Optimum Sovereign Debt Levels

Over at Angry Bear, Bruce Webb asks the question "What is the optimal level of US Public Debt?". I felt compelled to reply to this, even though it will be seen as heterodox.

But first, some history. Back in the late 1990s when I was working out my economic understanding, I came to the mistaken conclusion that government deficits were bad and government surpluses were good. This was, in part, due to the influence of then Australian treasurer Peter Costello, who, with PM John Howard, made deep budget cuts after the 1996 Federal election. These budget cuts were made because the previous government, the ALP under Paul Keating, had run budget deficits and increased debt to around 20% of GDP. At the time I thought such debt levels were terrible but in hindsight they are very small compared to the gigantic levels of government debt experienced by the US and Europe. Chalk that one up to successful Liberal party propaganda.

So, armed with a dangerous amount of a little knowledge, I began to play around with the idea of governments running huge surpluses. Never being burdened with Randian anti-government attitudes helped me through this process. I began to understand that any government with huge amounts of savings had the luxury of increasing spending or lowering taxes as time went by. After all, with the money in these surpluses being ploughed back into the economy in the form of buying shares or depositing with banks, the interest and earnings of these investments would act as a secondary source of income to taxation. Taxes could therefore be cut, and spending could be increased, without having the problem of running deficits and increasing debt. Taken to its logical extreme, taxes could be cut altogether as revenue from investments covered the entire budget. Nevertheless I still believed that running a surplus over the course of the business cycle was the best thing to do.

Of course this is an interesting idea, but after a while I began to understand the balance between the government and rest of the economy - if government went into debt, the rest of the economy saved; if the government saved, the economy went into debt. You can't have both the government AND the rest of the economy saving at the same time (at least if you ignore external forces coming into play). If the government saved, and saving was good, then the rest of the economy borrowed, and borrowing was "bad" apparently. But of course I knew that not all debt was bad, so my thinking began to change.

Since then my view has been that the optimal, long term, debt level should be zero. And by that I do wish to stress the importance of the phrase long term - I have no problem with governments getting into debt or having net savings. This is where I'm happy to be a Keynesian, whereby governments respond to economic downturns by running deficits (as a result of less tax revenue and increased spending due to automatic stabilisers such as unemployment benefits) and to economic expansions by running surpluses (as a result of increased tax revenue and decreased spending on such things as automatic stabilisers). Yet over the course of the business cycle - that is, when expansions and contractions balance each other out over many years - net government debt should be zero, and budgets should be balanced.

Unfortunately I can only offer axiomatic and logical arguments for this point of view. Most advanced nations have erred on the side of deficits and debt. Australia, by contrast, is perhaps the only nation around at the moment whose level of government debt is nearest to zero. Norway, by contrast, has been running massive surpluses for years now and has government savings of around 119% of GDP. While my younger self would congratulate Norway on this, my current view is that Norway's fiscal situation is just as bad as Greece or Italy. The aim should be zero net debt, not large net debt, nor large net savings.

The axiomatic argument that I have is that, in a perfect economic model, borrowing matches savings and money owed matches money lent. Moreover, sectors like the government, business and households do not actually exist but all are one. Since the government represents a huge percentage of national GDP (15-25% in the case of the US, more so in European social democracies), how a government operates naturally affects the rest of the economy. My argument therefore is that balance is best: a government that is neither a net saver nor net lender allows the non-government sector to operate in balance as well. One argument that I have heard from fiscal doves is that government deficits increases non-government sector saving, and that is a good thing isn't it? Well no it's not. The reason is that the non-government sector should be allowed to function as close to a theoretical "perfect economic model" as possible. As soon as a government runs a massive long term deficit, the non-government sector naturally gears itself towards savings. Similarly, if a government runs massive long term surpluses, the non-government sector gears itself towards deficits.

It's the "gearing" here which is important - and by "gearing" I mean that the economy begins to focus upon that which will make the most profit. A government that borrows too much will create a non-government sector that saves and invests too much since it is more profitable to do that than to borrow. Similarly a government that saves too much will create a non-government sector that borrows and spends too much, since that will be the most profitable thing for the non-government sector to do. If you have a long-term balance, whereby the government neither borrows nor saves too much, you will have a non-government sector that is in balance as well.

Of course my argument for this issue is axiomatic and not dependent upon hard evidence. This is because international trade and investments gets in the way. The presence of massive current account deficits in the US and massive current account surpluses in Japan and China affect my whole argument and render hard evidence impossible to gain. Yet my attitude towards current account imbalances is the same: over the course of the business cycle, a nation's current account should be balanced. In short, the US should not be running huge current account deficits and Japan and China should not be running huge current account surpluses: massive deficits are just as bad as massive surpluses. In the case of the US, massive deficits have created an economy that is geared towards borrowing and consumption, while massive surpluses in Japan and China (a hangover of mercantilism) have created economies that are geared towards saving and production. For the world economy to function better, nations need to ensure that their current accounts remain balanced over the course of the business cycle (ie long term).

But then it is also obvious that some nations need more investment than others, while some patently need less investment. In this situation, imbalances can exist so long as a common currency is used. And this is also one reason why I am pro-Euro and pro-internationalist and see an eventual one-world government and one-world currency as a good idea in the end.

But there's one more thing to add: inflation and deflation. Since inflation represents a devaluing of currency it is therefore a period when the economy gears itself towards consumption and borrowing. Deflation represents a devaluing of goods and services and is thus a period when the economy gears itself towards saving and production. In a perfect economic model, prices are stable over the long term as the force of saving and spending, of production and consumption, balance each other out. Unlike most economists, I see no room for a little inflation over the long term. If an inflation index is 100 today, it should be 100 in 25 years time, with brief deflationary forays below 98 and brief inflationary forays above 102.

So, in short, this is my position:

1. Governments (no matter how large or small) should have zero net debt and run balanced budgets over the long term.
2. Currency areas should have balanced current accounts over the long term.
3. Prices should be stable, neither inflating nor deflating, over the long term (absolute price stability)
   

Balance is the key. Do we dare to aim for an economy in which the government sector has zero net debt, in which the nation or currency area runs a balanced current account, and in which prices are neither allowed to rise too much or fall too much but remain stable?