Recently, I’ve had a few friends ask me about government responses to the pandemic and how sustainable this level of borrowing can be. They are all worried about government debt. With the amount of increased debt we are looking at, I’m not worried at all. And for your peace of mind, I think it’s worth outlining my thoughts.
A government is not like you
This is an important point because people often use personal finance analogies when arguing that government debt is a problem. But a government is not like a person. If it were, it would be a person that could live forever, whose income would grow forever and who could print money.
Governments get great interest rates
Because of these characteristics, rich stable countries can borrow at very low interest rates. So low, in fact, that real (accounting for inflation) interest rates are negative.
Look at the yields (interest rates) on 30-year Government of Canada Bonds:
With inflation at around 2%, a 1.2% nominal interest rate translates to a real interest rate of -0.8%. Put another way, inflation erodes that value of the bond faster that the interest accumlates.
These low interest rates are here to stay
But what happens when interest rates go back to normal? Well, take a look at what has happened to real interest rates over the last 800 years:
Interest rates have been on a downward trajectory for a long time, and there is no reason to expect that this trend will reverse.
Now, you might argue that even though the long-term trend is downward, interest rates could spike for a few years, or even decades. Even if that were to happen — and there are many reasons (e.g., a global savings glut) to think that it wouldn’t — the interest rates on government bonds are fixed for their term. These terms can be 10, 30, even 100 years in some cases. This provides a lot of certainty when it comes to government borrowing costs.
The debt never has to be paid off
There is no date where all of a government’s debt has to be paid back. When a bond becomes due, a government can issue another one, rolling over the debt indefinitely. In practice, a government has a diversified debt portolio with some bonds maturing and new bonds being issued on a regular basis.
Inflation and economic growth work to erode the relative value of the debt over time
The Canadian economy grows at a nominal (including inflation) rate of about 4% per year. It grew about 4% per year over the last decade, the last 20 years, and the last 30 years.
Imagine that you had an annual income of $100,000 and a debt of $100,000. In government terms, that would be a debt-to-GDP ratio of 100%. Now imagine that you lived forever, only paid the interest on your debt every year, and your income grew by 4% per year. Your income would be:
- $220,000 after 20 years
- $480,000 after 40 years
- $1,050,000 after 60 years
- $2,305,000 after 80 years
- $5,050,500 after 100 year
One hundred years later your debt is still $100,000 but your income has grown 50 times for over $5 million. Your debt-to-GDP ratio fell from 100% to 2% and all you did was pay the interest on your debt.
Alternatively, if you were happy with a constant debt-to-GDP ratio of 100%, you could have borrowed nearly an additional $5 million dollars over that time.
Canada’s gross debt-to-GDP ratio for all levels of government was just under 90% in 2019. The PBO projects Canada’s federal deficit to add about 8.5 percentage points to this by the end of the 2020-2021 fiscal year. For comparison, leading up to the crisis, Japan’s government debt-to-GDP ratio was over 200%. For the US, it was over 100%.
But don’t high levels of government debt lead to printing money and runaway inflation?
It is true that many central banks, including the Bank of Canada buy government bonds, which reduces borrowing costs but also increases the monetary base (essentially printing money, although it is all electronic).
But will this result in inflation? Look what happened to US money supply following the Fed’s quantitative easing program (essentially printing money, but through electronic purchases of bonds):
As you can see from the spike starting around 2008, money was created at an unprecedented rate. At the time, a number of people were warning that this would lead to runaway inflation. This is what happened:
It had no effect on inflation. This may seem unintuitive, and inconsistent with what you heard heard about hyperinflation in history class. But it’s not if you understand how inflation works and that printing money has a very different effect when interests are near zero.
Inflation is caused by activities in the real economy: the more intense use of machinery causing it to depreciate faster, or higher wages for works (e.g., due to competing offers or overtime). When interests are near zero, these is no difference between cash and debt. Therefore it does not matter whether a government chooses to create money or issue debt. And creating money does not affect the liquidity of financial institutions and change their behavour — they could already borrow from the central bank for free. It also does not create better investment opportunities in the real economy. All it does is put downward pressure on interest rates, which can help consumers, businesses and governments during recessions.
The cost of not taking on government debt during a recession
It’s not that I am in favour of wasteful government spending, even if high levels of government debt are sustainable. The question is, during a recession, what is the alternative? Not spending results in greater suffering now, and a prolonged downturn with lower GDP in the future.
The purpose of economics is to maximize well-being. In the current crisis that means supporting those who have been hit hardest and ensuring that there are jobs to go back to when this is over.