Analysis by Keith Rankin.
“We are borrowing tens of billions of dollars from our children and grandchildren to get us through the Covid crisis…”. (James Shaw in interview on Radio New Zealand’s Nine to Noon, 23 April 2020)
Debtors and Creditors
Literally, for me to be in debt to somebody means that the ‘somebody’ (the creditor, maybe my friend) has incurred a sacrifice so that I (the debtor) can access some want or need today that I am not otherwise entitled to. We accept that people will not normally make such sacrifices without compensation, and that such compensation is called ‘interest’.
A good example would be if both my friend and I wanted to buy a bicycle. He could afford a basic bicycle now, and I cannot. But I claim to have a more immediate need for a bicycle now. So he lends me enough money so that I can buy a basic bicycle now, and, over time, repay him with interest. As a result, a year later he gets to buy a better bicycle – one with bells and whistles – on account of the interest he receives from me. He makes a present sacrifice (a year without a bicycle), and gains a future reward (a bicycle with bells and whistles). I make a future sacrifice (no bells and whistles), and gain a present reward (a bicycle).
In this financial view of debt, my friend both saved (ie did not spend) and invested (gained a yield in return for a sacrifice). A finance professional would say that my friend had invested in me by buying my ‘bond’. An economist might tolerate that view of my friend as an ‘investor’ if I only wanted my bicycle for pleasure. But, if I needed my bicycle to run a courier business, then I would be the investor, not my friend. To a financial analyst, the words ‘saving’ and ‘investing’ are synonyms. To an economic analyst, ‘saving’ and ‘investing’ are antonyms; to an economist ‘investment’ is the process of purchasing goods and services (spending) that help someone to run a business. To a financial analyst, ‘investment’ is the process of purchasing a promise (which is saving, not spending).
This example shows how the language of finance is somewhat murky, and why so many people give up on trying to understand finance, and how they often extend that abstinence by giving up on economics too.
We may also note that, this bicycle example of a debt transaction explains why many people believe that it is impossible to have negative interest rates; this view is that interest is compensation for sacrifice. This is the prevailing view of financial analysis. (We may note that financial analysts extoll the magic of compounded interest; that by making repeated sacrifices ‘investors’ can accumulate rewards at an exponential growth rate. One catch is that investors must abstain from the enjoyment of their rewards. Another catch is something economists call ‘negative real interest rates’.)
Economists, on the other hand, understand my bicycle example as inter-temporal trade (trade between the present and the future) and that interest is the price that balances supply and demand for such trade. Thus, in economics, interest rates can be positive or negative. Further economists like to talk about ‘real interest rates’ (essentially the contracted interest rate minus the rate of inflation), and accept that, for much of history, real interest rates have been negative. (So much for the alchemy of compound interest!)
(As an aside, for much of the 2010s’ decade, Switzerland had both deflation – falling prices, eg annual inflation of minus one percent – and negative interest rates, eg minus half a percent. When those numbers applied, real interest rates were positive; minus half a percent minusminus one percent equals plus half a percent!)
Saving as Insurance
The reality is that finance is not really about savers making sacrifices. For example, most retirement savings are not spent by old people enjoying their bells and whistles in the last years of their lives. Rather, most private retirement savings ends up in the savers’ estates. In many cases it is their adult children who spend what their deceased parents did not; in perhaps more cases, the inherited money is left in the bank and forms part of the inheritors’ estates. (In matters of inheritance, who is the ‘inheritee’?)
By and large it is high-income people who save; people who do not have to make sacrifices and by and large do not make sacrifices. (Traditional misers – such as Dickens’ Scrooge – may appear to make sacrifices by living miserly lives; but those lives represent their choices. Others may stay in basic cabins when they go on holiday, despite the fact that they could easily afford much better accommodation; again, these frugal lifestyles represent preferences, not sacrifices.)
Most savers do not save for a ‘sunny day’; they are rich enough to not need to save for things they really want. The real reason that most people save is for a ‘rainy day’, as a precaution in case something goes wrong in the future. Their sacrifice is akin to an insurance premium; and it’s a very small sacrifice given that most savers do not live noticeably frugal lives.
What they do want is to be sure that they can withdraw some or all of their savings when it rains very hard. As such, they face a general problem that exists with all insurance. My insurance works when it rains on me, but not on other people. My family or myself gain a payout when my rainy day happens (it could be my death).
What happens when it rains on everybody at the same time? In Christchurch in 2011 the insurance industry could not cope. Further, even Christchurch people with mortgage-free houses and lots of money in the bank had to compete for the services of builders and plumbers and the like. The constraint on happiness was the shortage of essential workers and essential equipment; and an unsafe environment where many workers (including essential workers) were unable to ply their trades. There are times when money cannot buy happiness. The insurance industry’s solution is reinsurance; insurance companies ensuring themselves against large claims.
Neither conventional insurance nor lots of money in the bank can guarantee policyholders or savers security in times of war, pestilence or famine. These are cases when it doesn’t just rain on everyone in your city; rather, it rains on everyone everywhere. When the supply chains are broken, attempts by savers to spend their money result in inflation, maybe hyperinflation. A million dollars of savings is worthless when inflation reaches one billion percent.
Saving represents the creditor side of transactions for with the other parties are debtors. The debtors get extra happiness today; the creditors expect to get extra happiness in the future. A particularly important form of happiness is economic security. (When Cinderella married her prince and lived happily ever after, we may assume that she got three meals a day and a roof over her head; her marriage was like a pauper winning lotto; having a sense of economic security is a very important form of happiness.)
When supply chains are broken, government spending to resurrect and recreate supply chains, and to ensure everyone can access those supply chains, becomes all-important. Such government spending is necessarily debt-funded, except perhaps in a few countries where governments (such as Norway or Saudi Arabia) have large sovereign wealth funds. Governments are insurers of last resort; refer David Moss (2002), When All Else Fails.
James Shaw, co-leader of the New Zealand Green Party
What do we make of Shaw’s claim that we are borrowing from our grandchildren? Does it make sense? Will there be some future financial reckoning which might have an adverse impact on our children? If our grandchildren are debtors, will they have to make sacrifices to settle this debt? Or are they creditors who may become victim to a default? A literal interpretation of Shaw’s statement is that our grandchildren are creditors, not debtors. Creditors by definition gain their benefits in the future, having made sacrifices in the present.
Certainly, there is no shortage of economic commentators who suggest that in the future all this ‘borrowed money’ will have to be ‘paid back’. I think Shaw was making the point that we need to spend wisely, equipping our grandchildren so that they will be able to pay the money back rather than default on debt contracts signed by their grandparents. That makes them debtors, not creditors. Who will they pay the money back to?
They will owe the money to themselves. There need be no reckoning after all.
By ‘we’, Shaw means the New Zealand government. The New Zealand government clearly is the debtor, here, the government of course being a proxy for the New Zealand people.
It sounds as if Shaw really means the opposite of what he said, that our grandchildren will be debtors, in the sense that they will inherit government’s debts incurred by their grandparents. I think that Shaw was trying to say that our grandchildren may inherit a government debt to GDP ratio of (say) 100 percent, and that they will have to pay higher taxes in order to get that ratio down to the 20 percent of GDP that this somewhat austere government believes is appropriate.
Government debt comes in four categories; that is, there are four different possible classes of creditor. Some creditors are less benign than others.
In the first case a government borrows directly or indirectly from its Reserve Bank (aka ‘central bank’), creating what some commentators call ‘monetised debt’. The debtors are the economic citizens of New Zealand, who also happen to be the shareholders of the Reserve Bank. So long as the resultant spending is done to ease the problem of a broken supply chain, and to pay benefits to ensure that all the resident population can draw sustenance from that supply chain, then the putative sacrifice (inflation) becomes less likely, not more likely.
In the second case, a national government borrows from that nation’s private savers, either directly (as in the historic cases of war bonds) or indirectly through the commercial banks. Interest rates may be high, low, zero, or negative. In the latter three cases, there is a surfeit of private savings and the government is acting as borrower of last resort. Private savers like this arrangement, because it is an alternative to increased taxation. The government spends while private savers refrain from spending; the savers are not making a sacrifice because they would have been savers anyway. The advantage for the savers – the creditors – is that they can still access their savings when individual savers face individual crises; this they could not do had they paid tax to the government instead of lending to the government. (This is the Japanese solution, where Japanese lend to their own government at minimal interest rates; they do this in preference to paying higher taxes. The massive Japanese government debt to its own middle class has many economic benefits to all concerned, and few detriments. Japan is not constrained by this debt.)
The third case does not apply in New Zealand, but certainly does in the European Union. This in when the governments of some European Union states are in financial debt to middle class savers mainly resident in other European Union states. In a well-functioning Union, such debt would be comparable to Japan’s government debt. But in Europe the north-south schism is such that this has become a huge problem, albeit an artificial problem.
The fourth case is when sovereign governments are in financial debt to unambiguously foreign creditors. In these situations, creditors may to take it upon themselves to throw their weight around; in particular to make unreasonable and unsustainable demands on debtor governments.
Thus, the problem that can arise from government debt is principally a political one, that relates to the creditor-debtor relationship, and the inequalities that reflect an asymmetrical creditor-debtor relationship.
So, what do we make of James Shaw’s statement? Covid19 sacrifices have been made by all the world’s people, in terms of direct or indirect health outcomes, in terms of lost liberty and induced agoraphobia, in terms of public policy mistakes in many countries, in terms of compromised livelihoods, and in terms of lost benefits which were tied to persons’ now-precarious market incomes. The increased public debt is required to offset these sacrifices.
There is no obvious creditor sacrifice. Rather, for those people with the capacity and preference to be creditors (especially in the second case sense above), government as borrower in a time of few viable private debtors may enable interest to be paid at positive interest rates; so there is a clear creditor reward. As for most debt contracts, the outcome is win-win.
A Constructive Rhetoric around Debt
Debt need not be the bogey which it is often portrayed as. The principal return on coming government emergency outlays will of course be the resurrected and reimagined supply chains, and the incomes (including tax revenues) they generate. Our children and grandchildren will be foremost among those beneficiaries. We can credit them.
Instead of invoking the debt bogey, Mr. Shaw, you could say:
“We are investing tens of billions of dollars for the benefit of our children and grandchildren. May their lives be stable, equitable, and sustainable.”