Managing Government Debt

When tax revenue does not fully cover expenses, a government will issue new government bonds. The Treasury Department sells them to the commercial banks (primary market), and the banks will sell part of them to the private sector and to foreigners (secondary market). If these potential buyers are reluctant to buy, the government must offer higher interest rates on these bonds to make them more attractive. But the resulting high interest payments would put further stress on the government. In most countries, the central bank is not allowed to directly finance the government, but buying government bonds from commercial banks as an intermediary has proven to be a viable solution in the U.S., the EU, Japan, and other countries since the GFC. The central bank "pays" for these government bonds by simply increasing the size of commercial bank deposits in the central bank's computer system. Interest payments for government bonds owned by the central bank, which in effect is also a government entity (see here), do not really matter, and when the bonds mature, the debt simply disappears. The technical term for this trick is monetization of government debt. A less polite name is "printing money", although officials will never admit that this is what they were doing to deal with the euro crisis in the early 2010s.

A variant of this trick was used in the U.S. in the aftermath of the GFC. Since commercial banks lost a significant amount of money in the GFC, the central bank bought existing government bonds and other financial assets from commercial banks to refinance them. With these rebuilt reserves, commercial banks could continue to grant loans to the private sector and help the economy recover. The technical term coined for several rounds of this trick was Quantitative Easing QE. Many years later, when the central bank reduced its balance sheet, partly by selling these assets and mostly by simply letting the bonds mature without buying new ones, the procedure was called Quantitative Tightening QT.

Another trick central banks use to help their governments is Yield Curve Control. Again, they print money to buy government bonds, especially older bonds in the secondary market. By targeting mid- to long-term (10+ years) maturities, the artificial demand causes rising bond prices and thus lower bond yields. While the central bank can directly set the short-term interest rate, with this trick it can also lower the interest rate for newly issued bonds of longer maturities. The central bank of Japan was the first central bank to officially admit to using this policy. Forcing interest rates to decline below the current level of the inflation rate CPI is many politicians' favorite strategy, as it seems to devalue the debt and make later repayment easier. However, interest rates below CPI have a negative effect on those who save. The concept is known as financial repression.

What is the influence of all these money-printing policies on inflation? It depends on the economic situation and where the newly printed money ends up. Quantitative Easing was used to refinance what the banks lost in the GFC. The money stayed mostly in the banking system in the U.S.. Banks used the new reserves to grant loans to the private sector again, which helped the economy to come out of the deep recession. CPI stopped declining and slightly increased, but stayed in the 2% per year range, which central banks consider desirable. The inflation effect we saw was asset price inflation in the stock and real estate markets. Low interest rates allowed investors to speculate on margin at the stock exchanges and to take cheap mortgages to finance real estate investments. The Covid-19 crisis, however, resulted in a year with the CPI above 10%. This inflation had two primary triggers. First, several supply chains broke and factories closed for some time, that is, the amount of goods and services available decreased. Second, governments gave money to struggling businesses and households, which they spent once goods and services were available again. A textbook example of supply and demand driving inflation where the private sector spent more money on a constant or decreasing amount of goods and services.

Sustainable Debt Levels?

All the money printing policies increase the debt of a country. There is a lot of debate among economists about what amount of debt is sustainable for a country. If you know the free cashflow of a household or company and if you can come up with realistic expectations as to how it will develop in the coming years, simple math allows you to calculate which amount of interest and debt repayment is feasible. Commercial banks granting loans and mortgages for the private sector make these calculations every day. And they usually claim the house, car or whatever was bought with the loan, when the debtor does not repay.

But where to get the free cashflow for the complex economy of a country? So economists use the GDP and the debt-to-GDP ratio instead. But nobody knows, which fraction of the GDP can be safely used to pay for the debt without having a negative impact on the future GDP. They do not even agree on how to calculate the outstanding amount of debt. While it is easy to sum up the amount of outstanding government bonds, what to do with obligations like future payments for social security, pensions of government employees, and so on. And is it enough to look at government debt or is it necessary to add private debt to assess the taxpayers' ability to repay?

Does it matter who owns the debt? When government debt is owned within a country, its taxpayers collectively repay interest and debt to themselves. So some politicians consider it a matter of how to distribute wealth and money inside the country, not about how to earn it. However, when your debt is owned by foreigners, will they send their military, if you do not repay? These foreigners are not your voters, so if you do not fear their military, why not default on this debt? This puzzle still waits to be solved and we will stop this discussion here.

Company Financing

Companies have basically two ways to get financing:

Equity (owning a company)
- The founders of a startup typically put their own money into the company. When they need more capital, they try to find private investors and sell a fraction of their company to them (private equity) on terms negotiated on a case-by-case basis.
- When the company is on a route to stable growth, the company may decide to go public (Initial Public Offering IPO), i.e. create stocks (shares, public equity) which are sold via an investment bank. Stocks are a regulated fraction of ownership of the company which require standardized accounting practices and force the company's board to report about the financial success of the company every few months. IPOs often happen when the original investors want to cash out because they believe the future upside to be no longer attractive.
- Stock buyers are co-owners of the company. They receive a share of the company's cash flow (dividends) and have voting rights to appoint and control the board of directors.
- Stocks are traded daily on stock exchanges at market prices, i.e. based on supply and demand, which will depend on the business success of the company as well as on the overall economy and the public mood.
- When the company needs more money, e.g., for an acquisition of another company, it may issue additional shares, often diluting existing ones.
- When the company creates profits, instead of paying dividends to its shareholders, it can also buy its own stocks (stock buyback). This makes the remaining stocks more valuable, i.e. their market price should rise.
- Stocks offer unlimited upside (if the company is successful). The downside risk is a loss of up to 100%, if the company is not successful or eventually goes bankrupt.
- It's important to understand that the issuing company only receives new funds for investment when you purchase stocks (or bonds) at the initial public offering IPO, i.e., in the primary market. Buying on a stock exchange, i.e., the secondary market, simply means swapping money with the holder of the stock.
Debt (lending to a company)
- The simplest forms of debt are credit from private investors (private credit) or loans from banks. The donor of the capital does not acquire ownership of the company, but gets a promise that the company will pay interest (typically at a fixed rate of the debt's nominal value) and repay the loan within a certain time frame. Terms are negotiated on a case-by-case basis.
- Corporate bonds are a standardized form of loans, where the loans are split into small chunks, so that less wealthy investors can buy them.
- Bonds can be traded with other investors at market prices, if the investor needs the money back before the bond expires.
- Bonds rather than loans are used, when the sum of the debt is too big for a bank or a small group of investors, or when the company thinks that bond investors will accept lower interest rates than a bank or a group of private investors would.
- Bonds offer a predefined limited upside, i.e. the interest paid. Once they mature, their nominal value will be repaid, no matter how successful the company's business model is. However, if the company goes bankrupt, the bondholder will only get part or none of her capital back when the company is liquidated. The presumed probability of bankruptcy does influence the interest rate of the bond. Riskier companies or bonds with a longer maturity have to pay higher interest rates.

Both private credit and private equity are less regulated and largely opaque. Because nobody knows exactly how much money is in these markets and who owns it, a default of such an instrument could trigger a larger financial crisis, as happened in the GFC, when the bubble in the opaque asset-backed securities ABS market burst.

Managing Government Debt

Sustainable Debt Levels?

Company Financing

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