16.5 Other Perspectives on Government Debt

The policy debates over government debt have many facets. So far we have considered the traditional and Ricardian views of government debt. According to the traditional view, a government budget deficit expands aggregate demand and stimulates output in the short run but crowds out capital and depresses economic growth in the long run. According to the Ricardian view, a government budget deficit has none of these effects, because consumers understand that a budget deficit represents merely postponement of a tax burden. With these two theories as background, we now consider several other perspectives on government debt.

Balanced Budgets Versus Optimal Fiscal Policy

Economists and politicians frequently propose rules for fiscal policy. The rule that has received the most attention is the balanced-budget rule. Under this rule, the government would not be allowed to spend more than it receives in tax revenue. In the United States, many state governments operate under such a fiscal policy rule, since state constitutions often require a balanced budget. In Canada, this issue has been a recurring topic of political debate and several provinces adopted such a rule in the 1990s.


Most economists oppose a strict rule requiring the government to balance its budget. There are three reasons why optimal fiscal policy may at times call for a budget deficit or surplus.

Stabilization A budget deficit or surplus can help stabilize the economy. In essence, a balanced-budget rule would revoke the automatic stabilizing powers of the system of taxes and transfers. When the economy goes into a recession, taxes automatically fall, and transfers automatically rise. While these automatic responses help stabilize the economy, they push the budget into deficit. A strict balanced-budget rule would require that the government raise taxes or reduce spending in a recession, but these actions would further depress aggregate demand.

Tax Smoothing A budget deficit or surplus can be used to reduce the distortion of incentives caused by the tax system. As you probably learned in courses in microeconomics, high tax rates impose a cost on society by discouraging economic activity. A tax on labour earnings, for instance, reduces the incentive that people have to work long hours. Because this disincentive becomes particularly large at very high tax rates, as we learned in the appendix to Chapter 6, the total social cost of taxes is minimized by keeping tax rates relatively stable rather than making them high in some years and low in others. Economists call this policy tax smoothing. To keep tax rates smooth, a deficit is necessary in years of unusually low income (recessions) or unusually high expenditure (wars).

Intergenerational Redistribution A budget deficit can be used to shift a tax burden from current to future generations. For example, some economists argue that if the current generation fights a war to maintain freedom, future generations benefit as well and should bear some of the burden. To pass on some of the war’s costs, the current generation can finance the war with a budget deficit. The government can later retire the debt by levying taxes on the next generation.

These considerations lead most economists to reject a strict balanced-budget rule. At the very least, a rule for fiscal policy needs to take account of the recurring episodes, such as recessions and wars, during which a budget deficit is a reasonable policy response.

Effects on Monetary Policy

It is often argued that a large budget deficit leads to high expectations of inflation. We first discussed such a possibility in Chapter 4. As we saw, one way for a government to finance a budget deficit is to have the central bank buy up the newly issued government bonds—that is, simply to print money—a policy that leads to higher inflation. Indeed, when countries experience hyperinflation, the typical reason is that fiscal policymakers are relying on the inflation tax to pay for some of their spending. The ends of hyperinflations almost always coincide with fiscal reforms that include large cuts in government spending and, therefore, a reduced need for seigniorage.


In addition to this link between the budget deficit and inflation, some economists have suggested that a high level of debt might also encourage the government to create inflation. Because most government debt is specified in nominal terms, the real value of the debt falls when the price level rises. This is the usual redistribution between creditors and debtors caused by unexpected inflation—here the debtor is the government and the creditor is the private sector. But this debtor, unlike others, has access to the monetary printing press. A high level of debt might encourage the government to print money, thereby raising the price level and reducing the real value of its debts.

Despite these concerns about a possible link between government debt and monetary policy, there is little evidence that this link is important in most developed countries. In North America, for instance, inflation was high in the 1970s, even though government debt was low relative to GDP (at least by the standards of the years to follow). Monetary policymakers got inflation under control in the early 1980s, just as fiscal policymakers presided over a large increase in the debt ratio. Thus, although monetary policy might be driven by fiscal policy in some situations, such as during the classic hyperinflations, this situation appears not to be the norm in most countries today. There are several reasons for this. First, most governments can finance deficits by selling debt to the public and don’t need to rely on seigniorage. Second, central banks often have enough independence to resist political pressure for more expansionary monetary policy. Third, and most important, policy-makers in all parts of government know that inflation is a poor solution to fiscal problems.

Debt and the Political Process

Fiscal policy is made not by angels but by an imperfect political process. Some economists worry that the possibility of financing government spending by issuing debt makes that political process all the worse.

This idea has a long history. Nineteenth-century economist Knut Wicksell claimed that if the benefit of some type of government spending exceeded its cost, it should be possible to finance that spending in a way that would receive unanimous support from the voters. He concluded that government spending should be undertaken only when support was, in fact, nearly unanimous. In the case of debt finance, however, Wicksell was concerned that “the interests [of future taxpayers] are not represented at all or are represented inadequately in the tax-approving assembly.”


Many economists have echoed this theme more recently. In their 1977 book Democracy in Deficit, James Buchanan and Richard Wagner argued for a balanced-budget rule for fiscal policy on the grounds that it “will have the effect of bringing the real costs of public outlays to the awareness of decision makers; it will tend to dispel the illusory ‘something for nothing’ aspects of fiscal choice.” Similarly, Martin Feldstein, president of the National Bureau of Economic Research in the United States, argues that “only the ‘hard budget constraint’ of having to balance the budget” can force politicians to judge whether spending’s “benefits really justify its costs.”

These arguments have led some economists to favour a constitutional amendment that would require a balanced budget on an annual basis. Often these proposals have escape clauses for times of national emergency, such as wars and depressions, when a budget deficit is a reasonable policy response. Some critics of these proposals argue that, even with the escape clauses, such a constitutional amendment would tie the hands of policymakers too severely. Others claim that a balanced-budget requirement can be evaded easily with accounting tricks. Despite these concerns, several Canadian provinces have introduced legislation that restricts the size of their deficits (New Brunswick in 1993, and Alberta, Saskatchewan, and Manitoba in 1995). The European Union also has had such a rule. As this discussion makes clear, the debate over the desirability of a balanced-budget amendment is as much political as economic.

International Dimensions

Government debt may affect a nation’s role in the world economy. As we first saw in Chapter 5, when a government budget deficit reduces national saving, it often leads to a trade deficit, which in turn is financed by borrowing from abroad. For instance, many observers have blamed U.S. fiscal policy for the recent switch of the United States from a major creditor in the world economy to a major debtor. This link between the budget deficit and the trade deficit leads to two further effects of government debt.

First, high levels of government debt may increase the risk that an economy will experience capital flight—an abrupt decline in the demand for a country’s assets in world financial markets. International investors are aware that a government can always deal with its debt simply by defaulting. This approach was used as far back as 1335, when England’s King Edward III defaulted on his debt to Italian bankers. More recently, several Latin American countries defaulted on their debts in the 1980s, Russia did the same in 1998, and in 2011 Greece encountered the same outcome. The higher the level of the government debt, the greater the temptation of default. Thus, as government debt increases, international investors may come to fear default and curtail their lending. If this loss of confidence occurs suddenly, the result could be the classic symptoms of capital flight: a collapse in the value of the currency and an increase in interest rates. As we discussed in Chapter 12, this is precisely what happened to Mexico in the early 1990s when default appeared likely.


Second, high levels of government debt financed by foreign borrowing may reduce a nation’s political clout in world affairs. This fear was emphasized by economist Ben Friedman in his 1988 book Day of Reckoning. He wrote, “World power and influence have historically accrued to creditor countries. It is not coincidental that America emerged as a world power simultaneously with our transition from a debtor nation . . . to a creditor supplying investment capital to the rest of the world.” Friedman suggests that if the United States continues to run large trade deficits, it will eventually lose some of its international influence. So far, the record has not been kind to this hypothesis: the United States has run trade deficits throughout the 1980s, the 1990s, and the first decade of the 2000s, and it remains a leading superpower. But perhaps other events—such as the collapse of the Soviet Union—offset the fall in political clout that the United States would have experienced from its increased indebtedness. And Friedman’s prediction was perhaps made with a somewhat longer time horizon in mind.


The Benefits of Indexed Bonds

Several years ago, the federal government started to issue bonds that pay a return based on the consumer price index. These bonds are long-term. They have a 20- to 25-year maturity period, and they pay a low interest rate (until recently about 2 percent), so a $1,000 bond pays only $20 per year in interest. But that interest payment grows with the overall price level as measured by the CPI. In addition, when the $1,000 of principal is repaid, that amount is also adjusted for changes in the CPI. The 2 percent, therefore, is a real interest rate. No longer do professors of macroeconomics need to define the real interest rate as an abstract construct. They can open up the daily newspaper, point to the bond-yields table, and say, “Look here, this is a nominal interest rate, and this is a real interest rate.” (Professors in the United Kingdom and several other countries have long enjoyed this luxury because indexed bonds have been trading in other countries for years.)

Of course, making macroeconomics easier to teach was not the reason that the government chose to index some of the government debt. That was just a positive externality. Its goal was to introduce a new type of government bond that should benefit bondholder and taxpayer alike. These bonds are a win–win proposition because they insulate both sides of the transaction from inflation risk. Bondholders should care about the real interest rate they earn, and taxpayers should care about the real interest rate they pay. When government bonds are specified in nominal terms, both sides take on risk that is neither productive nor necessary. The new indexed bonds eliminate this inflation risk.

In addition, the new bonds have three other benefits:

First, the bonds may encourage the private sector to begin issuing its own indexed securities. Financial innovation is, to some extent, a public good. Once an innovation has been introduced into the market, the idea is nonexcludable (people cannot be prevented from using it) and nonrival (one person’s use of the idea does not diminish other people’s use of it). Just as a free market will not adequately supply the public goods of national defense and basic research, it will not adequately supply financial innovation. The government’s new bonds can be viewed as a remedy for that market failure.


Second, the bonds reduce the government’s incentive to produce surprise inflation. After many years of large budget deficits, the government is now a substantial debtor, and its debts are specified almost entirely in dollar terms. What is unique about the federal government, in contrast to most debtors, is that it can just print the money it needs. The greater the government’s nominal debts, the more incentive the government has to inflate away its debt. The government’s small switch toward indexed debt reduces this potentially problematic incentive very slightly.

Third, if the bonds were issued for much shorter maturity periods, they could provide data that might be useful for monetary policy. Many macroeconomic theories point to expected inflation as a key variable to explain the relationship between inflation and unemployment. But what is expected inflation? One way to measure it is to survey private forecasters. Another way is to look at the difference between the yield on nominal bonds and the yield on real bonds. As this book goes to press, these yields differed by about 2 percentage points, so at the time, Canadians were expecting inflation of 2 percent per year over the coming 25 years.

In the past, economists have proposed a variety of rules that could be used to conduct monetary policy, as we discussed in the preceding chapter. Indexed bonds expand the number of possible rules. Here is one idea: The Bank of Canada announces a target for the inflation rate. Then, every day, the Bank measures expected inflation as the spread between the yield on nominal debt and the yield on indexed debt. If expected inflation is above the target, the Bank contracts the money supply. If expected inflation is below the target, the Bank expands the money supply. In this way, the Bank can use the bond market’s inflation forecast to ensure that the money supply is growing at the rate needed to keep inflation close to its target.

Indexed bonds can, therefore, if made available for shorter terms, produce many benefits: less inflation risk, more financial innovation, better government incentives, more informed monetary policy, and easier lives for students and teachers of macroeconomics.8 image