Attack of the Killer Debts!
Last Saturday the Globe and Mail (November 28, page B1) ran a multi-page spread on national government debt. It was a mish mash of large titles, large numbers and sensational assertions: “A World Awash in Debt”; “Climbing out of this hole wonâ€™t be easy”; “the numbers are staggering”, “debt would climb to about 300 percent of GDPâ€¦ tweak that and it grows to an astonishing 800 percent”, “the debt run-upsÂ (of ) the civil war WW1,WW2 are mere hiccups” (compared to what we face in the future), “itâ€™s difficult to understate the rickety foundation on which the worldâ€™s developed countries will attempt to support the aging of the baby boom generation”, “there is a day of reckoning” , and on and on.
Bring on 2012. Letâ€™s just sink into the sea and be done with it!
The patient reader searching for an actual explanation for the impending catastrophe has to wade through the hyperbole until the very last part of the article. Finally we learn that “the bonds governments issue to pay the bills from their economic stimulus programs will absorb money that otherwise would have been invested in the economy. Interest payments will rise, leaving less money in treasuries for education, infrastructure or tax cuts.”
Well thankfully then we donâ€™t have much to worry about. Perhaps our biggest worry should be newspaper writers who donâ€™t understand how the monetary system works. The author is recounting an aspect of loanable funds theory which goes like this: there is a limited supply of loanable funds available in the economy which is given by the flow of household saving. When the government runs a deficit it competes for them in a big way, pushing up the demand for these funds. As a result, interest rates rise to equate the demand for and supply of the funds. High interest rates have a variety of bad effects, one being to increase the cost of government borrowing.
Loanable funds theory sounds plausible but itâ€™s wrong. There is no pot of funds to be lent. When the federal government needs money to spend it sells securities to the Bank of Canada. The Bank supplies the government with the money it requires out of nothing (“ex nihilo” for Latin enthusiasts). Thatâ€™s where the money comes from – a digital entry at the Bank of Canada. No pot of money – just a typist keying in a number. In fact this is how money is created by the chartered banks as well. Go for a car loan or a mortgage and thatâ€™s where your bank will find the money, out of nothing. Mind blowing perhaps, but true nonetheless!
The Bank of Canada will later keep some of the government of Canada securities for itself and auction the rest to the highest bidder among the chartered banks and brokers, but the money was first created by the Bank and paid to the government of Canada. There is no pot of money. There is no possibility of the government competing for limited funds.
Let us return to the story of impending catastrophe. It mostly hinges on a scary increase in interest paymentsÂ “absorb(ing) money that otherwise would have been invested in the economy”. Sounds ominous. But it ignores the reality of how interest rates are set. Short term interest rates are set by the Bank of Canada. Today the rate for the chartered banks is 0.25 percent on overnight deposits, not too scary. And the overnight rate greatly influences other rates as well. For example the rate on the three month treasury bill is also about 0.25 percent, on the one year treasury bill itâ€™s less than 0.5 percent, on three year bonds 1.5 percent and on 10 year bonds about 3.8 percent. Nothing too scary there. So if the worry involves interest paid on government debt, remember it is the Bank of Canada, a creation of the government of Canada, that sets the short term interest rates and greatly influences the longer term ones. Keep these low and the interest paid on government debt is low.
Itâ€™s true a number of years ago the Bank of Canada set interest rates very high. This was unnecessary then and is certainly unnecessary now. In fact the situation in Japan is most indicative. There the government has debts that dwarf anything Canada faces. But the interest rate the Bank of Japan sets is low so payments on the debt are very manageable.
Finally, the fact is the Bank of Canada could decide not to sell government securities at all in which case the government of Canada would have no interest payments to make. But thatâ€™s a story for another time.
One last point. Stories of debt gloom and doom always include a common implicit assumption. While not saying it overtly they imply that the scary interest payments go down a black hole, sucked out of the economy, vanishing forever. This is complete nonsense. Government bonds are a secure place for people to save their money. The interest payments provide income for Canadian households and firms and the payments are taxed and spent just like other income. And of course the original spending provided benefits to Canadians: money for the unemployed, funding for health care, better infrastructure such as sewers or bridges, improved national parks, etc.