Why do governments borrow money? Can’t they balance their budget like everyone else?!

Susan
By Susan August 29, 2014 11:01

Why do governments borrow money? Can’t they balance their budget like everyone else?!

 

 

A government spends its money on several things: social welfare, public sector wages and capital expenditure (investments in buildings, roads, public facilities etc.). To finance this expenditure, it relies on taxes and other revenues. But as we all know taxes are notoriously unpopular… Who likes paying more tax?!

 

Why do governments borrow money?

 

Governments regularly run a deficit when the money they take from their citizen in the form of tax is less than the money they spend. In that case they have three options:

  1. increase taxes (which has the risk of scaring off multinationals, putting small companies out of business and driving the economy into a recession)
  2. decrease expenditure (which would lower the standard of living of the least well off, increase unemployment and take on the mantle of dealing with unions as well as decrease potential economic growth in the future)
  3. borrow the money from more-than-willing-to-lend investors

 

 

Borrowing is a healthy option

– as long as the government can repay its debts!

 

The last option is the easiest politically and is actually the healthiest economic choice also (given the right economic circumstances), since the other two have adverse economic consequences. In fact, the government might borrow more than what it actually needs to bridge the deficit, in order to take in extra funds to stimulate the economy and increase its debt/GDP ratio (this is like the household debt ratio of a country).

Of course, this is a master plan if you can pour money into the economy, boost people’s confidence and (re)start the money flowing around the economy before things turn nasty (e.g. confidence gets too low or servicing the amount of debt you hold gets unsustainable).

The problem is when it doesn’t quite work out like this. When this spirals out of control you need to either:

  1. turn to a lender of last resort, for example the IMF as in Ireland’s case in 2010,
  2. default on the repayments of your debts as Argentina did in 2001 … and again in 2014
  3. or put your citizens through intense austerity measures through cutting expenditure and raising taxes (which we also have done since 2008).

This last solution endeavours to aggressively stabilise the deficit, but amounts to squeezing the economy dry when it’s already running on empty.

 

How do governments borrow money in practice?

 

Governments generally don’t borrow on a private basis, but instead operate a public debt market by issuing what’s called “bonds”. They contact an investment bank or else set up their own entity to carry out this function: in Ireland we have the NTMA, National Treasury Management Agency. They then arrange an auction with a small number of brokers (sixteen in our case) who do a deal with the government regarding what interest rate they’re going to pay. This is called the primary market as it is where the government deals directly with the broker.

Next, these brokers contact several other stockbrokers who represent investors and offer to sell these bonds on to them at a small profit. The stockbrokers do likewise with their own clients. This is called the “secondary market”, because in effect, the bonds are being sold second-hand. From this point onwards, the investors can buy and sell these bonds at any time on the stock exchange as they’re “liquid” instruments: there are plenty of buyers and sellers willing to transact at the stock exchange price (which can change several times a minute).

That is how governments borrow money, in practice. I won’t go into the finer details of bond price vs. bond yield, as I already explained these in another post.

 

Why are we so afraid of bondholders?

 

In times of economic prosperity, or even times that aren’t extremely bad, bondholders are paid as a matter of fact. The bond price or the bond yield wouldn’t even make the general newspaper, never mind taking up the headlines for months on end.

However, when you’re totally reliant on the money of new investors to keep a country going on a daily basis, you don’t want to upset them in any way as they are staving off financial ruin. What would upset them is a growing risk that they won’t be repaid. In addition, because it’s a public market, everybody can see what everybody else is doing with their money. Say for example, a Danish investor sees the price of Irish debt falling and falling and falling on the Irish Stock Exchange, he could be forgiven for getting worried himself and selling his own holding of Irish government bonds. The bond yield itself is like our reputation to repay, packed into a number.

And as I often remind people who give out against bondholders – the bondholders are not some abstract entity, or a shadowy group of greedy capitalists smoking cigars in top hats. They’re you and me. We might own bonds through our insurance or pension funds.

 

Why do people invest in bonds?

 

Developed market, pro-enterprise governments with healthy deficits are effectively a “risk-off” trade: there isn’t any risk in investing in their bonds (at least at a particular time). They may offer better rates than short term or demand accounts (cash deposits) in the bank, and are liquid on a market.

They also offer currency diversification. If I, as an Irish investor, buys UK government debt (called gilts), I would be exposed to the sterling or, as another way of looking at it, I would be decreasing my euro exposure. This was the reason that people and businesses bought German bunds a couple of years ago. They were hedging against a euro collapse. If the euro were to be dismantled into its constituent parts, the punt would have fallen dramatically against the Deutschmark. That would have been bad enough for an Irish investor – but if that Irish investor owned German government bonds, then part of their net worth would have been in the stronger currency.

 

Does anybody else benefit from the bond market?

 

Yes: the investors themselves. For example, in Malta, a country with a population one-tenth that of Ireland, the country’s citizens soak up all of the government debt in the country. By having a government debt market, the investors in a given economy have the opportunity to make a return from their own government, which is a direct way of earning their tax back through lending their money to the state…. The wheel keeps on turning!

 

I was interviewed on the Moncrieff show about this topic. Listen to the podcast here.

 

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Susan
By Susan August 29, 2014 11:01