How much debt is too much? When should the Bank of England create new money to finance spending?

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How much debt is too much? When should the Treasury borrow money and when should the Bank of England create new money to finance spending?

Total UK household debt is exceptionally high and projected to increase even further. Meanwhile, government debt is also at an all time high. Concerns over these circumstances have prompted Professor Robert Skidelsky of Warwick University to ask, ‘How much debt is too much?

In this post, we highlight the pertinent points that Professor Skidelsky makes about debt. We then clarify our position on when the Treasury could borrow money to finance spending and when the Bank of England should create money to finance spending.

Debt to GDP ratio

household debt to income ratioFirstly, debt in itself is not a bad thing, in fact it can be a very good thing! So it’s important to mention that the sheer volume of debt is not as much of an issue as the ability to pay that debt back. This is why economists prefer gauging levels of debt by comparing the ratio of debt to income – as this gives a better indication of whether the debt can be repaid or not.

Accordingly, Professor Skidelsky sets out to answer the question: ‘Is there a “safe” debt/income ratio for households or debt/GDP ratio for governments?’ His conclusion is that “In both cases, the answer is yes”. However, “…in both cases, it is impossible to say exactly what that ratio is.”

Household Debt

More specifically, Professor Skidelsky suggests that the answer to this question ultimately depends on the circumstances. The case studies of household debt in Denmark and the USA are first used to illustrate this point:

“Consider Denmark and the United States. In 2007, Denmark’s household debt/income ratio reached 269%, while the US peak was 125%. But household default rates have been negligible in Denmark, unlike in the US, where, in the depths of the recession, almost a quarter of mortgages were ‘under water’ and some homeowners chose strategic default – fueling further downward pressure on housing prices and harming other indebted households.”

The difference between household debt in these two countries, argues Skidelsky, is the composition of borrowers:

“In Denmark, high-income households borrowed the most, relative to their income, and standards for mortgage lending remained high (mortgages were capped at 80% of the value of the property).

In the US, households with the lowest income (the bottom quintile) had a higher debt/income ratio than the top 10%, and mortgages were dispensed like gumballs. In the US, as well as in Spain and Ireland, banks and households became what the Financial Times columnist Martin Wolf called “highly leveraged speculators in a fixed asset.”

Government Debt

Next, Professor Skidelsky shows that the appropriate debt to GDP ratios for governments also depends on the circumstances:

“As for government debt, Japan’s debt/GDP ratio is 230%, compared to Greece’s 177%. But the consequences have been much more dire in Greece than in Japan. The distribution of the creditors is crucial. Most of Japan’s bondholders are nationals (if not the central bank) and have an interest in political stability. Most Greek bondholders are foreign banks. Yet, while crises of confidence come much sooner if debt is mainly owned by foreigners, no steps have been taken to restrict government borrowing to domestic sources.”

In accordance with what Positive Money has argued for some time now, the reduction of government spending without a corresponding increase in exports, will ultimately mean that growth will depend on the private sector having to borrow more:

“And, while governments have been trying (albeit ineffectually) to reduce their net liabilities, they have been encouraging households to increase their debt, in order to support the restoration of “healthy” growth.”

How Debt is Used Matters

A report by McKinsey shows that since 2007 government debt globally increased by $25 trillion. Government debt-to-GDP ratios are forecast to rise in all advanced countries except for Germany, Ireland, and Greece.

Screenshot 2016-02-09 16.27.40

This might seem alarming to some, not so much because government debt is increasing, but because it further illustrates the reality that growth everywhere in the world is dependent on debt.

We do need to be cautious about how we approach debt and not stigmatize it. Attention should be paid to where and how debt is being used. As we have suggested before, when new debt is used to finance activities in the financial markets (i.e. to buy pre-existing assets) then there will be very low increases in output and therefore people’s incomes. However, if debt is to finance activities in the real economy then output will increase and so will people’s incomes.

This is why Professor Skidelsky suggests that we have to pay attention to how debt is used:

“But a great deal of the alarm is based on the oft-repeated canard that government spending is unproductive and a burden on future generations. In fact, future generations will benefit more than the current one from government infrastructure investment”

Issue Debt or Create New Money?

Professor Skidelsky then suggests that the government is in a great position to borrow:

“But now, when real interest rates are almost zero or negative, is the ideal time for governments to borrow for capital spending. Bondholders shouldn’t worry about debt if it gives rise to a productive asset.”

With very low interest rates, there is an argument that now is a great time for the government to borrow. At Positive Money, our position is that the government can borrow money (but doesn’t have to) from the financial markets if it wants to fund new capital investment projects.

However, we also believe that if indicators suggest that there is spare capacity in the economy, that aggregate demand is below a certain threshold – to the extent that price stability is endangered – then the Bank of England should step in. It should proactively create new money to finance government expenditure up until indicators for aggregate demand reach the desired threshold.

Sovereign-Money-Final-Web-1-212x300Thus, while interest rates are low and the government can benefit from low borrowing costs, with the UK in disinflation territory and aggregate demand not at its desired level (despite cheap oil prices and increasing real wages) the Bank of England should be creating money to finance expenditure. This is why we suggest using Sovereign Money Creation to stimulate the economy.

 

 

 

 

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Frank Van Lerven

Frank is our Research and Policy Analyst, and is responsible for our research on current events. Frank also leads our research in Public Money Creation and Quantitative Easing. Prior to working on the availability of credit under a Sovereign Money system, Frank also researched issues related to the 1844 Bank Charter Act and its implications for contemporary monetary policy. With a Research Master’s in Advanced Political Economy (cum laude) and a BA in African Development Studies, Frank is especially interested in how Western financial systems (and models) influence developing economies.
  • Marco Saba

    BoE can blackmail banks into submission very easily by asking: how much seigniorage from electronic money creation is past due by the banks ?

  • RJ

    Another first rate post.

    “As for government debt, Japan’s debt/GDP ratio is 230%, compared to
    Greece’s 177%. But the consequences have been much more dire in Greece
    than in Japan.”

    The KEY reason is that Greece is no longer monetary sovereign. In other words Greece no longer control their own central bank. And have a floating currency. So spending for them is restricted by their ability to borrow money from the markets or banks at the markets or banks interest rates. And terms re repayments.

    Not so with Japan. They can spend without limit without taxing. Bond issue are no more than a means of draining reserves (it also drains the extra bank credit created by deficit spending which I actually think is often a good not bad outcome). Monetary sovereign governments do not need to borrow (sell bonds) from anyone. Even in the current rule bound world Govts can sell bonds and then simple buy them back using QE. An indirect approach to financing deficits using the central bank.

    • http://www.jamesmurraylaw.com/about/who-is-jim-murray/ James Murray

      You really do insist on peddling your incomplete and confusing posts.
      You have been saying the same things through the four years you have been “contributing” to these pages.
      You dribble on about BoE reserves and insist that the BoE cannot merely CREDIT the Treasury’s account with say, £10 billion for the Govt to spend (ie Sovereign Money Creation).
      The balanced entry is a DEBIT account at the bank to record the transaction – your famous journal entry.
      The latter records that the Treaury had issued interest free bonds with no redemption date and the Bank was happy to buy them at face value.
      So, in SMC the Govt ends up creating and so gaining £10 billion to spend
      It does owe itself that money – but so what. .

      Normally, Govt expenditure is financed by Taxes or Borrowing, but now SMC is a wonderful new type of Govt income – SMC.
      Why go anywhere else for the shortfall in the books?
      So please RJ.
      Tell us all what is wrong with SMC and we can smile and go on our way knowing that you disagree with all the PM proposals.
      Give us a rest RJ.

      cc by way of answer to other RJ posts….

  • Vince Richardson

    “In accordance with what Positive Money has argued
    for some time now, the reduction of government spending without a
    corresponding increase in exports, will ultimately mean that growth will
    depend on the private sector having to borrow more”

    Seems exports are pretty steady,so presumably we are not expecting much growth there.

    https://www.uktradeinfo.com/Statistics/OverseasTradeStatistics/Pages/OTS.aspx

  • RJ

    Re the size of monetary sovereign government debt.

    IMHO opinion there is a lot of nonsense written about % of GNP etc. It’s all rubbish to stop government deficit spending to help the poor, build homes, hospitals, clean energy etc. It seems some want a down-trodden, almost slave labor workforce rather than free and prosperous people. And an excuse to justify governments selling off valuable assets on the cheap.

    The UK government can spend without limit. This is a fact. The BoE are required to issue reserves as a bank asset whenever the UK Govt spend (to back the bank credit liability). And currently mostly drain reserves due to deficit spending by issuing bonds. There is no borrowing required so the UK Govt can spend.Bond are issued after the event. (Euro countries are very different).

    The final outcome is the UK Govt acquires services or assets in exchange for bonds. Bonds have value because they can always be exchanged for tax. But how much is too much. Once again in my view bonds could be issued at least equal to our current savings requirements. So if say the UK has a retirement saving requirement of £10 trillion today (it’s likely more) . Then the government could responsibly deficit spend as required up until this level (and if required make Govt bond pension savings compulsory). And this should be net of government assets. And yet some wet their pants about £900 billion.

    We live in a strange world where many are scared of governemnt journal entries.

    • Crash

      >>The UK government can spend without limit. This is a fact. The BoE are
      required to issue reserves as a bank asset whenever the UK Govt spend
      (to back the bank credit liability). And currently mostly drain reserves
      due to deficit spending by issuing bonds.
      >>

      You still haven’t answered the following questions for your statements to make any kind of sense.
      Where does government get the liquidity from to deficit spend more than it receives in taxes?
      If the liquidity comes from the issue of new bonds only, how can the increase in government purchasing power be bigger than the reduction in purchasing power by private bondholders in order for the total money supply to grow?
      If the liquidity comes straight from the Central Bank because the government sold the bonds directly to the Central Bank, where does the Central Bank get the money from and how exactly does the government access this money?

      • RJ

        “where does the Central Bank get the money from and how exactly does the government access this money?”

        What do you think money is? In simple terms. Please don’t get lost in long pointless explanation about real money verse not real money. Or liquity. Today what is money. In other words what do the banks use to settle with each other and the treasury. And what do we (banks and the treasury with non banks / treasury and everyone else) for goods or assets purchased etc.

        • Crash

          I know very well what money is. Of course there are distinctions about what money is backed with – cash is backed by the government’s ability to collect taxes by force) and the rest of the money supply is backed by a debtor’s promise to pay in the future.

          But my question is more about the actual real world process of deficit spending. Where does the difference between collected taxes and the money spent come from? In any case someone has to front that money.

          Now you keep repeating that issuing government bonds is removing reserves, and I can follow that logic. What it does not answer, however, is how deficit spending by the government adds purchasing power to the system if the money that is used to buy the bonds upon their issue has to already be in existence. Bonds are peer to peer lending, they do not create new money the same way bank lending via balance sheet extension does. They are only neutral and redistributive in nature (patient bondholders’ purchasing power goes down vs impatient government’s purchasing power goes up).

          The only way this can happen is if:
          a) Non banks take out a loan with a commercial bank to purchase the government bond with that newly created money (very unlikely since that would be a net loss due to the interest for that loan being definitely higher than the interest payment from the bond)
          b) Banks buying the government bonds not from their existing equity, but via an extension of credit (balance sheet extension). In that case banks are printing the money they are buying the govt bonds with.
          c) The central bank buys the bonds directly off the treasury with newly created money. In this case the government would owe the money to itself essentially. Upon repayment the principal is cancelled out and interest paid on the bond goes from the government’s left pocket into the government’s right pocket – essentially cancelling itself out as well.

          • RJ

            When the UK Govt spends the BoE creates new reserves by a journal entry. These new reserves then becomes the asset held by the bank to back the bank credit liability = our new money

            DEBIT BoE reserves (banks asset / BoE liability)

            CREDIT Bank credit (banks liability / our money asset)

            So Govt paying an entity creates new money (bank credit). Just like a person taking out a new loan. It really is very simple so I’m unsure why many are so confused by it all. Bonds are simple sold to drain (cancel out) this increased money (bank credit) and increased bank reserves.

          • Crash

            Thank you, I just wanted you to clear up your thinking. So you are basically saying that the BoE is creating the money with which the government finances its spending. The BoE so to speak tops up the government workers’ bank accounts.

            It’s not so much that we are confused, it’s that most of us here still don’t get what your issues with Positive Money’s switch to sovereign money where this whole creating reserves/draining reserves cycle paired with interest payments to bondholders gets bypassed. It’s unnecessary in the first place and the interest payments are a deadweight loss. The accounting in the proposal is solid. What is different is that money redefined as a commodity/equity and not a debt and it does not disappear when a debt is repaid but instead is recycled within the system. It’s as simple as that.

          • RJ

            I have said that if starting completely from scratch I would likely go the sovereign money route. Although all this means is all money would equal central bank reserves (notes and coins would be a token for reserves rather than a token for bank credit).

            But changing now would be a massive change. Costing a fortune and taking many years (10 years minimum) And it wouldn’t achieve much. Banks would still recycle money as Lord Turner pointed out. So if Crash invested £100,000 of reserves. This could be invested in Lloyds who loans to RJ who invests back in Barclays etc. £100,000 could recycle 100 times. So £100,000 would create 10 million of reserves = new money. Just like at present.

            And the UK Govt would have no more power. They can create all the money they need without restriction using BoE reserves today (as an asset to support NEW bank credit). The ruling elite just do not want people to know this though. So all the misinformation about this subject.

            And once again. Only monetary sovereign Govt’s have this power. This requires. 1 A floating currency. 2 No gold standard. 3 Bonds denominated in the local currency. 4 Govt owns and controls their own central bank.

            I will add a strong economy and responsible Govt. This isn’t a requirement but without this inflation or a collapsing currency might result.

          • Crash

            “But changing now would be a massive change. Costing a fortune
            and taking many years (10 years minimum) And it wouldn’t achieve much.
            Banks would still recycle money as Lord Turner pointed out. So if Crash
            invested £100,000 of reserves. This could be invested in Lloyds who
            loans to RJ who invests back in Barclays etc. £100,000 could recycle 100
            times. So £100,000 would create 10 million of reserves = new money.
            Just like at present.”

            This does not make a whole lot of sense to me. How can 100.000 GBP of reserves create 10 million in a sovereign money system where there are no reserves but just base money? Did you mean income? Because that’s a flow, not a stock. Banks cannot recycle any debt that is repaid as the repayment reduces the bank’s balance sheet. Plus, there are no reserves in a sovereign money system. Imagine it to be a 100% cash economy.

            I disagree that it would cost more. In fact, it would cost a lot less. It would take 10+ years to convert the whole existing money supply (bank loans) into sovereign money, sure, but it wouldn’t cost a fortune and it would allow the government a huge reduction of their outstanding government debt to the private sector via the one time conversion seignorage.

            Each loan that gets repaid remains in existence, as opposed to being destroyed. So when banks want to give out a loan they cannot extend their balance sheets any more. Instead what happens is that the repaid loans that did not get destroyed are recycled back into the economy by the government via government spending and then used by savers in a peer to peer lending model with the banks as mere intermediaries.
            A true monetary sovereign does not need a system where it needs to drain reserves from the private sector and pay interest to it. It’s as simple as that. Interest payments for tax credits (which is what money essentially is) just skews the system towards more inequality.

  • Marco Saba

    If we reverse the prospective proposing that the Treasury issue the money and lend it to banks what happens ? Maybe we can save the banking system ?

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