Getting My head Round Deficits and Debt and What Happens Next

I’ve sort of got my head around this stuff. But I need to write it down to be sure.

Firstly – ‘Debt’  is money a country borrows on ‘the markets’ by issuing bonds, of a particular value/price, paying a particular rate of interest (eg 3%) and which may be redeemed for the purchase price after, say, 10 years.

People buy these bonds at the issuing (nominal) price and may then either hold them or trade them. This is where it gets interesting – because when they are traded on the open market, the price, here, may go up or down according to supply and demand. Thus, depending on the risk perceived by the markets, the price increases or decreases on this open market. But since the interest paid is static (eg 3%) in respect of the original issue price, if their market price goes down (too little demand, because too much perceived risk) then the interest they actually pay on the actual price they are traded at will be higher than their nominal interest. The real interest paid is inversely related to the price at which they are traded. It is this real interest which gets quoted and is seen in the press. The more risk there is perceived to be that the Sovereign (the issuing country) will not be able to redeem the bonds from whomever now owns them, at their original face value at the end of those bonds’ fixed period, the higher is this quoted interest rate (ie the lower the price at which they can be traded on the open market). Phew!

Now, obviously, if there is a perceived significant risk that a country will ‘default’ on its obligations to redeem the bonds at their face value (or maybe even keep up the interest payments!) the harder it will be for the country to issue more bonds – because ‘the market’ will be demanding that new market interest rate has to be paid by the issuing country on its new bonds – to a point that it will no longer be able to afford to service its Debt and pay its internal and external bills. If the price of its bonds collapses on the open market (interest rates quoted skyrocket) this is a sure sign that the market (that is – the traders – mainly banks) believes the country is on the brink of national bankruptcy. Even if there is no foundation to such a belief, the belief itself would make it very difficult or impossible for the country to issue any more bonds – thus it would become a self-fulfilling prophesy.

So the ‘confidence of the markets’ is very important for a country.

However, it is important to note that low yields on government bonds (as currently for US and UK Treasuries) do not necessarily mean that the market is confident in the way the country is being run economically – only that there may be nowhere else for the market to put its money – eg shares being considered a dead loss, as at present! (Evidence: August 5, 2011 S&P Downgrade the U.S, but the 10-Yr US Treasury Yields 2.5%…)

‘The Deficit’ is not the national debt. The deficit is the difference between national income and national expenditure – approximately. Sometimes a country is in surplus with this respect, and sometimes it is in deficit. Often a rich country will run a deficit for years and years – adding to the size of the national debt as it issues more bonds. But as long as the markets believe the country will not default, they’ll keep buying the bonds and the quoted interest on them remains relatively low. How can this happen? Never mind. It just usually does for advanced economies. Perhaps the subject of another blog piece – talking about say, the USA, Japan and the UK and maybe the role of Sovereign Wealth Funds…

So – what is going on at the moment in the UK and the USA?  Here is my take:

  1. The whole developed world is going into austerity mode at the same time, particularly all the European countries – so no European country which is in trouble is going to be able export their way to GDP growth and hence out of trouble (eg the way Sweden did in the mid-90s via domestic austerity);
  2. In the meantime austerity is contractionary – and the private sector is not going to pick up the slack because it is also in austerity mode: profitable businesses are actually sitting on their cashpiles rather than investing because they do not have any confidence that their markets will buy their goods/services in sufficient quantities to make it worthwhile to invest; consumers are trying hard not to spend too much, and to reduce their own debts;
  3. It’s not a good idea for economies to run large deficits over a long period of time and thus increase their debt: so in the long run (even the medium run) deficits need to be reduced or eliminated;
  4. If a country with large deficits wants to be able to keep borrowing money on the markets at advantageous rates, it needs to keep the markets confident: thus it needs a credible plan to reduce its deficits in the medium term.  Nobody out there apart from the ‘Pain Caucus’ – (we have overborrowed and binged and sinned, therefore we must suffer pain, painItellyou, nownownow) – really needs a short-term plan to reduce the deficit. But is may fit in neatly with an ideological-cum-religious desire to ‘shrink the state’ and ‘let me keep more of my own money’ – eg, as with UK conservative party and US Republican party type people and Libertarians;
  5. Economies can have any level of national debt they like – as long as they can afford – via their tax receipts – to pay the interest on their debt – just as you or I can take out any mortgage we like – as long as the bank will lend it to us and we know that through our income we can afford to pay the interest, and ideally some of the principal;
  6. Currently, for the USA for Japan and for the UK  – the market is willing to buy our debt for very low interest rates – in other words, pay a  high price for our bonds (especially now that the stock market has tanked!)
  7. The ratio of debt or of deficit over GDP depends on the absolute size of the deficit or debt and also the absolute size of the GDP
  8. If you want to reduce this ratio you can do it in two ways – (a) cut the deficit or (b) raise the GDP
  9. There are various ways to cut the deficit – however, it should never be done ‘nownownow’, but over the medium term, if you do not want to harm your economy/reduce your GDP; (contractionary policies are, well… contractionary… doh!)
  10. Reducing taxes for the rich (typically, unfortunately, these are the so-called ‘Very Serious People’ that government ministers mix with) produces hardly any dividends for the economy – because they hoard their excess money or spend it (often abroad) on yachts, planes, property and jewellery. It’s a myth that it encourages them to invest productively or work harder (that’s checkable by the way: lots of research);
  11. Reducing taxes for the not-so-rich – most especially the relatively poor – does stimulate the economy because they spend the extra money on goods and services;
  12. So one way of stimulating the economy is to reduce taxes on the relatively poor – and this may possible produce more income for the govt than it loses. But reducing taxation across the board for rich and poor is only deficit-increasing – because it is the rich who benefit the most (which is why the GOP in the USA is so hypocritical about its desire to reduce the deficit);
  13. Because of the low price of borrowing for, say, the UK and even the USA (despite the most recent shenanigans in the USA) – now is a good time for those countries to borrow more – provided only that they can put their borrowing to GDP-enhancing use;
  14. The most important thing is to kick-start the economy and get growth; ideally via capital projects, etc, that will pay dividends longer term;
  15. This implies that  fiscal stimulus via government spending and *judicious* tax reduction would be A Very Good Thing;
  16. There is an economic theory that government spending squeezes out private investment – but this is incorrect when interest rates set by central banks are near zero;
  17. Monetary policy (interest rate-setting by the central bank) cannot help because we are up against this ‘zero bound’ – unless possibly via quantitative easing (about which the jury is out – it may just be pushing on a string);
  18. We have high unemployment, set to grow further: this reduces Government income and also increases Government spending to keep the unemployed unproductively alive and living a sort-of life;
  19. So wage-increase demands will certainly remain weak – unless and until the unemployment becomes ‘structural’ (square pegs and round holes) which all the research shows it is not, currently – here or in the USA; (but long-term unemployment does tend to become structural eventually as skills are lost);
  20. Worldwide, most inflation, currently, is imported, via commodity price (etc)  increases, not domestic – and is anyway going down (‘core’ inflation definitely is going down);
  21. So – as thing stand – the governments of the UK and the USA can ‘print’ as much money as they like and it will not be inflationary; those who believe it will be inflationary do not understand the difference between domestic inflation and imported inflation;
  22. A household cannot print its own money – but a sovereign country can do so; although eorozone members are not sovereign in this sense: they have no control of their own money supply, which is controlled by the European Central Bank;
  23. Obama’s fiscal stimulus was too little, and has now run out.  Some economists were predicting it was too little right at the beginning; others are saying this shows that fiscal stimulus cannot work – but that is bullshit;
  24. Apart from bailing out the banks – the UK, since the Conservatives came to power, has not even tried fiscal stimulus;
  25. The last great depression was ended by the fiscal stimulus of a big war and its aftermath; I don’t see that happening this time, thank goodness – so this ‘lesser depression’ could last a very long time, because current policies are likely not to reduce the deficits;
  26. And now – because of the latest shenanigans in the USA Congress and the governance of the eurozone – things can only get worse… We may be heading straight into another Great Depression.

Er… that’s all I can think of for now.
But when things get better in an economy, that can also send bond yields up!!
This is because their traded price goes down because investors are confident enough not to need to park their money in bonds (at low yields) but prefer to use it for investment and/or buying shares, for higher expected yields. So they sell the bonds.
Thus rising bond yields do not automatically mean loss of confidence in a country’s ability to service its debt: you need to know what else is going on in its economy.


About DMO

Market Research Consultant View all posts by DMO

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