National Debt. Is it good? Bad? Too big? Worth bringing down? Big scare tactic?

Great Debates
21

I like the descriptions and explanations of government debt in this thread, so I’m not going to bother to try to add to those.

Instead, I’ll address the other aspect of government debt: its necessity to investors.

Investment Characteristics of Government Debt

Government debt is viewed as risk-free of default. Countries like the US, UK, France, Germany etc. are seen as being absolutely 100% reliable when it comes to being able to pay the debt back and 100% on the nose when it comes to the timing of the payments too.

From an investment point of view, this is frequently essential.

The concept of Liability Matching

Investment is not normally about earning as much as you can. Instead, it’s about earning as much as you can subject to meeting your liabilities as they fall due.

Suppose that you have a liability that results in you having to pay $4 per year every year for the next 20 years. Suppose further that there is a government bond that pays $4 per year every year for the next 20 years. This means that you can purchase the government bond and your liability is taken care of. No risks, no problems, your ability to pay your liability stream is assured. This idea is called matching

That sounds like a simplistic example but it’s not too far removed from many situations, particularly when we’re looking at things like pension funds. Here’s a slightly more complicated example:

Matching in the context of a pension fund

Suppose a pension fund has $10m. It needs to pay out $400k per year until its members die. What does it invest its money in? Let’s say that the options are 20 year 5% government bonds and equities.

The equities may look more attractive. They certainly have a higher expected return than government bonds. But their trouble is one of uncertainty. Suppose all $10m is invested in equities and the economy experiences recession. Dividends drop below the 3% mark and all of a sudden you don’t have the liquidity to pay your pensions. This forces you to sell some of those equities… at the bottom of the market. Not good. Even worse, there are often statutory regulations requiring you to value your assets at market level. This means that a typical violent equity market swing may leave you technically insolvent even though your asset base is unchanged!

All in all, 100% investment in equities in such a case is too risky. But if we invest $8m in the 5% bonds, we know that we’ve got our pension payments covered no matter what. The average life expectancy post retirement is less than 20 years, so the 20 year lifetime should be sufficient and we can always reinvest later if necessary.

We now have $2m left over to invest as we wish - typically for maximum return.

I’ll stop there before really launching into financial economics, since this subject can be 100x more complicated. Rest assured however that this is how you need to think if you are investing in the context of a pension fund or similar.

Conclusion

Institutions such as pension funds, life companies and insurance companies (to some extent) view government bonds as absolutely crucial to their management. But who are the recipients of life policies and pensions? Us! So the stability of our long term financial futures are all dependent on the existence of a sizable and liquid government bond market.

I’m not sure quite how big that market needs to be. But bear in mind that typically less than 50% of a pension fund is invested in equities and an even smaller percentage of a life company’s funds and note that 70% of the stock market is owned by these institutions! That implies that the government bond market needs to be very large indeed.

So next time you worry about government debt, remember this: without it we’d all be screwed.

pan

22

kabbes:

Your point is an interesting one, and a perspective I had not fully considered before. However, I do not think we would be “screwed” with less government debt in the form of bonds. Perhaps our premiums for insurance would be higher, but that could potentially be offset by lower taxes (as less treasury money go to pay off interest). In effect, we as taxpayers are paying the premium for our insurance, but also the returns paid to the insurance company for their bond investment. What form that payment actually takes seems irrelevant, as the money ends up in the same place. To my mind, I would much rather have the direct link of my money going directly to the insurance company so that I could make a rational choice as to how much to pay for how much coverage. Again, I am a stranger in a strange land in the world of economics, so feel free to educate me, if you would be so kind.

CTB

23

RickJay, or anyone else who cares to answer:

So, is there any compelling reason that the debt should be paid off, or even paid down, other than satisfaction of knowing we’re paying off debt? If the ROI on investments is always such that we stand to gain more by investing money (into the economy, or whatever) than we stand to gain by reducing our interest payments on the debt, why bother?

Also, how does one determine if the debt is rising “too fast” - is it just if the interest payments exceed the payout of said investments, or is there some other limiting factor?
Jeff

24

ElJeffe, there are limiting factors, such as when the return on projects falls below the interest rate. However, government uses fuzzy math in determining return (not fuzzy bad, just fuzzy as in not always quantifiable). Social aspects have to be determined. Impact on other government costs (how much does a government sponsored works package reduce welfare, and what if any is the tax revenue gain? what other effects on the economy does this have?)

One compelling reason is questioning how much of a tax burden debt will have in future periods. In economic downturns when tax revenue is down, servicing government debt uses a greater percentage of tax revenue, takes limited resources away from potentially better uses, and it should hinder how the government can move financially. However, presidents will generally listen to economists who share similar viewpoints, and we all know the only thing two economists can agree on is that the third is wrong, and we end up with tax cuts when greater revenue is needed.

P.S. I’m not blanketly against Bush, nor am I pro- or anti- either political party, but I feel that a tax cut right now is the wrong move. Now it’s time to sit back and hopefully be proven wrong once again

25

Thanks, D_Odds. That being said, is there some general rule of thumb that gives one an idea of whether the growth of the debt is acceptable? Like, “Keep the growth rate of the debt below inflation,” or something?

Jeff

26

Not that I know of. Public companies have fairly specific formulas regarding the issuance of debt over equity to raise money. The government, however, loves pork, and I don’t know how they decide when to limit spending. Additionally, little things like wars come about and destroy fiscal planning. When President Clinton was forecasting 5 years forward, he didn’t account on Gulf II. President Bush doesn’t know what cash guzzler is going to come 5 years from now either. I don’t think contingency funds are large enough to handle an all-out war, but I may be wrong on that.

[aside]While wars are very expensive, most of the money spent does get circulated through the economy, increasing tax revenue and creating jobs, lessening the net cost. So when someone cries how the war cost 600 trillion or whatever, remember that the money was put into citizens’ (and corporations) pockets, and a good chunk is coming right back. For every $5 the government spends on a bullet, it will get approx. $1.67 back in direct taxes, and more on the ripple effect.[/aside]

27

CTB if (general) insurance companies were all we were talking about then I’d say fuck 'em. And that’s from someone who is a general insurance consultant.

The consequence of poor investment for a GI company is that their profit goes down the plug hole. Well boo-fucking-hoo. But in the worst case they go bust. In this case, policyholders may well be screwed. They’ve paid their premium and they haven’t got a policy to show for it.

But that’s not such a big deal. Firstly, GI products don’t tend to be life or death, for the main. Secondly, structures tend to be in place to protect the serious losers from the collapse. Thirdly, GI companies tend to invest mostly in cash anyway so the issue is somewhat more moot.

But unfortunately when it comes to life insurance policies and pension funds it’s a slightly different matter.

If a life company goes down the drain, that’s peoples’ life savings we’re talking about. And lest you think it can’t happen, I’d point you to Equitable Life in the UK as a recent example. People have lost on average 25% to 50% of their savings in one fell swoop.

And pension funds are even worse. Generally all of peoples’ income eggs are in the one pension basket. If that pension disappears (or even gets halved) the consequences are extremely dire.

So we agree (hopefully) that these things are very much to be avoided. How can we avoid them?

Well you suggest that if we didn’t have to pay the tax to cover interest payments then we could afford the higher premiums instead. This is possibly true, but I’m not convinced actually. A life company will attempt to operate at the 99th percentile, i.e. there is a 1% chance of insolvency in the time horizon being considered. Without the existence of matching investments the volatility of the assets less the liabilities increases enormously. It’s hard to get a feel for the numbers but I wouldn’t be surprised to see at least a 25% hike in premium prices, possibly a lot more. I don’t think the tax savings would cover this.

In the meantime, the life company would have to hold a far higher capital base to support its liabilities, which would be inefficent resulting in a net loss to the national GDP. Again, the combined effect of this across all such investors is hard to quantify but it wouldn’t be insignificant.

No – all in all I’m pretty certain that a country is far, far better off with at least enough national debt to support its long-term institutional investors. Things get bad enough even when the government starts paying off rather than issuing its bonds and the prices of those bonds start to escalate. We’re seeing all kinds of technical insolvency problems in the UK for these reasons.

pan

28

kabbes,

Thanks again for the insightful response. You have won one small battle in the fight against ignorance and I am thankful, as I previously had thought of the national debt as an entirely bad thing.

However, I am still a bit distrustful of the indirect nature of all of this. I do not see why the government cannot just tell the American (or British) people “Look, we want to do some cool stuff, but the budget does not cut it, so we are going to introduce a temporary tax hike of X% for the next 5 years.” Yes, I know that no one has ever gotten elected by promising to raise taxes, but we are in effect doing that in the present system, just in an indirect fashion. Such would of course require more honesty than is present in the current batch of politicians (from any and all parties), but in the abstract, is this not more efficient? Every time money changes hands there is increased inefficiency due to middle men and mangement of the process.

As far as the insurance companies go, as you said, fuck 'em. They are supposed to be experts at risk analysis, and should well be able to come up with a new model that covers their financial bases even without rock-solid gov’t bonds. Perhaps during a changover, the government would need to bail out a few insurance companies that fail to make the transition. The costs of doing such would seem to pale in comparison to even a single year’s interest payment on the national debt. I quite agree that the policy holders need to be protected, and thus the bail-out.

29

To add to kabbes, Markowitz Portfolio Management Theory says that the addition of a risk-free asset to a portfolio shifts the risk-return curve up. What that means is that you get a greater return for the same amount of risk with the addition of risk-free assets. There is a financial need for risk-free assets. The question is what level? Is a servicing level of 25-30% of revenue too much? I think so, but I can’t quantify it for you.