Hardly a day passes without some voice on social media lamenting the indebtedness of major economies. Either governments have borrowed too much (e.g., the US, Japan) or the private sector has (e.g., China). But is such handwringing always or even mostly warranted?
Below, we explore why indebtedness—public and private sector alike—is often misunderstood. Importantly, the most common misperceptions reside the inability to understand linkages between public, private, and foreign indebtedness.
Before turning to that discussion, however, two points are worth emphasizing.
First, this is not an apology for just any borrowing. Debt can become excessive. Misguided borrowing occurs all-too frequently. Borrowers, lenders, and regulators have responsibilities to ensure that debt burdens are appropriate and sustainable.
For example, this century China has borrowed and spent too much on its stock of housing, while simultaneously borrowing and spending too little on productivity-enhancing investments. Those misallocations of resources are significant, they are robbing China’s economy of its vitality, and they will take years to undo.
Still—and this is the second point—much borrowing in any economy is legitimate. We should not moralize borrowing. Financing short-term working capital needs, long-term investment, housing, or other big-ticket items is both normal and usually desirable. So is smoothing consumption over one’s lifetime, which often involves borrowing at younger ages (for example, for education or housing) with repayment later in life.
But our primary point here is different—namely that the fundamental drivers of economy-wide borrowing are often misunderstood, meaning that criticisms are either wide of the mark or, worse, lead to poor and even dangerous policies.
In this context, it is worth recalling a truism—an identity—that for any economy the gap between private sector savings and investment must equal the government’s budget balance less the country’s trade balance. For instance, borrowing by the private sector (if investment exceeds savings) must be financed by either public sector savings (a budget surplus) or capital imports (a trade deficit), or some combination thereof.
The key insight—which many debt moralizers miss—is that private sector, public sector, and foreign borrowing outcomes are interdependent, not independent.
To see why that insight is helpful, consider the experience of the US since the global financial crisis (GFC).
Over the past fifteen years, the average US personal savings rate has roughly doubled (excluding the distortions of the pandemic years), relative to its rate from 1997-2007. Unsurprisingly, household borrowing, as a share of GDP, has therefore declined, falling almost a third from its GFC peak. Meanwhile, business investment spending has remained relative constant (as a share of GDP) and corporate borrowing, also as a share of GDP, has roughly remained unchanged.
The algebra of GDP accounting, therefore, suggests that following the GFC, as private sector savings rose relative to investment, either the trade deficit would decline, or government borrowing would increase. It turns out that from 2010-2017, the trade deficit shrank from 6% of GDP to 2% of GDP. The federal government budget deficit fell even more, narrowing from-9.8% of GDP in 2009 to -2.5% of GDP in 2017. Hence, in the years immediately after the GFC, both the US private and public sectors became relatively thriftier, leading to a decline in the trade deficit and a slowing of foreign debt accumulation.
However, since 2017, both the budget and trade deficits have again widened. Since, 2017 (courtesy first of un-funded Trump tax cuts and then Covid-related government spending), public sector borrowing has surged. The result has been a predictable increase in the trade deficit, as the US has relied on foreign capital inflows to finance growing federal government budget deficits.
The preceding examples illustrate the linkages between aggregate private, public, and foreign indebtedness. But there is another, even more important, aspect to consider. Namely, when private sector savings surges and investment collapses, as often occurs during times of economic stress, and when those episodes are accompanied by a collapse of foreign demand due to recessions abroad, then it is inevitable that the public sector will move into a large deficit. That is simply algebra.
Moreover, as Keynes pointed out, we should welcome, not resist, that outcome. As he noted in the paradox of thrift, while increasing one’s savings may be individually rational, it will be economically disastrous if simultaneously undertaken by all. The result, after all, is a collapse in demand, recession, or worse. Therefore, replacing lost private sector demand with public sector spending is exactly what should occur. Of course, government budget deficits should also be pared when private sector demand recovers (which is not always the case).
In short, public-sector indebtedness can, should, and will rise when private sector savings spikes (relative to investment) during economic downturns. It is also important to note that the public sector may also tend to borrow for longer periods of time if a country has chronically low private sector savings relative to investment as, for example, was the case in the US for two decades prior to the GFC.
Yet logic of interdependent debt outcomes across the economy is lost on many debt moralizers, who only see public sector indebtedness as the consequence of a failed political system, or who only see private sector indebtedness as the result of financial excess or consumption-obsessed households.
One strand of such moralizing is frequently heard from Germany. To be sure, German concerns about debt have auspicious historical roots. It was, after all, an impossible debt burden imposed on Germany in the Versailles Treaty that ultimately pushed the Weimar Republic toward debt monetization and hyperinflation in 1923. Germans, scarred by that history (and what followed), can therefore be forgiven for their collective distrust of debt.
But some Germanic attitudes go too far. As a relatively small economy, Germany can extol the virtues of fiscal rectitude and high private savings relative to investment knowing that their resultant excess production over domestic demand can be readily exported abroad.
To suggest, however, that their model ought to apply universally is merely a restatement of the dangerous folly Keynes noted in his paradox of thrift. At the global level, an attempt by all countries to simultaneously pare debt and save would be globally ruinous.
To put it differently, (German) trade surpluses can only exist if other countries run deficits. To suggest all countries can run surpluses at the same time is an arithmetic impossibility.
Moreover, for one country—the US—a national trade deficit serves the global good. As the issuer of the preferred currency of global payments, the US—via its persistent trade deficits—offers a steady supply of dollar liquidity to the rest of the world.
In sum, debt is both more and less complicated than many think. It is more complicated in the sense that, in the aggregate, measures of private, public, and foreign indebtedness are interconnected. Thinking of them as independently determined is not just incorrect—it can lead to bad policy outcomes (such as trying to balance the government budget during a recession).
But the good news is that once debt relationships are better understood, the tasks of policy-making and economic financial management also become much more straightforward, led by pragmatism and logic, not dogma.