The Spectre of Public Debt C.P. Chandrasekhar

Pegging their arguments on the still-ongoing drama relating to sovereign debt in Greece, conservative opinion is making a case for a reduction of the size of public debt in developed and developing countries across the world. The latest signatory to the appeal is IMF chief Dominique Strauss-Kahn who reportedly told an audience at the inaugural conference of the Soros-funded (Financial Times, 10 April 2010) Institute for New Economic Thinking that public debt in the advanced economies is forecast to rise by about 35 percentage points on average, to about 110 per cent of gross domestic product in 2014. In his view: “Reversing this increase will be a tremendous challenge – let alone reducing debt to below pre-crisis levels, which may be needed to leave enough fiscal space to tackle future crises.”

There are three components to this view. First, that a crisis that had its core deficit household and corporate budgets and debt-burdened household and corporate balance sheets has been resolved in ways which substituted public deficits and debt for private ones. In the event public debt is seen to have risen to unsustainable levels. Second, that this threatens widespread sovereign default and weakens the capacity of governments to deal with fresh problems that may arise in the private sector, necessitating correction. Finally, that the fear of sovereign default has reduced access to debt and significantly increased the cost of borrowing for many governments. Greece, for example, had been facing difficulty in getting adequate subscribers for its debt issues. And the interest rate at which that debt had to be incurred had risen sharply. This means that the possibility of dealing with the debt burden by rolling over debt (or incurring new debt to repay old ones) and postponing the date of redemption is reducing.

There is an element of truth in this since additional government borrowing during the crisis was not all aimed at financing a fiscal stimulus. A part of the build up of public debt amounted to borrowing good money to throw it away. Governments borrowed to buy up worthless assets from banks and financial firms that were seen as systemically significant in order to clean up their balance sheets and keep them solvent. Or they lent against collateral in the form of such assets at extremely low interest rates. In the aggregate this amounted to exchanging government paper for toxic assets in the portfolio of the private sector, and moving those assets onto the balance sheet of the government. Expecting those assets to yield the revenues that can help finance debt service commitments would be to expect too much. If there are no other means to cover these costs, default on debt is a real possibility.

However, the argument that public debt is a time bomb waiting to burst is a bit difficult to swallow because there are other options. This argument amounts to treating public and private debt as being essentially similar. That is indeed surprising since an important difference between the private sector—whether households or firms—and the government is that while the former does not have the option of increasing revenues through taxation, the latter does. In other words, governments can resort to increased taxation to mobilise the resources needed to meet their interest and amortisation commitments and pay their way out of debt. And this should be easier now since it is widely accepted that a feature of the growth trajectory that led up to the 2008 crisis was a sharp increase in inequalities resulting from increased profit and rentier income shares and extremely high executive compensation. Absorbing a part of this surplus through taxation is both feasible and justifiable.

Further, when revenues accruing to the state through these means are used to sustain and expand domestic expenditures and absorption, output increases. This expands the revenue accruing to the state, making it even easier to deal with the debt burden. It is for these reasons that debt-financed government expenditure is seen as an instrument to deal with a downturn and, therefore, a handy policy tool.

If these differences between the public and private sector are ignored and private and public debt are treated symmetrically, the assumption must be that for some reason—ideological or otherwise—taxation, especially taxation of surplus incomes, is being ruled out as a policy option. Seen from the point of view of the wealth holders this assumption must make eminent sense. If the government through its borrowing had converted the surpluses they had invested in worthless toxic assets into safe government securities, then to tax those surpluses to finance that borrowing seems unreasonable from their point of view.

It is this assumption that makes dealing with the public debt delivered by the process of crisis resolution a challenge. If the debt burden has to be reduced to forestall sovereign default on the part of governments that are not permitted to increase revenues through taxation, the immediate option available is a cutback in expenditures. This cutback cannot of course include the interest and amortisation payments on debt that are the problem. So the cuts must fall on capital expenditures that adversely affect growth. They must involve austerity measures such as a wage freeze and reduced social security support and spending combined with higher indirect taxes and reduced subsidies that increase prices and erode real incomes. They must include reduced employment through retrenchment and attrition so as to curtail the wage bill. In sum, the debt must be reduced by taxing directly or indirectly the man on the street rather than the wealth holder. Unfortunately, this would impose much pain on the people who are left with the confusing argument that though they have been rescued from a crisis which was not of their making they have to still bear the costs that the crisis would have involved. The people may not accept this argument and take to the streets or dislodge governments that advocate such policies. This makes resolution through a reduction in expenditures difficult.

But that is not all. If spending is cutback to deal with the “problem” of public debt, then the recession that was overcome by debt-financed public spending may return. This did happen during the Great Depression of the 1930s when as a result of the stepped-up federal spending under the New Deal, an economy that had been contracting for four consecutive years (1930-33) returned to growth and bounced back sharply. Impressed with that growth and concerned about deficit spending and public debt, President Roosevelt cut back on deficit spending triggering a second recession in May 1937. Realising that this could recur today as well, even those like Strauss-Khan who speak of the dangers of excessive public debt and deficit spending are also quick to recognise that the “global economic recovery is still sluggish and uneven and needs continued policy support in many advanced economies.”

If taxes cannot be increased and expenditures cannot be reduced then governments would indeed find it difficult to meet their debt service commitments without borrowing more. But this kind of Ponzi finance only scares off wealth holders who have to buy government bonds and give the government credit. Credit is difficult to come by and interest rates rise. Sovereign default is a real possibility, unless, for example, German taxpayers are persuaded to buy Greek government bonds that private investors reject. The difficulty in assuring such an outcome is what is leading to the “public debt scare”.

This then constitutes the “challenge”. But some among those raising this issue, especially financial capitalists, may have larger motives in mind when raising the scare. The direction in which they would like this diagnosis to take economic policy is to the other obvious, even if not necessarily correct, way in which the debt burden can be addressed, which is by liquidating state assets. It is likely we would soon hear strident calls for disinvestment and privatisation aimed at generating the resources needed to retire and reduce public debt. Rather than tax the surpluses that have accrued with the private sector during the period of inequalising growth, private wealth holders, who are now reluctant to hold government paper, would be asked to hold their wealth in real assets currently owned by the government. This would more than satisfy private investors as they can diversify their portfolio into real assets other than commodities or real estate, even while ensuring that the value of the government securities they hold is as safe as it was originally presumed to be.

But this is not the best option for the government or the ordinary tax payer. No private investor would buy government assets unless those assets promise a return significantly higher than the interest on “safe” government securities. By selling such assets to retire public debt, the government would, therefore, be giving up a profile of future incomes higher than the interest to be paid on an equivalent amount of debt. That is irrational from the point of view of the government and the ordinary taxpayer. But it is not from the point of view of finance capital.