Public Debt Deserves Respect for its Economic Role – There is no Alternative to Public Debt

 

        The public debt is the debt raised by the government to bridge its gap between income and expenditure. It is called the public debt as the general public has to repay it as the government is owned by the public. Depending on the maturity and repayment profile of the debt, members of the future generations also have to pay a part. As governments habitually roll over short-term debt (repay the debt by raising a new short-term debt) due to their cash flow constraints, short-term debt is also passed to future generations. Therefore, debt cannot be virtually divided between short-term and long-term.

Public Debt and Inflation Hypothesis

Public debt which has a long history is a topic widely consumed by Economists. Economists following Monetarist views tend always to find fault with public debt. Their core contention is about the underlying budget deficit and its adverse impact on the money supply and inflation. The bread and butter of the Monetarists are money and inflation. They believe inflation as a monetary phenomenon always everywhere as money is neutral on the output in the long run. Therefore, any increase in money stock eventually raises prices and inflation as money fuels aggregate demand in the economy. Therefore, their immediate recommendation for the control over inflation is the control over the expenditure of the government being the major player in the aggregate demand.

Accordingly, the government’s link to inflation is the money created in the banking system to finance the budget deficits that underlying the expenditure. Therefore, they don’t like both the sovereign deficits and debt. Accordingly, some tend to prescribe arbitrary benchmarks for maintenance of budget deficit below 5% of GDP and public debt stock below 75% of GDP, the fiscal space to control inflation. Further, the widespread concept of central banks for being kept independent from the Treasury/government is the recommendation made by this monetary school of economists to guard the money stock aligned to inflation targets insulated from the budget deficit and debt.

Coronavirus and Public Debt

The historic rise in budget deficits and public debt globally to fight the Coronavirus and the recession induced by the virus through sudden disruptions of global supply chains is now well known. Further, historically ultra-loose monetary policies to facilitate debt creation for fiscal deficits by printing money in quite coordination with the governments are now in place. In fact, leading central banks in the world urged the governments to offer fiscal stimulus to households and businesses affected by the virus as loose monetary policies alone are not adequate.

The Chair of the Federal Reserve, the world’s most influential central bank, stated that the Fed has only lending powers and it can lend to those who are considered able to repay. Governments have to use their taxing and spending powers to help those affected by the virus. He further stated that the Fed’s monetary policy at this juncture did not consider possible inflation hypothesis and debt sustainability as those can be addressed later, if necessary, once recovered from the virus. Therefore, both monetary policy and fiscal policy were stimulating budget deficits and public debt to expand aggregate demand for the recovery of production, income, spending and employment by leaving out the conventional inflation targets.

The resulting fiscal outcomes of developed countries and Asia are given in the table below to understand the quantum increased in 2020 and expected in 2021. As the virus is spreading in new variants in 2021, the fiscal and monetary stances are globally pursued at the same loose strength in 2021.

Although Monetary Fundamentalists at the beginning did not quarrel over such ultra-loose policy stance, they have now begun to demand central banks to start tightening now to prevent future inflationary pressures arising from the fiscal-induced monetary expansion. However, most central banks respond that present inflationary pressures are transitory due to supply constraints/disruptions caused by the virus and state that they have instruments to deal with permanent inflationary pressures, if any, in the future.

Therefore, anti-public debt stance now seems to resume among those monetary economists and opposition politicians whereas money dealers who gamble on inflation expectations and monetary policies debate on tapering timelines for assets purchased by central banks. Meantime, few central banks in developing countries have shown bizarre interest in tightening monetary policies (possible influenced by those critics/monetary fundamentalist) now to prevent possible future inflationary pressures based on monetary hypothesis even when their economies are further affected by the new stronger Delta virus variant without any firm signs of the socio-economic recovery from the first virus.

How Public Debt helps economies and public – An Insight into Debt Fundamental

Many who criticize budget deficits and public debt also refer to debt bubbles, traps and bankruptcies similar to debt of households and companies in addition to inflation hypothesis. However, they do not seem to understand the public debt fundamental in economies. This can be easily understood by looking at how economies depend on public debt for smooth momentum as highlighted below. In that context, nobody can propose any alternative to public debt. However, the public debt management is a different subject.

Aggregate Demand in the Economy funded by the Public Debt

The government is the single largest contributor to the aggregate demand which decides the fate of the economy in any country. This is done through public debt as the governments are not able to tax the people in the current year to finance its all demand for goods and services required to provide a host of public services in the public interest in the present governance systems. Everybody understands the contribution of public services such as law and order, social safety net, economic infrastructure that build the production and social capacity in the countries. Therefore, the extent of the economy funded by the public debt is vast. Nobody can think of an alternative to keep the momentum of the economy without public debt.

Money Printing based on Public Debt

Several central banks have evolved from state-chartered commercial banks established as banks to raise debt for the government. Therefore, those banks effectively operated on assets created on public debt which was instrumental in creating public trust in such banks. During that time, banks could issue their own currency notes as money. This position has continued with the state central banks licensed to print money later in the 20th century where some central banks have been assigned with public debt manager function.

Accordingly, central banks print money on the purchase of government debt instruments in the primary or secondary markets. Their lending to banks as lender of last resort is also based on the collateral of government debt instruments. Few central banks are mandated to print money on the purchase of private debt too, but it is done mainly in economic crisis times due to risks involved in private debt. The purchase of foreign exchange as a major source of money printing in developing countries is also virtually the purchase of government debt of reserve currency countries as such currencies are the liabilities of the issuing country governments. Further, the source of the major part of foreign currency reserves of central banks in developing countries is the proceeds of public debt raised in foreign currency. As such, the money printing by central banks is virtually a derivative of public debt. Therefore, central banks virtually exist on public debt as they or their mandates passed by the respective governments regarding public debt as risk-free.

Money Stock created on Public Debt

The source of money stock (or Money Supply) held by the public in form of currency and deposits is the credit created/granted by the banking system, i.e., banks and central bank. The credit to the government, a part of the public debt stock, is a major component of the bank credit system as the government is the major participant in the economic activities and spending. Therefore, a major source of money stock in any economy is the public debt that depends on the size of fiscal spending and deficit. If the government cuts down the growth of spending and debt, the money stock also will decelerate causing shortages of money in the economy unless bank credit to the private sector expands to offset the deceleration in the bank credit to the government. 

Monetary Policy based on Government Debt

The monetary policy is the fundamental duty of central banks. Money printing is a key part of the monetary policy. It further involves in regulating the liquidity in the money market on various targets. Central banks conduct open market operations (OMO) for this purpose, i.e., injecting money to and moping up money from the money market. Most part of OMO is based on the trade of government debt instruments through auctions for outright and repo basis. For example, daily OMO carried out to keep the overnight inter-bank interest rate within the policy rates corridors (main monetary policy instrument) of central banks is the overnight repo and reverse repo trade in government debt instruments.

In addition, longer-term trades also are carried out to regulate the liquidity in the money market from the short to longer-term as central banks consider appropriate. In addition, sterilized OMO is routinely carried out in the domestic currency market to neutralize the effects of the foreign currency market. Further, interest-free liquidity facilities are offered to participants in the central bank payment system on the collaterals of government securities.

Government Debt as the Most Secured Financial Asset

Investment in public debt is regarded as credit risk-free asset in the country. It comes from the monetary system itself as central banks base their operations primarily on assets created on purchase of public debt as highlighted above. Therefore, the private sector, individuals and businesses, tend to hold a part of their asset portfolio in public debt instruments such as direct loans and securities/Treasuries depending on their risk appetite mix across the broad spectrum of assets. As such financial markets are driven by frequent portfolio readjustments between private assets and public debt assets depending on the speculation based the information set available relating to the profile of risk and profit.

In this exercise, banks and insurance firms value their sustainability quite on the basis of the liquidity maintained primarily in public debt instruments. Regulators also prescribe public debt instruments as part of the liquidity statutorily prescribed under institutional soundness criteria. Therefore, the financial system outside the government too virtually operates on public debt.

The Yield Curve to drive the Monetary Policy and Financial Markets

The yield curve which depicts a plot of yield rates on public debt across different maturities tradable in the market is considered as the benchmark for assessing and determining the risks involved in the private debt. Accordingly, the yield curve is the lowest risk benchmark in the economy. Therefore, the risk of any private debt/credit transaction can be upsized by adding a risk premium on the relevant maturity point of the yield curve. Accordingly, the yield curve is divided into separate parts i.e., short end, medium and long end, to assess risks and determine interest rates on private debt and investments.

Central banks use very short end of the yield curve to drive the money market liquidity and interest rates under the monetary policy. In fact, they control those yield rates for the monetary policy purpose outside the real public debt market in order to influence interest rates in the economy. Although central banks mainly focus on overnight yield rates, some central banks adopt targets on few short-term yield rates such as 7-days, 14 days and 3-months. Accordingly, OMO in debt securities on repo for those times are undertaken through money printing.

For example, monetary policy in Bank of Japan for several years so far has been based on targeting 10-year government securities yield to be kept around zero. The US Fed used the “operation twist” strategy in 2011-2012 to lower long-term yield rates to encourage long-term investments for economic growth affected by the 2007-2009 financial crisis. In this strategy, the Fed first purchased short-term government securities to bring down the short-term yield rates close to zero and then started buying longer-term government securities by selling some of the shorter-dated government securities portfolio to bring down long-term yield rates.

Indian central bank also announced such a similar twist in March 2021, that is, the purchase securities maturing in 2025, 2028, 2030 and 2033, and sell short-dated securities maturing in November 2020, and February and May of 2022 with the aim of bring down the 10-year benchmark yield to below 6% in order to support the economy through facilitating the government’s borrowing programme.

Therefore, the yield curve and thereby interest rates on public debt are fundamentally controlled by the central bank monetary policies. For this purpose, central banks with agency functions for the management of public debt and state pension funds also operate various direct devices to control the yield curve at various ends/points outside the conventional OMO-based monetary operations. As such, the monetary policy controls and manipulates interest rates on public debt and, therefore, those rates are not primarily driven by the real debt market developments/fundamentals. Therefore, various concerns over irregularities taking place in fixing yield rates in a non-transparent/non-disclosed environment also are raised from time to time. In some periods, central banks in fact follow the trends on yield rates/interest rates on public debt controlled by themselves as highlighted above to gauge the market interest rate trend and then adjust the monetary policy to follow suit.

Resolution of Economic Crises and Slacks through Public Debt

The best example for the use of public debt to resolve economic crises is the present global coronavirus as highlighted at the beginning. Another recent example is how developed countries responded to the global financial crisis 2007-2009 primarily through fiscal deficits and debt supported by ultra-loose monetary policies. There are many country examples also for this. In general, during crisis times, governments bail out people and businesses, especially banks and financial institutions, in order to revive public trust and the economic momentum. In this regard, governments provide grants and capital to systemically important parties. In addition, blanket guarantees over businesses such as banks, deposits and bank credit are provided by governments to calm down panic minds.

These guarantees are contingent public debt that will realize as and when governments have to oblige them in the future. Governments provide such guarantees to businesses or contractors even in normal times to resolve cash flow difficulties involved in government businesses. If such guarantees are counted, the actual volume of public debt would be much more than what is reported. Even in normal times, the presence of moral hazard on the government shows how economic activities significantly depend on such contingent government debt. In fact, currencies issued by central banks are the liabilities of the governments and, therefore, resolution of any financial crisis requires public debt expansion to enable central banks to issue more currency to restore the financial system.

Further, governments are recommended to expand its spending through debt whenever economies confront slack times in the business cycles. It is the most recommended macroeconomic stabilization policy referred to as the ” Keynesianism” to fight recessions and slowdowns in economies. The present modern monetary theory is an advanced concept for the fiscal policy to dominate the monetary policy in modern monetary economies with electronic payment systems which is not unreasonable in view of the above facts on public debt and its direct and fast impact on the economy as compared to the inflation target based monetary policy.

Concluding Remarks

Monetarist views on the fiscal space are expressed without regard to the facts highlighted above. In this context, nobody can find an alternative to the public debt for its macroeconomic functions. Therefore, public debt deserves receiving due respect for its unique service to the economies.

The source of concerns over public debt seems to have links to certain aspects of debt management issues such as bunching, rollovers, repayment difficulties and debt sustainability. Therefore, resolution of those concerns is a separate subject that should not affect the economic role of public debt.

The need to allow the debt market to operate on market forces without so much direct and indirect control by central banks must be recognized for effective debt management in the real world. For this purpose, central banks have to find alternative instruments in their mandates to manage their functions.

Selected Fiscal Indicator, % of GDP

Item	2018	2019	2020	2021(p)	Increase in 2020
Govt Expenditure
Advanced Country Average	38.4	38.6	47.4	45.8	8.8
G 7	39.2	39.3	48.9	47.4	9.6
USA	35.4	35.7	46.2	45.0	10.5
Emerging Asia	30.3	31.3	34.4	33.2	3.1
Budget Deficit
Advanced Country Average	2.5	2.9	11.7	10.4	8.8
G 7	3.4	3.7	13.2	11.9	9.5
USA	5.4	5.7	15.8	15.0	10.1
Emerging Asia	4.5	5.9	10.8	9.2	4.9
Govt Debt
Advanced Country Average	102.5	103.8	120.1	122.5	16.3
G 7	116.9	118.0	136.7	139.5	18.7
USA	106.6	108.2	127.1	132.8	18.9
Emerging Asia	54.4	57.3	67.6	69.9	10.3
(p) Projected.             Source: IMF Fiscal Monitor, April 2021

 (Views in this article are based on the author’s hands-on experience on the related subjects)