Why exactly do governments borrow? Well it’s not for the same reason as most private sector entities (households or firms) borrow, i.e. to make investments. While there are many who argued that government should borrow only to invest, that idea has not actually been put into practice.
The sad reality is that governments the world over borrow for a much more devious reason. The reason is that politicians are always tempted to ingratiate themselves with voters by increasing public spending and to ingratiate themselves even more by abstaining from raising taxes. That results in a need to borrow to cover the difference between money flowing into government coffers and the amount flowing out.
Simon Wren-Lewis (former economics prof at Oxford) calls that the “deficit bias”. And David Hume, writing three hundred years ago pointed to the same phenomenon. As Hume put it, “It is very tempting to a minister to employ such an expedient, as enables him to make a great figure during his administration, without overburdening the people with taxes, or exciting any immediate clamours against himself. The practice, therefore, of contracting debt will almost infallibly be abused, in every government.”
To summarise, the process that gives rise to government debt is for the most part as follows. First, politicians collect an inadequate amount of tax, i.e. they spend, or at least find themselves planning to spend more than will come in from tax each year. That in turn means the private sector (households and employers) are in possession of too much money (base money to be exact), and that would be inflationary if something were not done about it. So governments offer attractive rates of interest to those with cash to spare with a view to inducing those concerned to lock up their cash for a period of time, rather than spend the cash and thus cause excess inflation. And that whole process results in an entirely artificial rise in interest rates.
Worse still, it is not even clear that if public borrowing was limited to funding investments, that that would justify such borrowing. The reasons are obvious to every taxi driver: that is, if a taxi driver wants a new taxi and happens to have enough cash to buy one, the taxi driver won’t borrow money to buy the taxi!! Why pay interest to anyone when you don’t need to? In short, what justifies borrowing is a shortage of cash, not the fact of making an investment.
And as for large corporations, their investments are nowhere near all funded via borrowing: some of the funds come from shareholders and some from retained earnings.
But governments are never short of cash in that there is no limit to how much cash they can grab off taxpayers plus governments along with their central banks can simply print a certain amount of cash most years.
The latter point about the debatable reasoning behind “borrow to invest” simply reinforces the point that governments’ motives for borrowing are thoroughly murky, and probably unjustified.
To summarise so far, any rate of interest paid by governments on their debt is an entirely or largely artificial contrivance, and the same goes for interest paid by central banks on money deposited with them (i.e. interest on “reserves”).
But if a government does borrow, how is the interest funded? Well it’s funded out of general taxation, while the interest is paid (as already pointed out) to those excess amounts of cash. So in short, any rate of interest above zero involves robbing the poor to subsidize the rich!
Mad or what?
This simply reinforces the point made by advocates of Modern Monetary Theory (and Milton Friedman) namely that the best rate of interest is zero: i.e. that governments should not borrow, except perhaps in emergencies.
As for exactly WHERE advocates of MMT make the latter point, Warren Mosler, founder of MMT, made the point in the two works listed at the end below.
The above argument to the effect that any rate of interest above zero is unjustified (except in emergencies) leads to the inevitable and and somewhat disturbing conclusion that interest rate adjustments are not a justifiable way of regulating aggregate demand: that is, demand should be regulated simply by adjusting the amount of new money created and spent by governments and their central banks.
1. Huffington article by Warren Mosler entitled “Proposals for the Banking System”, 2nd last paragraph.
2. Paper entitled “The Natural Rate of Interest is Zero” (co-authored by Matthew Forstater.)