Public debt isn’t ‘money for nothing’, but we shouldn’t panic about it

Public debt in the wake of the global pandemic isn't something to fear, especially when considering the benefits of wise investment, writes Professor John Quiggin.

OVER THE LAST YEAR, governments around the world have spent trillions of dollars to mitigate the economic consequences of the pandemic. In the process, long-held dogmas about balanced budgets and the evils of public debt have been discarded. But what, if anything, should replace them?

Debt, in itself, is neither good nor bad. When we borrow money, we gain the capacity to consume or invest more today, in return for giving up some of our income in the future. In the language of mainstream economics, the opportunity cost of having more today is having less tomorrow. Whether or not that is a good idea depends on how well we use the money we borrow today and on our capacity to repay the debt when it falls due.

Exactly the same is true on the other side of the transaction. The lender gives up consumption and investment opportunities now in return for more in the future. This will be beneficial if the lender – for example, a household saving for retirement – expects to need more in the future than today.

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Most of the time, the (near) future won’t be very different from the present. So, it doesn’t make sense to take on debt obligations to finance current consumption at the price of being poorer in the future. The wise uses of debt are to ride out crises like the current pandemic and to finance investments that will yield us higher income in the future.

Governments are different from households in crucial respect, but they are subject to the same logic of opportunity cost. Because governments continue indefinitely, there is no specific point at which debt has to be repaid.

But if the Government is to maintain any given level of debt at some point in the future, it faces the same trade-offs as a household. Suppose, for example, that the U.S. Government wishes to maintain debt at its current level of around 100% of GDP. As will be explained in detail below, this is consistent with a deficit budget balance equal to around 2% of GDP. Once this level is reached, any additional spending must be matched by tax increases, or cuts in other areas of spending, if the ratio of debt to GDP is to remain stable.

What about allowing a steadily larger ratio of debt to GDP? That sounds problematic, but the problems are more subtle than is commonly supposed.

Claims were made around the time of the Global Financial Crisis (GFC) that debt in excess of 100% of GDP led inevitably to disaster. But this analysis did not stand up to scrutiny. As often happens, some of the strongest claims turned out to have been generated by a spreadsheet error.

The bigger problem was that real-world experience showed the claim to be untrue. Most dramatically, the Japanese Government ran up debt equal to more than 200% of GDP without running into any trouble. The reality is that there is no simple rule to determine how much debt governments (or, for that matter, households) should take on.

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On the other hand, there are plenty of examples where governments have run into serious difficulties using debt finance. Most of the time, the problems arise when debt is owed to foreigners and denominated in a foreign currency. But governments only borrow in foreign currency when they are unable to borrow in their own currency at low rates. So, foreign debt crises typically start with governments hitting a limit on their capacity to borrow domestically.

The best approach to public debt starts from thinking about the opportunity cost of trading present benefits for future costs. It makes sense to take on debt to deal with emergencies like the pandemic and, before that, the GFC. Between disasters like this, growth in economic productivity, along with moderate inflation, will gradually reduce the ratio of such debt to GDP.

Increased public debt also makes sense when it is used to finance new investment, including investment in education. Particularly at the low rates of interest likely to prevail for the foreseeable future, properly selected public investments will generate more than enough income to service and repay the associated debt, leading to an increase in the net wealth of the public sector.

In summary, public debt isn’t “money for nothing”, but we shouldn’t panic about it.

John Quiggin is Professor of Economics at the University of Queensland. His new book, The Economic Consequences of the Pandemic, will be published by Yale University Press in late 2021.