By Michael Huang
Debt has always been a concept that we have been taught to stay away from, and the idea of
owing others money is certainly not an idea that we are fond of. Governments have the same
problem – debt is a part of almost all economies around the world. But a government borrows
slightly differently as compared to us: they issue bonds to their investors. Government bonds are essentially a loan that a government takes from its lender (the investor), and they would promise to pay back the loan before a set date with a particular rate of interest. These investors can range from individuals, like you and I, to large entities such as foreign countries. Bonds of developed countries such as the US and the UK are a popular form of investment because of its relatively minimal risk nature and its reasonable yield. Governments borrow mostly for their spending, which include matters such as benefits, education, and healthcare. Yet governments pay back their debt slightly differently from how individuals and households do. In fact, most healthy economies don’t repay their debt, but they refinance it.
How do governments refinance debt?
In simple terms, governments repay their debt by borrowing more (refinancing). From an individual point of view, this would be a terrible idea that would only put you in a bigger burden. However, governments can do this simply because economies grow. Economists often use a Debt-to-GDP ratio to measure the size of the debt compared to the size of the country’s GDP (gross domestic product, the total monetary value of a country’s goods and services produced at a given amount of time), and the smaller the ratio, the more likely the country is able to repay its debt since the debt is small compared to the size and the output of its economy. Countries that have a small Debt-to-GDP ratio can refinance their debt easier, since their debt looks more sustainable, and this would gain the trusts of new investors. Therefore, in effect governments are not paying their debt, but rather they are refinancing it by borrowing more. In 2019, former chief economist of the International Monetary Fund (IMF) Olivier Blanchard gave an important speech that went against all previous conventions. Blanchard suggested that governments can borrow more than previously thought, as long as GDP is growing faster than the country’s debt is accumulating interest. In a nutshell, Blanchard suggests that economies can grow their way out of debt. This puts a tremendous contrast to many government’s attitudes after the 2008 Financial Crisis. However, many countries now buy Blanchard’s ideas because of the failure of austerity during the recovery of the crisis.
What is austerity and what happened?
Austerity is a measure that cuts government spending and increases taxes in attempt to reduce a government’s budget deficit, where the budget deficit is the amount of government spending that exceeds its income (usually through taxes). However, austerity often comes in the form of cutting government spending rather than raising taxes because raising taxes can cause more complications and controversy. During the 2008 Financial Crisis, governments around the world borrowed lots for various stimulus packages to help the population as they have suffered a massive economic shock. A way to think of this is that since the crisis has caused unemployment to soar, people will consume less because they have less income, as well as because they have less confidence. This will hurt the economy, and hence the government will have to spend more to make up the loss of consumption by individuals and firms in hopes of economic recovery and to encourage people to spend again. However, in doing so, especially in such a large scale like what happened in 2008, the government builds up huge debt. This became a concern to many politicians in many countries, especially so after seeing Greece fall into a debt crisis. Therefore, many politicians around the world decided that repaying debt was a priority, and they turned to austerity. It all sounds fine and reasonable – you borrow lots of money, and then you try and pay it back by cutting government spending to avoid a debt crisis. But the problem is in the nature of government debt and the circumstances of the economy when austerity was introduced. For instance, the Conservative-Lib Dem coalition government of the UK introduced austerity measures in 2010, when the economy was still far from recovery. As a result of this, the UK ended up with an economy where there was still soaring high unemployment, and the economy was barely achieving growth because the government decided to cut its spending to pay back debt; keep in mind that government spending is essentially what stimulates the economy out of a recession, and now the government was cutting their spending before the economy was even out of the crisis. This resulted in a mess. It stagnated the UK’s economic growth and caused a long recovery out of the recession. But the British government was not alone in this, as many other Western countries had also used austerity measures to counter its enormous debt. So why then, you may wonder, would governments have turned to austerity in the first place?
The main factor was due to political reasons. Governments were afraid that taking on huge debt would result in risks of defaulting (failure to pay back debt) and risks of declaring bankruptcy should they not repay their debt, which would end in massive political consequences. They had already seen Greece on the verge of defaulting, only to be bailed out by the EU. However, it should be noted that the economic structure of Greece was significantly different than that of countries like the UK. The UK had its own central bank and its own currency, while Greece had restricted monetary instruments due to the use of a shared currency (the Euro). Therefore, from this perspective, the UK had much more control on stimulating its economy to grow its way out of recession. Greece had already taken on mountains of debt before 2008, hence the massive economic shock only made matters worse. Politicians made the premise of austerity a popular one because they argued that by reducing budget deficit, the country would avoid a huge debt crisis like that in Greece, and the economy will be benefitted in the future and it will leave the future generations with a smaller burden. But it turned out that bringing more unemployment due to the cut in government spending left the youth with an even bigger burden. Furthermore, the use of austerity was not only a “non-sense”, as regarded by many economists such as Mark Blyth, but also unfair. The huge debt that was built up as a result of the 2008 Financial Crisis was caused by the high-income individuals and firms in the financial sector but using austerity measures would only hold the low-income households responsible for the mess that the riches had effectively created (because low-income households rely on government spending more than high-income households). In the end, can one really blame governments for taking on austerity measures? Defaulting a country would mean that the government will take on great responsibilities, as well as suffering enormous political consequences such as increased political distrust and losing the confidence of their voters. Along with the risks of losing the market’s confidence and pushing up bond yields also being too high to gamble, it was perhaps justified. However, austerity was still against the wisdom of many economists at the time, such as Paul Krugman and Simon Wren-Lewis, who opposed austerity strongly and argued that the UK saw a revival in the economy only in 2013 due to the slowing down or stopping of austerity measures across the country. Therefore, without the interference of politics, austerity would have most likely not been introduced around the world because it was seen to stagnate economic growth, which was a widely accepted argument amongst
If not austerity, then what?
Growth, in my opinion, is the best way to repay government debt. Cutting government spending during a recession can potentially put the economy in a deep hole it can never dig itself out of. Should growth be achieved and prioritized, the use of automatic stabilizers can help reduce cyclical deficit when the economy has recovered and booming (at its peak). What this means is that during recessions, it is normal that governments will have a bigger budget deficit because of the increased government spending on benefits and stimulus, as well as the decrease in tax revenues as the population’s income has generally fallen and unemployment has soared. This can be compensated by when the economy recovers and at its boom, where tax revenues would be high and government spending low, reducing the deficit, and offsetting the effects made during the recession. In other words, should the economy recover, time will repay the debt. The common use of stimulus during recessions also helps create the Multiplier effect. The concept of the Multiplier is simple: imagine if you had 10 dollars. You decided to save 2 dollars and spend 8 dollars on ice cream. The 8 dollars that you spend becomes someone else’s income and they would do the same saving and consuming process that you did, but with 8 dollars this time. What this means is that all the money injected by the stimulus during the recession will circulate around the economy multiple times, making GDP grow at a bigger rate than the injection that was put in. This decreases, but not eliminates, the worries that supporters of austerity have of taking growth for granted. Furthermore, government spending encourages investments during recessions, known as “crowding in”, due to there being spare capacity in the economy. Therefore, I believe that an economy should prioritize economic growth during recoveries of a recession, and the government deficit can be reduced after the recovery by elevated levels of taxes and low government spending.
Covid-19 pandemic and what happens next?
As we see everywhere in the news, Covid has brought countries mountains of debt. However, the world has learnt a lesson from 2008. The world now is no longer looking to turn to austerity, but to prioritize economic growth. If anything, the concern raised in the US economy now by the Republicans is the sheer size of the Biden Stimulus, and his infrastructure plans, will overheat the US economy and cause inflation. Austerity looks now to be past our time. But as history has taught us, people forget quickly, and the possibility of the return of the austerity argument still remains on the table. Whether austerity would be used with more justifiable reasons in the future due to the changes in the world’s economy, or if austerity is ever necessary at all, remain a mystery.