Understanding government debts and deficits

10 Feb, 2019 at 00:45 | Posted in Economics | 28 Comments

The balanced budget paradox is probably one of the most devastating phenomena haunting our modern economies. The harder politicians — usually on the advice of establishment economists — try to achieve balanced budgets for the public sector, the less likely they are to succeed in their endeavour. And the more the citizens have to pay for the concomitant austerity policies these wrong-headed politicians and economists recommend as “the sole solution.”

One of the most effective ways of clearing up this most serious of all semantic confusions is to point out that private debt differs from national debt in being external … A variant of the false analogy is the declaration that national debt puts an unfair burden on our children, who are thereby made to pay for our extravagances. Very few economists need to be reminded that if our children or grandchildren repay some of the national debt these payments will be made to our children or grandchildren and to nobody else. Taking them altogether they will no more be impoverished by making the repayments than they will be enriched by receiving them.

Abba Lerner The Burden of the National Debt (1948)

Few issues in politics and economics are nowadays more discussed — and less understood — than public debt. Many raise their voices to urge for reducing the debt, but few explain why and in what way reducing the debt would be conducive to a better economy or a fairer society. And there are no limits to all the — especially macroeconomic — calamities and evils a large public debt is supposed to result in — unemployment, inflation, higher interest rates, lower productivity growth, increased burdens for subsequent generations, etc., etc.

But the truth is that public debt is normally nothing to fear, especially if it is financed within the country itself (but even foreign loans can be beneficent for the economy if invested in the right way). Some members of society hold bonds and earn interest on them, while others have to pay the taxes that ultimately pay the interest on the debt. The debt is not a net burden for society as a whole since the debt cancel itself out between the two groups. If the state issues bonds at a low-interest rate, unemployment can be reduced without necessarily resulting in strong inflationary pressure. And the inter-generational burden is also not a real burden since — if used in a suitable way — the debt, through its effects on investments and employment, actually makes future generations net winners. There can, of course, be unwanted negative distributional side effects for the future generation, but that is mostly a minor problem since when our children and grandchildren repay the national debt these payments will be made to our children and grandchildren.

To both Keynes and Lerner, it was evident that the state has the ability to promote full employment and a stable price level – and that it should use its powers to do so. If that means that it has to take on debt and (more or less temporarily) underbalance its budget – so let it be! Public debt is neither good nor bad. It is a means to achieve two over-arching macroeconomic goals – full employment and price stability. What is sacred is not to have a balanced budget or running down public debt per se, regardless of the effects on the macroeconomic goals. If ‘sound finance,’ austerity and balanced budgets means increased unemployment and destabilizing prices, they have to be abandoned.

Discussing within which margins public debt is feasible, the focus today is solely on the upper limit of indebtedness, and very few ask the question if maybe there is also a problem if public debt becomes too low.

To guarantee a well-functioning secondary market in bonds it is essential that the government has access to a functioning market. If turnover and liquidity in the secondary market become too small, increased volatility and uncertainty will, in the long run, lead to an increase in borrowing costs. Ultimately there’s even a risk that market makers would disappear, leaving bond market trading to be operated solely through brokered deals. As a kind of precautionary measure against this eventuality, it may be argued – especially in times of financial turmoil and crises — that it is necessary to increase government borrowing and debt to ensure – in a longer run – good borrowing preparedness and a sustained (government) bond market.

To view government debts in terms of the ‘functional finance’ concept introduced by Abba Lerner, is to consider their role in the macroeconomic balance of the economy. In simple, bare bones terms, the function of government debts that is significant for the macroeconomic health of an economy is that they provide the assets into which individuals can put whatever accumulated savings they attempt to set aside in excess of what can be wisely invested in privately owned real assets. A debt that is smaller than this will cause the attempted excess savings, by being reflected in a reduced level of consumption outlays, to be lost in reduced real income and increased unemployment.

William Vickrey


  1. “can only provide means of sharing and distributing risk” – Bruce Wilder
    Derivatives allow risk to be split up and sold to those who want the risk exposure, often because they have other investments that expose them to another risk that moves in the opposite direction. The contract that splits up what was formerly indivisible many-faceted risk is itself a new net financial asset.
    Inflation swaps, for example, allow both inflation profiteers and inflation losers to remove inflation from their contract. The inflation winner gives a little of his inflation winnings back; the inflation loser gets higher payments offsetting his losses due to inflation. If disinflation pressures manifest, the party that profits more from higher inflation gets a minimum level of inflation and the party that wants lower inflation locks in a maximum rate. Both sides maintain their ratio of assets to liabilities no matter what inflation does. Both gain. Thus do derivative contracts constitute a new market-priced net financial asset.
    In panic times, the Fed has proven it will backstop the market price of the derivative contracts.

  2. The torrent of payments entailed by a large and marketable public debt — both the taxes that fund the debt and the regular payment of promised interest and principle — stabilize the banking and payments system, separating the demand for currency from the demand for money. A shortage of currency is so unfamiliar an experience in the modern world that we scarcely notice that the management of currency supply is a function of the central bank.
    Fractional reserve banking, which has attracted so much skepticism as Ralph Musgrave notes in a comment above, would scarcely be conceivable without a massive marketable public debt to serve as zero-risk ballast. What would the “reserves” consist of otherwise? Bullion and specie as in the days of the goldsmiths?
    Before economists question any other aspect of money and banking, I would suggest that they prohibit their own ungrounded use of a numeraire without money. Stabilizing the supply of credit and currency, and thru them, the value of a fiat money in prices of goods is no mean feat and it is accomplished in large part by managing the fiscal capacity of the state and a large marketable public debt.

    • — stabilize the banking and payments system, Bruce Wilder

      Which are currently one and the same which is the reason the banks hold the economy hostage during a banking crisis.

      • It seems to me that the banking and payment system is often not adequately regulated by public authority, in large part because our shared public understanding of how it works is so impoverished. Mainstream economics is an exercise in agnatology as far as money and banking are concerned.
        The U.S. acquired quite a stable system as a consequence of reforms undertaken during the Great Depression, designed by people who had a deep, practical understanding of the problems to be solved. That system was progressively abandoned beginning circa 1980 and continuing into the early 21st century while mainstream economists sat on their thumbs or cheered the reforms mindlessly.
        The Euro provides another instructive case in design by idiots. The architects of the Euro have only recently noticed that the banking systems of several European countries use their nation’s public debt for reserve; that debt is no long risk-free and several national banking systems are sliding slowly toward oblivion as a result — most notably Italy’s. I understand the gnomes of Frankfurt are designing some kind of complex derivative to serve banks in their need for a zero-risk security. Probably will work out about as well as “bail-in” bank rescue plans and plans for EU-wide deposit insurance.

        • The two should be separated since citizens have an inherent right to use their Nation’s fiat in account form anyway (e.g. Where’s my Federal Reserve debit card?) and because government privileges for the banks such as deposit insurance violate equal protection under the law and are an affront to a so-called free market.

          Not to mention how ludicrous and ad-hoc it is to co-mingle what should be 100% liquid, 100% risk-free deposits with at-risk, not-necessarily-liquid deposits via heavy explicit and implicit government privilege and for what good reason?

          There is no good reason unless looting the poor for the benefit of the banks themselves and for the most so-called credit worthy of what is then the public’s credit but for private gain counts as a “good reason.”

          • Well, I certainly would not want to affront “a so-called free market”. Heaven forfend!
            If you want 100% liquidity, just skip the bank altogether and keep a hoard of coins made from precious metals. Not risk-free, but can’t have everything.

            • Not risk-free, but can’t have everything. Bruce Wilder
              Why not? The banks have inherently risk-free accounts at the Central Bank. Why not citizens too?

              • I do not think I understand you. In an uncertain world, money (meaning the whole system of finance and payments) is a means of calculating and hedging and sharing risks in the doing of deals and transactions (at least those risks that can be financialized). In actual practice, as you indicate, the financial system itself can be subverted from its usefulness as an instrumental public good into a source of additional volatility and predation. But, even under ideal public administration, it is not possible to create an absolutely “risk-free” deposit. Uncertainty and risk are aspects of the world, and systems of credit, payment, et cetera can only provide means of sharing and distributing risk (including the unexpected consequences of uncertainty) and dampening the vicissitudes and otherwise unnecessarily risk aversive behavior that follow. What a central bank administering a marketable public debt funded from an efficiently administered fiscal capacity can do is create instruments that are useful as benchmarks and hedging instruments for a system; combine that with regulatory policing of frauds (including especially control frauds) and strategic subversion of the system, and that’s as good as it gets. Which is to say, the problems addressed by institutions of money and finance remain problematic because uncertainty is inherently and irreducibly problematic.
                That so many mainstream economists are making us suffer from their Dunning-Kruger effect — that they know so little about money and banking that is true, that they do not even know how little they know — adds to the world’s suffering from financial debacles.

                • But, even under ideal public administration, it is not possible to create an absolutely “risk-free” deposit. Bruce Wilder
                  Nominally speaking, it is possible and quite easy to create absolutely* “risk-free” deposits; i.e. accounts at a true Central Bank are risk-free and 100% liquid. Not so with private bank deposits** – hence they are unsuitable for anything but an at-risk, not-necessarily-liquid payment system in addition to a risk-free, always-liquid payment that accounts for all at the Central Bank would constitute.
                  and that’s as good as it gets. Bruce Wilder
                  That’s impossible to know since we’ve never had 100% private banks with 100% voluntary depositors since that requires quite a few conditions such as inexpensive fiat, accounts for all at the CB or Treasury, and no other explicit or implicit privileges for depository institutions.
                  * short of the end of the World as we know it, that is.
                  **except via heavy government privilege.

  3. And why, exactly, should government borrow private bank-created money at interest rather than creating the same amount of money itself to spend interest-free? Other than to provide unearned income to those who can’t be bothered to find a more productive employment for their excess purchasing power, that is.

    • Governments which issue their own money don’t actually borrow commercial bank created money: they borrow their own state created money (which is arguably even more ridiculous). But I agree with your point that it’s silly for government to borrow when it can print.

  4. Given that the debt of a monetary sovereign is inherently risk-free it should, on ethical grounds alone, return no more than ZERO percent MINUS overhead costs, i.e. negatively; otherwise we have welfare proportional to account balance.

    And since the debt of monetary sovereigns have, in fact, been auctioned at negative yields in recent history, the above cannot be dismissed easily.

    So the debt of monetary sovereigns is not so much debt as safe storage for fiat – for which there should be a storage charge, at least.

    Then who’ll complain about National Debt that is a revenue earner, not a revenue consumer?

    • Agreed. 3 MMTers (Mosler, Bill Mitchell and me) have written papers advocating the zero rate.

  5. “when our children and grandchildren repay the national debt these payments will be made to our children and grandchildren.”
    Or to Chinese children or grandchildren 😦

    The possibility of contracting national debt at reasonable rates, is a strategic asset, which no one should take away from a future generation, without an overwhelming reason.

    • What constitutes “reasonable rates”? My suggestion of reasonable is where inflation exceeds interest, i.e. where the debtor rips off the creditor.

    • Reasonable rates are negative (more in my comment below) and would also help with the trade deficit since they would no longer provide welfare to foreigners.

    • The best way to contract debt is by inflation. To my knowledge, no country has successfully actually PAID BACK their debt without doing more damage in the process. You simply outgrow the value that the debt is denominated in.

      Talking about debt as if the chinese “own our debt” is very silly in my opinion. China owns huge reserves of foreign currency, they just happen to choose to invest most of it by buying bonds denominated in those respective currencies. That’s not a problem because those bonds are still denominated in the respective national currencies.

  6. I had write about this on “Riodialogues”:I suppose a new rule for Central Bank: when one of the CB, respectively of each country or through international agreements ,have a new emission of money whith each rate the same bank print corresponding quantity of money of rate off budget ,and give this quantity,ffor free, to compense the monetary mass to solve the lack natural compensation previously provided by ‘gold mining , at a pubblic commission that use for pubblic necessity etc etc…we resolve three problem :pubblic necessity,pubblic balance,and market crisis,;for example : the B.C. have a emission of hundred billion unit and fix a rate of 3% and give this money to privat bank or pubblic… at the same moment print 3 billion extra and give these to “pubblic commission” that spend for pubblic problem …i hope to be clear but if not you can also have a look to :http://www.facebook.com/…/137335536277534

  7. Dear Lars,

    Do you consider wasteful (government) spending as a problem or should we not worry about it?

    • Of course we should! But we should also remember Keynes suggestion that in deep depressions “the Government should have people dig up holes and then fill them up”. Even though digging up holes and filling them up again may seem crazy, the multiplier effect on aggregate demand … 🙂

      • Thanks for the reply, Lars. I also had Keynes’ suggestion in mind. That is why I was asking if you consider wasteful spending to be a problem or not.

        If you think that Keynes was right and also believe that public debt is no problem, then why should we worry about wasteful spending?

        • Wasteful spending is not a problem (as Keynes said) in that hole diggers spend the money they earn, which employs yet more people (hopefully doing something more useful). But wasteful spending clearly is a problem in that with a very small amount of ingenuity, it is possible to find something better for people to do than dig pointless holes.

        • Keynes was being hyperbolic, which is something that is purposefully left out almost every time that quote is referenced. He was making the point that in a fictional hyperbolic scenario in which we can literally come up with no other productive ways to employ people, even something as crazy as having people dig holes and then fill them up again is preferably to doing nothing while unemployment rises and the economy tanks (paraphrasing here). Public debt is a problem if it’s being used to finance stupid things, like pointless tax breaks for the richest few (which does nothing for investment in productive capacity or increasing aggregate demand, mostly only inflating asset bubbles). This is because you can’t keep stimulating an economy in perpetuity with public debt without eventually hitting inflationary pressure, so while you shouldn’t fear debt as we’ve all been brainwashed to do, you also (the way I understand it at least) need to keep in mind that doesn’t mean debt doesn’t matter or can keep growing forever. You need to prioritize what you use it for, which is what I THINK Lars means when he says wasteful spending is bad.

          Personally, I think we can probably come up with about a million things we should do before all that’s left is digging holes and filling them up when unemployment starts rising.

      • “dig up holes and then fill them up”
        No, an unconditional universal basic income is a better alternative, except of course if you propose such hole digging mostly as a physical exercise routine.

        • People must be controlled. Idle hands are the devil’s workshop! If people are allowed to think for themselves, they might realize just how fickle and arbitrary society’s valuations are, and economists would get less attention …

  8. Professor…why not simplify this entire process, which at best can still be difficult for most citizens to understand, by changing the way the US Federal Gov’t. creates money…by removing the private sector (the Fed – a joint private/public ownership – and with US commercial banking) from the equation and allowing the Federal Gov’t. 100% control over creation of money and credit (like South Dakota does today, on a state-wide basis), without the resulting debt (sale of US Treasury securities)? Pls help me understand better where I maybe missing the mark with this possible solution? Many thanks for your insights. Clyde Weller, Jonesboro GA USA

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