Should We Dread Deficits?

Should We Dread Deficits?

One of the key battlegrounds in the toxic left/right divide in Western countries concerns government debt and the budget deficit. Although probably 90% of those who get into acrimonious debates have limited knowledge about the nuances of fiscal policy, this has not prevented it from becoming a heated political issue (like everything seemingly at the moment). The current debate goes something like this:

  • Left-wing progressive: The deficit and the debt load don’t matter. Austerity is a political choice. A political choice used by evil conservatives to murder our children!
  • Right-wing conservative: If the government spends too much money now, we will face higher taxes for generations. Increasing the budget deficit and the debt load will burden our economy for years. Spending beyond our means is a political choice. A political choice used by evil communist progressives to murder our children!

I’m not even sure those explanations were hyperbolic, given the collapse in political discourse witnessed in recent years. Those on the left and the right view everything in the world as a war between the good and pure (them) and the bad and evil (those on the other side). Nuance is now a dirty word. In this article, I’m going to pursue a line of argument which will make both the left and the right hate me. As with most political or macroeconomic issues, the truth usually lies somewhere in the middle. Having a large deficit or government debt load does not matter much for some countries, but matters hugely for others. Let me explain.

At this stage, you’re probably aware that this is an article about economics (sorry). The budget deficit is the difference between what a government spends each year, and receives in taxes. If it’s in deficit (as it usually is), then this means the government needs to borrow money to make up the shortfall. The government debt load is the amount of existing debt that a government owes. It’s usually described as a proportion of an economy’s size (its GDP). Given how mundane the reality of these macroeconomic concepts are, it’s quite funny that debating these issues can lead to shouting matches in the current environment.

For Certain Countries, The Deficit Doesn’t Matter Much

This might get technical, but I’ll try to keep this as simple as possible. For developed, Western, and large economies with their own currencies and central banks, the size of the deficit or the government debt load do not matter nearly as much as people are led to believe. This is the argument supported by Modern Monetary Theory (MMT) economists. The US, the UK, Japan, Australia, and Canada would be good examples of this. Whatever you may read, these countries simply cannot run out of money. Why?

I’m going to avoid some of the more mundane nuances of fiscal and monetary policy here, to try to make this as clear as possible. Let’s take the US. The US Federal Reserve (the Fed) controls the amount of US dollars that exist in the world. When the US government needs to pay for something, it does not collect taxes first and then spend the money (as we’re led to believe). The US Treasury instructs the Fed – its bank – to make the payment on its behalf. In effect, the ‘money’ is created out of thin air, with keystrokes on a computer. When US government debt matures (is due to be paid back), there will never be a situation where the US says, “Sorry, we’ve run out of money and cannot pay you back.” First, because the United States is a fictitious entity that exists only in the mind of humans, and cannot talk. Second, because the US government has the ability to print as much money as it likes.

Another good example is Japan. It has the highest government debt load in the world, at one quadrillion yen (around 240% of GDP). Sounds scary, right? But is Japan running out of money? Of course not. How can you run out of money when you’re the only entity on Earth responsible for making it in the first place? Japan’s central bank has been clever. Like in the US, UK, and many others, it has been printing money (creating it on a computer by pressing some buttons) and then using this money to buy government debt. This is often referred to as quantitative easing (QE). As a result of this, Japan owes around half of its debt to its own central bank. The Bank of Japan (BoJ) could press a button on a computer and this debt would disappear instantly. It won’t, for a variety of reasons associated with confidence in financial markets. Instead, it will roll over the debt ad infinitum. It will never be paid back. This debt, in effect, does not exist.

What About Inflation?

You might ask then, “If there’s a magic money tree, why not spend, spend, spend?” There is a catch, of course. There are no free lunches in economics. There are key reasons why governments in these countries have to maintain a semblance of spending restraint. If a country like the UK prints too much money, inflation can increase. This is bad. It means that if you’ve saved your whole life, the value of your savings can collapse depending on how high the rates of inflation are.

So, it’s reasonable fears over inflation – rather than an evil government conspiracy – that prevents Western governments from going on an even bigger spending frenzy than they currently are. Given that inflation has been too low in the developed world for a decade, in spite of massive QE programmes, fears over the inflationary impacts of QE may too be overstated. The US and UK have just implemented historic money printing programmes amidst Covid-19. If they can do this without stoking inflation (as it looks likely that they will), this could lead to much looser fiscal policy for the foreseeable future. And, increasingly, inflation might be viewed as the main constraint on fiscal policy in these nations than the deficit itself.

For Most Countries, The Deficit Matters. A Lot.

Any Guardian readers will have no doubt delighted in reading the previous paragraphs. It will have proved, once again, that their views are morally virtuous and that anyone who doesn’t agree with them is evil. Before you start slapping your own back, not so fast. As with every issue, there are huge caveats. There are no free lunches in this world. No one ideology has all the answers, and would immediately solve all of the word’s ills if implemented. Indeed, the worst countries in the world are generally the most ideologically driven. For most governments across the world, deficits do matter. A lot.

There are two main categories of countries here:

  1. Countries which do not use a currency that they can print. This is the case for every country in the eurozone currency union, but also for many emerging markets which use the US dollar as their currency.
  2. Countries which have their own currencies, but which are perceived to be ‘emerging’ or ‘frontier’ markets.

Remember Grexit?

To start with countries that don’t use a currency they can print, like the eurozone. Having a large debt load does matter. Remember Grexit in 2015? Perhaps not. Fears over Grexit were a function of Greece not having control over its own currency. If it still used the drachma, it would have exited its crisis by printing money to repay its debts, devaluing its currency, and eventually benefitting from the associated benefits to competitiveness. Instead, when the Greek government could not repay its debts, there was a problem. They had to raise money on international debt (bond) markets. And at high prices, as investors (rightly) worried that they would not get their money back.

Eventually, Greece had to seek a bailout from other eurozone countries. It was forced into painful austerity measures in order to boost its competitiveness profile by lowering the population’s wages. Years later, the debt load is larger than ever. The poor Greeks have endured a collapse in living standards and rise in poverty never seen in recent Western history. Although German and other northern European countries (who Greece owes its debt to) keep pretending that they will get their money back, there is not a sensible economist on Earth who thinks that Greece will repay its debts. But remember, if you live in the US, UK, or Australia and someone says, “But look what happened to Greece, and what could happen in Italy and Portugal,” when discussing deficits, remind them that this cannot happen in your country.

Emerging Markets Need To Worry

What about emerging markets which use their own currencies? Sadly, these countries cannot afford to spend excessively or run larger government deficits. Compared to the developed countries mentioned at the start, they do not command the confidence of international investors. Many of them hold debts in overseas currencies like the US dollar and their domestic currency needs to be strong enough for them to purchase goods from abroad. If they print too much money to fund large deficits, their currency will weaken and imports will become more expensive.

Inflation then increases. The government struggles to meet its overseas and domestic debt payments. So it prints more money, which causes more inflation, which leads them to print even more money. And so on. And suddenly, you have hyperinflation. As the citizens of Venezuela and Zimbabwe (where inflation peaked at 79,600,000,000% per month in November 2008) would no doubt tell you, it’s an awful affliction to be avoided at all costs. No economic phenomena can more quickly make basic goods too expensive to purchase, and lead to such a rise in national poverty. A period of hyperinflation in Germany in 1921-23 was a precursor for the rise of the Nazis. It’s not to be trifled with.

An Ode To Nuance, In A Zero-Sum World

So the truth is, debt and deficits matter a lot for some countries, but not so much for others. And this depends on a whole range of economic, political, and financial market factors, which are ever-changing. Unfortunately, this isn’t catchy, is it? It would be much easier to say, “Coronavirus has destroyed the myth of the deficit,” or “Covid debt time bomb could trigger new financial crisis.” And for most people they take the path of least resistance: follow the rulebook of their given political ideology, and kick nuanced discourse as far into touch as is humanly possible.

But you could always choose to take a different approach. What if, when someone starts talking to you about government debt dynamics, you try something novel? Instead of thinking that those who favour lower/higher deficits are evildoers intent on bringing about the end of civilisation, you could have an actual conversation. You could probe each other on your beliefs, your favoured fiscal policy programmes, and which countries are good examples of your ideas working in practice. Unfortunately, this would require everyone discursively engaging with issues on a case-by-case basis, and not regurgitating whatever The Guardian (for the left) or The Daily Telegraph (for the right) told them to think. In the current climate, I won’t be holding my breath.


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  • Robin Ritchie says:

    Hi Mike
    I do hope you are right. You will forgive a little scepticism from those of us who remember 12 Swiss Francs to the pound, and double digit inflation with matching interest rates in the 1970’s. Comparisons with the US and Japan ignore the relatively size of the domestic markets in those economies.
    I fear that Post Brexit Britain may be too close to frontier status to avoid pressure on the pound and its consequent effect on our living standards.
    Trust you are keeping well.
    Robin Ritchie

    • Mike Richards says:

      Hi Robin,

      Hope you are doing well, really nice to hear from you. Great to get a debate going! I still lament Brexit, and believe that it (more than anything to do with fiscal dynamics) has been the main factor moving the currency in recent years. That said, I believe comparisons to the 70s and 80s are not as pertinent as they once were. What we have witnessed in the post-2008 world is a complete redrawing of the paradigm of monetary policy and fiscal policy, with QE programmes implemented in most major developed economies. This has completely changed, and will continue to change, the way fiscal policy operates globally in the coming years.

      In any case, we are 10 years into this experiment in the UK, US, and eurozone, while Japan is 20 years into the experiment. I’ve been enjoying Rishi Sunak’s eat out to help recently. The food has texted extra tasty for me, given that I know its been paid for by money created out of thin air by the Bank of England (BoE). It is in effect, helicopter money. A new form of QE where money is printed to directly target the incomes of a group of society. This would have been unthinkable a few years ago, but investors have barely blinked as the scheme has been rolled out.

      Shortly after the UK announced huge stimulus packages in light of Covid-19, the BoE announced £300bn of QE. Most estimates suggest that the budget deficit will be around £300bn this year. Convenient! The extra coronavirus spending will not be financed by taxes, its has already been financed. Despite this huge increase in the deficit and QE (over 10% of GDP), the pound has strengthened by 13.0% against the US dollar since March 19 and 2.7% against the euro. Inflation is only hovering at 1.0%, down from 1.8% pre-coronavirus and pre-fiscal stimulus level. This isn’t to say this dynamic will last forever, but it’s interesting nonetheless.
      Since 2009, the UK government debt load has almost doubled from 49% of GDP to around 85% of GDP. It will probably rise to 100% of GDP this year. The BoE has printed an unprecedented amount of money in this period. Its bond holdings now mean that it has brought (and effectively retired) 40% of the government’s debt load. Despite this unprecedented period of monetary and fiscal stimulus, and a Brexit-induced currency collapse, inflation has only averaged 2% over the last decade.

      I’m not saying the UK should go on a spending frenzy (although it already is!). I’m saying that whether we like it or not, policymakers know they have fiscal wiggle room than they used to. So long politicians appear to be approaching fiscal policy with some degree of restraint and make the right noises in public about reducing the debt load, I don’t think a currency collapse is likely. Look at Japan. In the last 20 years they the BoJ has purchased (effectively retired) almost half of the government debt load, worth a staggering 90% of the size of its economy. Despite this, they are still battling deflationary pressures. Whether we like it or not, the UK, the US, and even the eurozone, are headed for Japanifaction in the coming years, with low inflation and low growth to be the norm. Against this backdrop, we will see wider deficits everywhere in the coming years.

      If inflation were to increase and the pound were to start falling aggressively, the BoE would not need to hike rates much to stabilise it, in my view. Remember that interest rates are negative in safe havens like Switzerland and Denmark and close to zero everywhere else. While Brexit risks are salient, as an investor, you know that investing in UK gilts is far, far less risky than buying German debt. Germany cannot print money to repay its creditors (even though fiscal prudence mean it shouldn’t be a problem). The big problem is that Germany and the fiscally hawkish eurozone countries are on the hook for the Greek, Italian, Portugues, and Spanish debt loads. We are going to see intellectual and monetary policy acrobatics by European policy makers as they try to pretend these debts will be paid back, while at the same time also finding clever ways to reduce the value of the debt via restructurings or debt mutualisation!

      I could probably go on for ever, sorry for the length of this! I find fiscal and monetary policy fascinating, and can’t help myself. I believe that two big recessions in just over a decade has put us into a unprecedented period for fiscal and monetary policy. Would be keen to get your thoughts!

      Hope you are keeping well and great to her from you,

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