Written for Hunmoco by Economics for Business
Benjamin Franklin noted back in 1789 that nothing in life is certain, except for death and taxes. A third near certainty for most people is debt. Whether it is borrowing multiples of one’s income for a mortgage, online purchases on a credit card for the protection it offers, or the government funding its spending through issuing bonds, we are surrounded by, and often drowning in, debt. But it doesn’t have to be that way, not for governments.
At its most simple level, governments borrow by issuing bonds. These are promises to pay back the creditor at some time in the future, with interest payments for the duration of the bond’s life. For day-to-day spending this can be a three- or six-month bond to balance out peaks and troughs in income and outgoings (much like putting everything on a credit card at Christmas to pay off through the rest of the year). Governments can also issue much longer dated promises to pay, typically in 10 or 20 years time – even 50-year bonds are not uncommon – to pay for infrastructure and other forms of capital investment.
In recent years, central banks have been buying up lots of government debt (as well as other assets), as part of what is known as quantitative easing, or QE for short. Barely a decade ago such a policy was unheard of outside of niche academic circles; now it is a regular fact of life, achieving considerable press-coverage and elevating central bank policy statements to front page news.
The end game for QE is widely considered to just be the end of QE – where central banks stop their spending spree and the assets on their books mature and expire. What if this is the wrong way to look at it? What if the end game for QE is actually the end of debt?
It could work like this: a central banks starts buying up government bonds to support the economy. If the economy never gets betters, it ups its purchases until it is buying more in a year than the government issues. This is possible as the central bank doesn’t buy directly from government (the flowing steam of debt) but from the secondary market where organisations like pension funds hold the government bond as an asset (the deep pool of debt).
If this process of buying more than is issued continues, at some point the central bank will own the entire stock of government debt. Every bond, every government I.O.U., every promise to pay, would be held by the central bank – which in most countries is an arm of government.
This is where it gets interesting. If the government only owes money to itself, meaning the only holder of its debt is itself, it could cancel its obligations without consequence. Pension funds would not lose money, savings would not be wiped out, banks’ capital buffers would be unchanged. No one would be worse off from what is in fact a sovereign default. Government debt would fall to zero and day-to-day borrowing needs would reduce as there would no longer be a need to pay interest or roll over maturing liabilities.
So what’s the catch?
No consequences? No chance. Economic theory suggests a number of fates may befell any government that risks this approach. First is inflation. Buying up government bonds with magically created cash pumps money in to the market. If this cash is spent, it drives up inflation, eroding the real value of the currency and undermining real wages. If it is invested, it inflates asset prices, resulting in bubbles that will eventually burst.
Second is interest rates. A flood of cash being used for additional investment will overload the market: there will be more money than assets to invest in, driving down the yield, or interest rate, on borrowing and saving. This is clearly not a uniformly bad thing, but it does create losers in any economy.
Third is market sentiment. If markets start to believe the central bank is financing government borrowing, they become unwilling to lend the government money. This is due to the belief that imprudent and unaffordable spending will lie ahead, and with it default and losses for investors.
A pipe dream then?
Perhaps not. Japan’s government is the most indebted government in the world. Gross debt, the total amount in the market, stands at 250% of GDP. (For the UK and US the comparable figures are 89% and 105% respectively.) Government institutions hold much of this, which when excluded leaves net debt still standing at 125% of GDP in 2015 (compared to 80% in both the US and UK). In cash terms this is 600 trillion yen – a six followed by 14 zeros (or 6 trillion pounds, a six followed by 12 zeros).
The central bank, the Bank of Japan (BoJ), has been buying bonds at a rate of 80 trillion yen per month for over three years. Its current tally of bonds held brings it to almost 350 trillion yen, more than half the total issuance in the market. The BoJ recently announced a change of policy to buy bonds in unlimited quantity, albeit only those with maturity of 10 years or less. Imagine that it carried on as before. 80 trillion yen per month, offset by bonds on its books maturing, and by the end of this decade the BOJ could own all the debt of the government of Japan.
What of the risks? Notoriously, Japan has battled deflation for two decades. Even with 350 trillion yen pumped in to the economy, inflation is running at minus 0.5%. An asset price bubble is hardly a concern either. The Nikkei 225 Index is less than half of its 1989 peak, and 20% below its mid-2015 level. House prices are not risen since 1991. Interest rates are among the lowest in the world – the BoJ policy rate has not risen above 0.5% since 1995 and currently stands at minus 0.1%; yields on government bonds are negative for all maturities below 10 years meaning the government can borrow for 10 years at no cost at all and get paid to do so. Finally, on market sentiment, the moniker for the market trade for betting Japan can’t keep borrowing forever is the “widow maker”.
A government without debt
In theory, and seemingly in practice, for Japan at least, a country could buy up all its debt and cancel it, meaning the end of debt. This would be huge, especially so for Japan. The most indebted country in the world would wipe the slate clean and the quarter of tax revenue that goes to servicing the interest on the debt would become available for other uses.
What would it do next? Well, with no consequences to borrowing, wouldn’t you just do it all over again?