Managing Government Debt

When tax revenue does not fully cover expenses, a government issues new government bonds. The Treasury Department sells them to the commercial banks (primary market), and the banks 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 the bonds to make them more attractive. But the resulting high interest payments would put further stress on the government. To manage the situation, central banks in cooperation with their governments use different mechanisms:

In most countries, the central bank is not allowed to directly finance the government, but buying government bonds from commercial banks as an intermediaries 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. When the bonds finally mature, repayment is a simple bookkeeping operation between the treasury department's account and the central bank's account to let the debt disappear. 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 and lower the interest rate. 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 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 (YCC). 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 (Consumer Price Index 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 savers. The concept is known as financial repression.

Money Printing and Inflation

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:

In the aftermath of the GFC, quantitative Easing was used to refinance what the banks had lost. The money stayed mostly in the U.S. banking system. 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 generally 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 became available again. A textbook example of supply and demand shocks driving inflation, where the private sector spent more money on a constant or decreasing amount of goods and services.

Government Bonds as Collateral

In the modern financial system, government bonds act not only as fiscal instruments financing public spending, but also as core building blocks of the money and credit system:

Banks hold government bonds not only for their interest income, but also because these bonds are highly liquid and broadly accepted as collateral in secured lending markets. In repurchase agreements (repos), banks obtain short-term funding in the interbank market or from the central bank by selling government bonds with an agreement to buy them back later. The bonds serve as collateral, reducing risk for the lender and facilitating liquidity management.
A sufficiently large volume of reliable government bonds is necessary to support bank liquidity and credit creation. A shortage of these bonds or a loss of confidence in government debt would reduce collateral values and tighten bank funding with severe consequences for the overall economy.

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, i.e. which interest payments are affordable and if and when the debt can be repaid. 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. As governments mostly roll-over their debt instead of repay it, what if the financial market in the future does not accept that anymore. What about justice, when future generations are forced to repay today's debt? And is it enough to look at government debt or is it necessary to add private debt to assess the taxpayers' ability to repay?

Technically, a country such as the U.S. or Japan will always be able to pay interest and repay its debt, if the debt is in its home currency which the country's central bank can print. Excessive money printing may drastically weaken the currency, as can be seen when looking at the Japanese Yen in recent years, or to a steeply increasing inflation rate, as it did in Weimar Germany in the early 1920s. But Japan has survived until now with about 230% debt-to-GDP and the weak currency has helped its export-oriented economy. Weimar Germany got broken with hyper-inflation as a symptom, not the root cause, because it had to pay reparations in FX currency beyond what its economy could generate after it lost World War I.

Does it matter who owns the debt? When government debt is owned within the own 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? A small country would face trade sanctions and being cutoff from international capital markets in case of a default, but what if the country is among the largest economies in the world?

This puzzle of debt limits for large economies 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. Typically, the debtor must provide some collateral to backup a loan. Banks often use government bonds. Private debtors
Corporate bonds are a standardized form of loans, where the loans are split into small chunks, so that less wealthy investors can buy them and the risk is distributed on many creditors.
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 cannot or will not provide required collateral.
Bonds can be traded with other investors at market prices, if the investor needs the money back before the bond expires.
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 and loans or bonds with a longer maturity have to pay higher interest rates.

Private equity and private credit, frequently called shadow banking system, 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

Money Printing and Inflation

Government Bonds as Collateral

Sustainable Debt Levels?

Company Financing

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