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I. The Incentives
for Holding and Issuing Government Debt
Many people
invest their savings in government bonds. They are obviously of the opinion
that government bonds offer an attractive yield and represent fairly little
risk.
But wait a
moment. What do government bonds actually stand for? Who pays the interest on
these bonds? And who repays them?
A government bond
represents a loan to the public sector, and the government uses the funds to
finance its outlays: it pays politicians, bureaucrats, favored groups, social
security, military spending, infrastructure, etc.
The government
takes recourse to debt financing because tax revenues typically don't cover
its outlays. But why doesn't the government raise taxes, or reign in spending,
to fill the financing gap?
People don't like
to pay taxes. At the same time, they do like to receive financial benefits
from the government. Those in government, in turn, love to make people happy
by giving them money — as this is the best way to secure reelection.
Of all the
financing instruments available, debt financing is, economically speaking,
the most attractive from the viewpoint of the government and the electorate.
First, via debt
financing the government can finance its hand-outs without burdening the
taxpayer. The electorate can enjoy financial benefits for which it doesn't
have to pay.
Taxpayers just
have to shoulder the interest-rate costs on government debt, whereas the
repayment of the debt is transferred onto future generations of taxpayers.
Second, people
tend to buy government bonds voluntarily, so new debt can easily be issued
and placed with savers without causing political opposition.
Third, government
bonds are considered low risk: the government has the power to tax —
that is, to expropriate taxpayers — so investors in government bonds
have reason to be fairly confident that they will recover their investment
plus interest.
And fourth,
socialist-ideological economics do their best to legitimize government debt:
for instance, it is typically said that credit-financed public outlays
stimulate production and employment.
This, however, is
a misconception. The government doesn't create new goods by credit-financed
spending. Debt financing allows the government to considerably increase its
grip over scarce resources, resources that would otherwise be available for
alternative investment projects.
As the foregone
benefits of the unrealized investments do not typically come into sight,
peoples' indignation about wasteful credit-financed public spending remains
subdued.
II. The Incentives for Servicing Government Debt
There is another
important question to answer: why are current taxpayers willing to pay for
government debt built up in the past, debt for which they are not to be held
responsible and from which they didn't benefit?
The answer is
this: because doing so upholds the quality of government credit. For
if the quality of government credit remains favorable from the viewpoint of
investors, the rulers and the ruled can continue to take recourse to debt
financing.
The picture
changes drastically, however, if and when debt financing becomes unaffordable
for the rulers and the ruled.
"Of all the financing instruments available, debt financing is,
economically speaking, the most attractive from the viewpoint of the
government and the electorate."
Once issuing new
debt becomes too costly — as, for instance, borrowing rates exceed a
certain level, or the debt level breaches a certain threshold — the
economic incentive for rulers and the ruled to service the public debt
declines rapidly. It may actually evaporate altogether.
"Why keep
paying for debt that has been run up by other people?" the taxpayers
will ask themselves. "Why keep spending money on something from which we
no longer benefit?"
And the rulers
ask themselves, "Why engage in the politically unfavorable business of
taxing people, as neither we nor our subjects can issue any more new
debt?"
Of course, if
government debt is held in great part by the electorate, the government and
the ruled class have a strong incentive to keep servicing government debt, at
least in principle.
However, if
government debt has reached a level that dampens economic expansion and
lowers tax revenues, and if other government outlays cannot be reigned in for
political reasons, debt service will have to be paid for by new doses of
government debt — a situation that leads, sooner or later, to a
collapse of the quality of government credit.
If government debt
is predominantly held by groups who do not have a direct say in setting
government policies (such as, for instance, bond holders in other countries
or a minority group of the domestic electorate), the incentive for rulers and
the majority of the ruled to renege on public debt becomes fairly high.
Nowadays, most
investors in government bonds don't expect that the government will actually
repay its debt. What they expect is that a government bond becoming due will
be rolled over. That means that an investor today expects that there will be
investors in the future who will willingly lend money to the government.
Applying the same
reasoning, the future investors must also expect that, when their government
bonds become due, there will be other investors even further out in the
future who will willingly lend money to the government.
So if today's
investors lose confidence that there will be investors in the future to roll
over maturing government debt — because they (rightly or wrongly) fear
that neither the ruler nor the ruled have an incentive to keep servicing
government debt, the trouble starts.
What happens is
that investors start fleeing out of government bonds. Bond prices drop and,
conversely, government funding costs rise.
It does not take
much to see that investing in bonds issued by nations that have no capacity,
let alone willingness, to repay their debt is a fairly hazardous business, to
say the least.
III. The Incentive for Inflation
Lately, investor
concern that governments won't service their debt has been rising, according
to price signals sent by financial markets. For instance, credit-default swap
(CDS) spreads have been going up drastically across all major government bond
markets.
Simply speaking,
a CDS spread may be interpreted as the price for insuring the bond holder
against default. In that sense, the higher the CDS spread is, the higher is
the probability from the viewpoint of investors that the borrower might
default on its debt.
Figure 1
Credit default swap spreads, five-year maturities, basis points
The latest upward
drift of CDS spreads — which remain below the levels seen in late
2008/early 2009 — has been triggered by growing fears about the credit
quality of Greece: the capacity and willingness of its rulers and ruled to
continue to service the public-sector debt.
This event has
obviously served as a reminder to many: investors have become increasingly
aware of the overstretched financial situation of many governments, a fact
that had been ignored for a long time.
However, growing
concern about government-bond defaults may be overblown. Investors should
remind themselves that printing new money to pay for government debt is, at
least from the point of view of the government, economically more attractive
than defaulting on public debt.
It shouldn't come
as a surprise if it eventually turns out that the real danger is, like so
often in the past, inflation rather than default. As Ludwig von Mises noted,
If a government
is not in a position to negotiate loans and does not dare levy additional taxation
for fear that the financial and general economic effects will be revealed too
clearly too soon, so that it will lose support for its program, it always
considers it necessary to undertake inflationary measures.[1]
Notes
[1] Mises, Ludwig von (2006 [1923]), "Stabiliz
ation of the Monetary Unit — From the Viewpoint of Theory," in: The Causes of Economic Crisis and
Other Essays Before and After the Great Depression, ed. Greaves, Percy L. Jr., p. 39.
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