debt that has accumulated as a result of attempts to bring stimulus.

Reducing the part of the debt that his held domestically does not involve austerity. In contrast, if foreigners SUDDENLY reduced their debt holding, and had it repaid in the form of real goods and services WOULD involve austerity, but at a guess, that is unlikely to happen rapidly.


National debt arises, amongst other reasons, simply because of politicians’ failure to collect enough tax to cover government spending, even at full employment. Politicians’ motive here is to win votes: taxes are unpopular. This is often called the structural deficit, and it will be given this name here.

Where politicians fail to collect enough tax with a view to gaining support from the electorate, and borrow instead, harm is done. Greece is a classic illustration. It strikes me it just has to be possible to get rid of this “dishonest” or “cloud cuckoo land” part of the overall deficit without doing any harm. The only question is how, or what exactly are the mechanics?

Christina Romer (former chair of the US President’s Council of Economic Advisors) puts the structural deficit at 6% of GDP and rising by 2020 unless something is done. Given that Geoffrey Sachs puts the CURRNET TOTAL deficit at 10% of GDP, the 6% figure seems a bit low. But this article is concerned with general principles, not with EXACT figures, so let’s move on.

Second, there is debt which has built up as a result attempts at Keynsian type stimulus.

Is the concept “structural” relevant?

The concept “structural deficit” can be questioned. For example Chris Dillow claims the structural deficit is near impossible to measure with any accuracy, and hence that the concept is not useful. The answer to that is that the fact that a concept cannot be quantified does not stop it being a vital theoretical concept. This sort of thing occurs over and over in science: that is, concepts pop up that are impossible to measure with any accuracy, but which are nevertheless essential for decent analysis. Many nuclear particles spent decades as nothing more than ideas in the brains of nuclear physicists before actually being seen in particle accelerators.

The tools used to reduce deficits reduce both the structural and stimulus deficit.

There is a big problem with the structural and stimulus elements of the debt and deficit, which is that the tools used to influence each category unfortunately influence both. This tends to lead to the idea that the structural deficit cannot be reduced without austerity. I’ll explain.

The best reason I know of for the idea that reducing the structural deficit involves austerity is that paying back government debt holders is the reverse of the classic Keynsian “borrow and spend” policy, which is normally seen as having a stimulatory effect.

So let’s go along with the conventional wisdom here and assume that having government borrow and spend $X in one year has the effect of raising aggregate demand by $X x Y. That means that when the policy goes into reverse, i.e. $X worth of taxes are raised, and used to repay government creditors, aggregated demand will decline by $X x Y.

And that doubtless makes it look as though the structural deficit cannot be reduced without austerity. But austerity by definition is “anti-stimulatory”. It is deflationary (in the aggregate demand reducing sense of the word).

A tool has been used to reduce the structural deficit which unfortunately has influenced the relevant country’s stimulus / deflationary stance. Thus to have an effect on matters structural alone, it is necessary to take measures to nullify the latter effect. It’s a bit like taking a drug which has an undesired side effect, and taking a second medication to nullify the side effect.

And the “medication” required to nullify the side effect is very simple: QE. That is, have the government / central bank machine create new money and buy back some government debt. The effect of that is stimulatory (though to what degree is obviously debatable). And apart from the desired stimulatory effect, national debt is also reduced, which is exactly what is needed, since the ultimate object of the exercise is the reduce the debt.

Conclusion so far: there is no good reason for reducing the structural debt to involve austerity, at least as far as domestic holders of debt are concerned. As to foreign holders, some austerity is possible, but at guess is unlikely to be significant.

Maturing debt does not involve austerity.

Initially, there is no pain or austerity when debt matures. That is, holders of the debt (in the case of the US) just swap their Treasuries for dollars. No real sacrifice is needed by the local population, regardless of whether it is domestically or foreign held debt. Indeed, the local population is at least temporarily better off because it will have to fund less by way of interest payments to former debt holders. (By the way, the US is used here only for purposes of illustration: the argument is just as relevant to other countries that issue their own currency.)


As to the idea that reducing the stimulus deficit results in austerity, well that is true by definition. But there is no point in reducing a stimulus deficit if stimulus is required! That makes as much sense as putting your foot on the brakes if you want your car to go faster. The result will be excess unemployment. And what’s the point of that? Anyone know? Please contact me if you know.

Foreign debt holders.

If foreign holders use their newly acquired dollars to purchase US produced goods and ship them out of the US, that is a REAL repayment of debt: it involves blood, sweat and work by US citizens. It is blood and sweat that could have been used to produce goods for consumption by US citizens. (I’m assuming here for the sake of simplicity that the economy is already at capacity and that anything produced for export must come at the expense of stuff produced for internal US consumption.)

That is a REAL cost or “sacrifice” for US citizens. But foreign holders are unlikely to do this QUICKLY. Certainly the Chinese have an obsession with exporting and building up an absurdly large stock of other counties’ debt. They have become more reluctant of late to hold US debt and have moved into European debt. But that has not dented their enthusiasm for US debt by much. So there is unlikely to be MUCH pain coming from this quarter, though there could be a finite amount of pain. See here and here.

As to the possibility that foreigners suddenly lose much of their faith in the debt AND currency of a country, and dump significant quantities of both, the currency obviously loses value on the foreign exchange markets. That certainly WOULD involve reduced living standards for US citizens. But it also hurts foreign debt holders (one of their assets, US debt, loses value). This is an additional incentive for them not to move quickly on this one.

There is of course there is always the possibility of a stampede for the exit, or “fire sale” of dollars and US debt. But would this lead to a total collapse in the value of a currency in the foreign exchange markets? The simple answer is that that has never happened (far as I know) except where the relevant government is clearly going for a wholesale debasement of the currency ANYWAY (a la Mugabwe or Weimar).

A partial dumping of both the debt and currency of a country certainly means a devaluation of the relevant currency, which in turn means a standard of living cut for residents of the debtor country. But the British pound lost 25% of its value relative to the US dollar in 2008 and has subsequently remained at that reduced value, yet the population of the UK scarcely noticed! There certainly weren’t any Greek style riots in the UK in 2008, 9 or 10. There HAVE been demonstrations in the UK very recently, but these have been aimed at the recently elected Conservative lead government.

To summarise so far, a potential source of austerity comes from a reduction in debt held by foreigners. But this is more likely to be a slow reduction than a sudden reduction, at a guess.

Cutting the INCREASE in foreign held debt.

As distinct from foreigners cutting their debt holdings, there is of course a stage to be gone through first, namely that foreigners cut the rate at which they are currently INCREASING their holdings. “Cutting debt holdings” and “cutting the rate of increase in holdings” are just part of the same continuum, and the effects are the same dollar for dollar.

For example, for the last decade or so, China (and other countries) have shipped billions of dollars worth of goods to the US. Effectively these countries have not asked to be paid for a significant portion of these goods because they have taken US government debt in payment instead. That represents a significant, if temporary, standard of living boost for US citizens.

The actual extent of this boost has been a bit over 3% a year in recent years according to my calculations. So an immediate stop to the INCREASE in foreign held debt would result in US living standards rising by a good 3% less than they would otherwise have risen. That would cause riots in Greece. And it would be more than enough for some politicians to be voted out of office in the US.

But to repeat, (and this is a political judgement), any change here is more likely to be slow rather than quick.

The real obstacles are debt reduction are political.

The REALLY BIG problems involved in debt reduction are political not economic. That is, as pointed out above, debt increases buy votes for the politicians responsible. Thus debt reductions tend to lose votes. Hence Obama’s near silence on the subject (apart from about one worthy sounding generalisation) in his recent State of the Union Address.

Of course voters CLAIM to be concerned about debt. But the claim involves a fair amount of double talk and hypocrisy: tell them what debt reduction involves in terms of tax increases, and they’ll immediately riot (in Greece at any rate). And what is even more ridiculous, is that those tax increases, as long as they are combined with the right amount of national debt buy back, DON’T result in austerity: that is voters are no worse off as a result of debt reduction (with the exception, as pointed out above, of a foreign held debt reduction).


Reducing or abolishing a structural deficit while maintain a constant stimulatory (or deflationary) stance does NOT lead to pain or austerity for the local population AS A WHOLE. (Though of course a particular MODE of debt reduction can always be arranged so that it hurts particular groups and benefits other groups of the local population.)

Reducing or abolishing a structural debt just involves raising taxes and/or reducing public spending by whatever amount we like, and at the same time, buying back some of the debt with new money or “printed money”. So long as the relative amounts of tax increases and money creation etc are correct, the deflationary effect of the former will cancel out the stimulatory effect of the latter. Thus, ideally, there is no net austerity (or simulatory) effect.

Ensuring that the actual sums involved in the latter tax increases, new money creation, etc ARE such that there is neither an austerity or stimulatory effect is difficult, of course. But the point is that there is no reason IN PRINCIPLE for debt reduction to involve austerity.

Advocates of Modern Monetary Theory (MMT) will note the MMT “flavour” here: that is, the actual AMOUNTS collected in tax or spent or borrowed are near irrelevant. The important point is the stimulatory or deflationary EFFECT of $X of tax, $Y of borrowing or $Z of spending.

As to the portion of the national debt held by foreigners, austerity certainly WOULD be involved if they arranged to have their debt repaid with real goods and services, and wanted this done quickly. But if foreigners want their debt repaid, it is more likely they go for a SLOW pace of repayment, at a guess.

Now I’m bound to have got something wrong there. Ideas anyone?

Incidental point: is reducing the national debt important?

The national debt in the UK and US relative to GDP is still less than half the level that existed immediately after WWII (over 200% of GDP). This debt level did not involve any great problems. A similar 200% level obtained in Britain immediately after the Napoleonic wars over a century earlier. Plus Japan’s debt is, or was recently over the 200% level. So the current debt level is not a cause for panic.

On the other hand, it is arguable that national debts are a nonsense for reasons I spell out here. So reducing or abolishing national debts is probably not a bad idea.



  1. I don't see the distinction between domestic and overseas holders of currency or bonds. When an non-domestic person holds your currency you have control over them.

    Anybody holding the national currency becomes part of the currency zone regardless of where they are physically located. The only way that anybody can swap the currency for stuff is if that stuff is on sale in that currency.

    If anybody holding 'money' (whether bonds or currency) starts spending rather than saving then that has a stimulatory effect on the currency zone. More stuff will be produced and you will get an increase in the activity of the zone.

    So if people start releasing their bonds for real stuff rather than holding them (or swapping them for other financial assets) it will be boom time for the economy concerned. The initial spend will be dwarfed by the ripple effect as the money bounces around the economy.

    And from that you collect more tax. It's the hoarding of money in bonds and currency that stops the tax being collected.

    If you have $100 spent by the government and if everybody spends immediately then the government gets $100 back in tax.

    The concept of a 'structural deficit' is meaningless, since it is nothing more than the mirror image of 'structural savings'.

    It is perfectly possible to engineer government policy so that money ends up as savings rather than being taxed away. Saving creates the same space for public spending as taxation does, but wins more votes.

    However if you do that, you can't really have 'tax advantaged pension schemes' to encourage people to save and then complain about a structural deficit.

    But if you use savings rather than taxation to make space for necessary public spending, then you have to ensure that the saving takes place and is maintained. Probably by putting interest rates up pre-emptively.

  2. You claim that “If anybody holding 'money' (whether bonds or currency) starts spending rather than saving then that has a stimulatory effect on the currency zone. More stuff will be produced and you will get an increase in the activity of the zone.”

    That is true assuming the relevant economy has capacity to spare. But under the heading “Foreign Debt Holders” I assumed the economy is at capacity.

    If the economy was NOT at capacity, then as you say, demand and employment would rise. But in this case, no standard of living increase would ensue from the employment rise because the extra production would all get shipped abroad (that assumes no multiplier effect). If there IS a multiplier effect (i.e. employment rises by more than is required to produce the exports), then to that extent there WOULD be a standard of living rise (far as I can see!).

    Re your claim that the structural deficit is meaningless, I think it is a quite widely accepted concept. E.g. this FT article defines it as “A budget deficit that results from a fundamental imbalance in government receipts and expenditures, as opposed to one based on one-off or short-term factors.” That’s pretty near my definition. See: http://lexicon.ft.com/Term?term=structural-deficit

    But there are plenty of other definitions. That just illustrates that this is a very difficult and complicated and abstract area. I had more trouble drafting the above article than anything to date.

    And finally…..I enjoyed your one liner on Bill’s blog: “1000 people believing in fairy stories and phantasms is a religion, 100 is a cult, 10 is a coven, 1 is a nutter.” If you’ve got any more of that quality, keep them coming.

  3. Ralph
    You may find this interesting re the revaluation of the RMB?
    "This means that China takes no loss. It can buy and pay for just as much “stuff” after the revaluation, and with less implied PBoC borrowing, as it could before the revaluation – and the real value of money is what you can buy with it. So the real value of the reserves hasn’t changed at all – just the accounting value in RMB, but this simply recognizes losses that were already taken long ago when the trade was first made, and should be a largely irrelevant number ... !



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