Is National Debt Owed to Foreign Nations Simply a Claim on Domestic Output?

In a thought-provoking post criticizing Post Keynesianism, Cynicus Economicus argues that

The trick to understanding [sc. government debt] ... is not to think of government borrowing money, but of borrowing of resources. When a government borrows money from overseas, they are actually borrowing the output of that overseas country. For example, if borrowing from the Gulf states, it is the equivalent of borrowing oil .... All the time this consumption is taking place, there is an accumulation of an obligation to provide goods and services in the future to repay the loan of oil in the future. Those goods and services will necessarily require the consumption of resources (including oil) in the future to repay the loan of oil. If this is the case, then a percentage of the total resources of the US must be allocated to making this repayment.

In response to this, I made the point that foreign investors who either (1) fund a current account deficit through capital account surpluses, or (2) fund a government’s budget deficit by buying bonds are lending money, not output.

Money can be used to buy output or financial assets or real assets.

When you attract foreign exchange via a capital account surplus (“borrow” this money), the foreigners have bought a financial asset or real asset in your economy. They have an asset in exchange for their money and a return through interest payments, coupon rates or dividends and so on. They might sell this asset, exchange the domestic currency for foreign exchange (often US dollars) and then take their money to another country and buy a different asset. This type of activity happens all the time. And here is the fundamental point: no claim on the domestic output of the borrowing country necessarily happens. There simply isn’t an obligation to provide goods and services by the debtor country. There might be, but very frequently people are exchanging money for assets (real or financial) or vice versa.

A country pays for its excess imports (= current account deficits) through capital account surpluses. It gives foreigners financial assets and real assets in exchange for their money and a return on ownership of these assets. The foreign investors always want a return on their money, but there is no necessary claim on the output of the debtor country at all. Money can be taken out of the country by converting it into foreign exchange (often US dollars) and then the investor can buy another financial asset in a different country.

In fact, capital movements around the globe in the past 30 years have seen an explosion of speculative transactions, movements of “hot money,” and short term speculation on financial markets. People are investing money to make money and then to take it somewhere else and get further returns there through ownership of new assets.

We live in a world of current accounts (goods and services) and capital accounts (real and financial assets). A very great amount of money used to fund current account deficits or government deficits just gets moved around between financial and real assets between different countries – no claim on the actual output of the debtor country happens. Of course it could and often does, but this is very different from asserting that all or even most foreign debt must be paid back in the borrowing country’s output or saying that government debt is just borrowing overseas resources. Clearly, it is not.

In response to this criticism, Cynicus argues that I am “saying that lenders are lending with no expectation of interest in return. If this is the case, why lend?.

But I said no such thing, and have said quite clearly that foreigners obtain an asset in exchange for their money and a return (e.g., coupon payment on a government bond denominated in US dollars). Of course people get a return on their ownership of most assets. That return comes in the form of money. But then we are simply back to the truth that money can be a claim either on output or on financial/real assets.

Furthermore, Cynicus argues:

When a creditor lends a country money, they do so in the expectation that the money will be returned to a value that will allow them to purchase goods and services to a value equivalent at the time of the lending + interest. They do not want money, but the ability to purchase goods and services (or assets) in the country that is the destination of the lending.

They certainly want to get a return on their money and might want to use that money to consume goods and services to a value equivalent at the time of the lending plus interest. But in no sense is it the case that they will all demand such goods and services from the debtor country.

I can give a personal example. In the late 1990s, I was swept up in the tech bubble mania going on the US (yes, I was naive back then!). However, living outside the US, I exchanged my foreign dollars for US dollars and put that money into shares on the US stock market. Some time later I sold the stock at a higher price than what I paid for it and converted my US dollars back to my own domestic currency and make a tidy profit both in the rise in the value of the stock and the fact that the US dollar had risen in value. The US dollars I brought into my country could be used to claim the output of China, the UK, New Zealand or many other countries by the person or company that next used them. And as for me, I had no interest in consuming US output with the money earned. I used both the original investment and profit to consume my own country’s output. There must be millions of people like me who do the same thing. We are not interested in actually purchasing goods and services in the US. We just want a return in the form of money and then take that money overseas as US dollars and convert it back to our domestic currencies.

Strangely, Cynicus also states that

Alternatively, rather than use the money returned in repayment [sc. from the debtor country] to directly purchase output, they might decide to purchase the output indirectly by purchasing an asset. In doing so, they take greater risk for the potential reward of securing even more of the country's output.

But purchasing an asset in the debtor country is not simply “indirect” purchasing of that country’s output. The asset can be exchanged for money on a market but that money can be used to buy output or financial assets or real assets. There is no obligation on the debtor country to provide its output in exchange for the asset. That decision rests entirely with the creditor, many of whom shun output for financial assets or real assets, either in the debtor country or in someone else’s country.

For example, creditors who have bought US government bonds can just take their return (money from coupon payments) and the money from selling the bond, and then take their total US dollars (principal plus return) overseas and convert them into a local currency and buy further financial assets there.

And here is the fundamental reality: the US dollars they brought to the new country can be used to claim output from any country on earth and there is no necessary claim on US output at all. The alleged claim on the original debtor country’s output is severed. The US dollar is the world’s reserve currency. Most commodities in international markets are priced in US dollars. Those US dollars could circulate in international trade without ever being used to buy US output.

Projections of the UK’s Interest Burden on Gilts as a Percentage of GDP: The Reality Versus the Rhetoric

Most recently, Cynicus Economicus has drawn attention to the fact that the cost of servicing the UK’s interest payments on government debt might become a serious problem. He states in a recent comment on his blog:

As countries like the US and UK approach 100% of GDP, they argue for more borrowing. At what point, really at what point, will they stop asking for this? In the case of the UK, for example, absolute interest on borrowing is already rising to painful levels.

http://cynicuseconomicus.blogspot.com/2010/06/post-keynesian-solutions-reply-to.html

He has made a good point that needs to answered. It might become a problem in the future, but needs to be put into perspective.

Here is what Liam Halligan says in the Telegraph:

Annual interest payments on UK government debt, already £40bn, are set to reach £70bn by 2015.

Liam Halligan, “Budget 2010: Courage and conviction needed to tackle the worst crisis since 1976,” Telegraph, 19 June 2010.

These numbers seem shocking, but notice that Liam Halligan does not give us the true measure of this burden: its percentage of UK GDP.

For this, we need to go to the Office for Budget Responsibility (OBR) report published on the 14 June 2010. The absolutely crucial figure is given on p. 53 of the report:

[the] central government debt interest as a percentage of GDP increases over the forecast period from 2.9 per cent in 2010-11, to 3.7 per cent in 2014–15. The key determinant of this rise is the sustained high levels of borrowing over this period. The average annual growth rate in debt interest payments from 2010-11 to 2014-15 is 12 per cent.

Office for Budget Responsibility Pre-Budget Forecast, June 2010, p. 53

So in fact the burden of interest payments on gilts is projected to be about 3.7% of GDP in 2014–2015. This isn’t a catastrophe – it is less than the burden in the 1980s and early 1950s. And remember that this is a pre-budget forecast, so this is the burden if we assume no austerity measures.

Another blogger has also provided some sober analysis of this burden, and has pointed out that contrary to the rhetoric we hear this isn’t absurdly high, but is less than the burden in the 1980s and the late 1940s and early 1950s (see The Interest Burden in Context, June 14, 2010, Stumbling and Mumbling).

For a realistic assessment of the “burden” of the UK interest servicing, one can consult this graph:

UK Debt Interest as a Percentage of GDP

I advise people to have a careful look at this graph. You have to put the absolute figure of 70 billion pounds into perspective.

It is perfectly obvious that this burden will not be unprecedented and is only at the higher end of the average historical rate. The cost of interest servicing as a percentage of GDP was higher throughout all of the 1980s under Thatcher (at over 4.2%), and in 1996-1999 was about 3.5%, only slightly lower than where it will be by 2015. The UK did not collapse under the weight of interest servicing under Thatcher. Why would it now? Why is a burden of 3.7% of GDP hysterically touted as a disaster, when the burden was higher under Thatcher?

Paying 3.7% of GDP as interest on debt by 2015 is certainly a cost, but then what is the benefit? The benefit is that deficit spending (mainly automatic stabilisers plus some fiscal stimulus) will prevent a catastrophic debt deflationary spiral, a depression and mass unemployment. The benefit easily outweighs the cost, and the cost is fully justified.

There is also the question of taxpayer money being used to repay the debt. Cynicus argues that “each GBP of interest payments has to come from the taxpayers. Each GBP spent on paying interest is not going to be available to pay for other resources.”

One should note that even interest payments can be funded by rolling over debt and bonds that are bought back by the Bank of England are effectively retired.

Since foreigners own about a third of UK government debt, this is a cost. But then two-thirds is domestically owned, as you can see here. So two-thirds of the interest payments are just payments back to British individuals and institutions. They spend the money back into the economy or make it available again for saving or investment in assets. In other words, two-thirds of the interest is just a transfer back into the UK national economy, so the government is just recycling money. This is hardly a serious problem.

All in all, if we put the 3.7% of GDP figure into context, then thoughtful commentators should be saying this: “On recent estimates (and before austerity), the interest servicing of UK debt by 2015 will be less painful than under Thatcher and slightly more painful than under the early years of New Labour, but hardly ruinous. It will also prevent a severe contraction in the economy.”

One important point that Liam Halligan makes in the Telegraph article is that the historically low yields on UK gilts are the result of government policy: these are (1) QE and (2) the banks have been forced to buy UK bonds. This just reinforces the fact that policy tools are available to keep yields low, just as Japan has keep its bond yields low for nearly two decades.

In reality, the free market ideology of the Conservatives will no doubt mean that they will abandon these policies to keep yields low, but that will be a quite deliberate policy choice on their part whose effect the Tories will be responsible for.

It can also be pointed out that Paul Krugman has made the same point about the US debt servicing burden in response to the same type of fear-mongering from US conservatives.

The reality is that today the US interest burden is historically low. As a percentage of GDP, the US interest burden was actually much worse under Reagan and George Bush senior. Here is what Krugman concludes about present projections of US debt servicing:

George Will [sc. said] … that we’re in terrible shape because by 2019 the interest on the debt will be [$700 billion] …. [but] what we’re talking about is a debt-service burden roughly comparable to that under the first President Bush [sc. in terms of a percentage of GDP]. How many of the people now warning about the impossible burden of currently projected debt were issuing similar warnings back in 1992?

Paul Krugman, “The Dogbert Theory of the Debt,” November 30, 2009.

Krugman also provides a graph of the interest servicing as a percentage of GDP in his blog post. The worst period in the cost of US debt servicing was in the 1980s and 1990s: and yet the US was not bankrupted. Even on the worst projections – and these are the worst projections – the cost of servicing US government debt would return to the position it was under Reagan and Bush senior by 2015, and be slightly higher by 2019. But this is hardly a catastrophe, just a return to a higher burden, which the US easily managed then and could now.

I have also been challenged in other comments to provide a “hard limit” to government borrowing.

In fact, for the UK I have already done this before and have said that for the next decade 80% to 120% of GDP is reasonable, if necessary (see my reply to Sobers towards the end of the comments here).

However, I do not believe that the UK needs to push its debt-to-GDP ratio this high. If the basic structural problems of the UK economy were fixed, then a return to growth could be accomplished. I have frequently given solutions to the structural problems of the UK economy. The UK needs to:

1. Audit its banks and clean their toxic assets;

2. Nationalise those banks that took bailout money and have the banks pay it back;

3. Re-introduce effective financial regulation like Canada;

4. Large fiscal stimulus to bring down unemployment and increase business activity;

5. Adopt aggressive trade and industrial policies and rebuild manufacturing and output of tradable goods and services to bring down the trade deficit.

I am often challenged to give details of industrial policy. I have done so recently by showing how the US could rebuild its manufacturing by government policies to encourage better and wider use of automation and technology to increase manufacturing productivity and to lower prices.

The Save Your Factory movement launched by a company called Fanuc Robotics America Inc. should be made a US federal government program (for excellent analysis of it in a 2005 issue of Manufacturing Engineering magazine, see Rick Schneider, “Robotic Automation can cut costs,” Manufacturing Engineering 135.6 (December 2005): 65-72).

The UK could adopt a similar policy. Direct government allocation of credit at low rates or even direct subsidies could be given to domestic manufacturers to challenge low-wage countries and keep manufacturing in the UK and create more industry.