Analysis by Keith Rankin.
Last week, out of left field, the government placed a three-year embargo on normal public sector wage bargaining, essentially a salary freeze. While there has been a certain amount of backtracking since, it is clear that the government has been very committed to ‘fiscal consolidation’ (aka ‘austerity’).
What were they thinking? What problem were they trying to solve?
Some governments are obsessed with their own debt levels, and prioritise the reduction of their own household debt over the economic management of the country. Such governments set themselves on a path of opting out of governance; it would be like teachers opting to save their employers money by not teaching.
Debt is a relationship.
The New Zealand government sees itself as a debtor who has gained recent favours from begrudging creditors who would really much rather spend their money on themselves, or lend that money to parties other than the government.
In real life, debt occurs as a contract between two parties who are both advantaged by that relationship; the parties to each contract are creditor (who owns the debt, as an asset) and the debtor (who owes the debt, as a liability).
The debt relationship that almost everyone is familiar with is depositing money in a bank. Householders are creditors, and banks are debtors, in this relationship.
Who decides when the relationship ends? It is normally the creditors who end (or diminish) the relationship, by withdrawing their money. Indeed it would seem very weird if the banks that we lend to keep trying to ‘pay us back’. Rather the banks expect to service their debt to us by paying us interest, and by allowing us to withdraw when we want to withdraw. (We all understand that, if most of a bank’s depositors want to recall their funds on the same day, then the bank would be unable to comply; banks, like almost all other debtors, invest – ie lend so someone else can spend – their borrowed funds. Banks are, indeed, intermediaries; we expect them to invest the funds we deposit with them, so that they can pay us interest.)
So, in life out of the public finance rabbithole, it is creditors who initiate the debt repayment process. The obligation of a debtor is to service the debt, including making sufficient provision to satisfy those creditors seeking repayment.
In the case of government debt, the creditor is essentially the wholesale banking system. Do we see any signs of our wholesale bankers asking government to reduce its liability to them? Of course not! Government debt is a mutually advantageous arrangement between creditor and debtor. Government action to reduce its debt to the banks would be like banks acting to get households to reduce their bank term deposits. Dumb and dumb.
Banks (in the broadest sense of this term) like to lend to – invest in – five sectors: businesses, unsecured consumers, asset holders, governments, and foreigners (especially foreign banks). They like to expand rather than to contract their balance sheets; ie to lend more to their customers, not less.
Conservative economists strongly emphasise banks’ lending to businesses; and deemphasise banks’ lending to governments. That is, they see it as right and proper that businesses – collectively – should have large and expanding debts, and that indeed it is business debt (aka business investment) that drives economic growth. So it is they – not the banks – who see bad government debt as ‘crowding out’ good business debt. That’s the source of the general opprobrium towards government debt, and that opprobrium resonates with the many householders who wrongly think of debt as an inconvenience to their creditors.
Who should the debtors be?
The whole capitalist system – with banking at its core – depends on debt. The majority of people who believe in economic growth necessarily also believe that total debt must be expanding.
Conservative economists at least have a consistent position; that business debt (lending to business) is good, that certain types of secured debt are also good (specifically house mortgages and hire purchase), and that a degree of foreign lending is also good. In the twenty-first century this ‘good-debt bad-debt’ thinking, however, represents another rabbit hole. The reality since the turn of the century is that the global corporates have become a creditor sector; in the aggregate, businesses now save more than they invest.
Bankers, unlike conservative economists, are indifferent. They will lend, rationally, on the basis of risk and reward.
For banks, lending to businesses is risky, because it is ‘secured’ only on the future revenues of their business customers; in an increasingly uncertain world, those revenues are also increasingly uncertain. Banks compensate for such ‘lack of security’ risks, by charging their business customers higher interest rates. While substantial business debt is an economic necessity, banks, as creditors, do sometimes recall that debt. (As the saying goes, a banker will lend you an umbrella when its sunny, but may ask you to repay it when it is raining.)
Also risky is unsecured consumer lending. (And semi-secured lending, in which a debtor’s likely future salary is the security.) This also drives the 21st century economy, especially in the form of credit card debt. The high risk is compensated for by charging high interest rates. Debtors like to repay these debts as quickly as possible, because of the high servicing costs associated with high interest borrowing. Creditors in this market need to keep finding new debtors to compensate for the repayments of existing debtors.
Secured lending is widely favoured by modern banks. This is lending secured by assets such as shares, land, houses, managed funds, and consumer durables. The problem here is that it fuels speculative behaviour through inflating the prices of those assets, especially, shares and land. Thus, too much of this type of lending is revealed as systemically unstable when asset prices periodically deflate. Banks which consider themselves too big to fail tend to give insufficient weight to this problem when they decide who to lend to. Thus, generally, this type of lending is seen by banks as less risky than the previous two categories. Interestingly, however, in the late-2000s’ financial crisis, the finance companies (included as ‘banks’ in this discussion) which failed were those doing secured lending; while few if any of the finance companies lending to the poor at high interest rates failed, some positively thrived).
A keenness to lend to foreigners – as some countries in northern Europe and East Asia like to do – is a political mercantilist strategy; historically prevalent as a political strategy, but not necessarily profit-maximising to banks. An important form of foreign lending is lending to banks in other countries. Indeed, when interest rates have been higher in New Zealand than in Australia, to maximise profits the Australian banks would lend to their New Zealand counterparts. In effect, much New Zealand mortgage debt was owned by Australian creditors.
Government debt has always been popular with banks. While it is low return, it is also low risk. Central Government debt is secured by the governments’ unique powers, the power of taxation. Even governments facing political constraints on raising taxes are seen as secure debtors because of their special reserve powers to tax their subjects. Governments are – and should be – borrowers of choice in times of emergency or great uncertainty.
Whenever capitalist economies face high levels of risk, banks prefer to lend more to governments. There is an ensuing natural feedback mechanism, in that non-corrupt government spending facilitated by increased government debt serves to reduce the amount of risk in the wider economy. The reduced risk then facilitates renewed lending to non-government unsecured and semi-secured debtors. The resulting private spending then results in more (tax) revenue to governments, and government debt to bankers automatically falls relative to the size of the economy.
One of the most destabilising types of event in financial history occurs when governments try to upset this benign arrangement by repaying debt to their banker creditors who do not want to be repaid, and who do not have enough good unsecured and semi-secured alternative debtors lined up. In this situation, economies may directly go into a state of depression – as in the 1930s, and as in the European Union in the early 2010s. Or, to forestall economic depression, banks may be induced into more of the speculative secured lending that creates financial bubbles, financial instability, and eventually economic depression.
This is the inept financial destabilisation that the present New Zealand government is indulging in. It’s a classic case of a lose-lose financial policy. When governments obsess about their financial deficits in uncertain times, everyone loses. Salaried workers lose, the poor lose, bankers lose (eventually), and governments lose.
Keith Rankin, trained as an economic historian, is a retired lecturer in Economics and Statistics. He lives in Auckland, New Zealand.
contact: keith at rankin.nz