Gross government debt should not be zero

Stephen Koukoulas (The Kouk) provides some history:

In 2002, Treasurer Peter Costello undertook a review into the future of the CGS market. At the time, Costello was keen to pay off all debt and given the state of the government’s finances at the time, could have easily done it. It seemed a good idea in that it would eliminate all government interest costs and allow for the non-government bond market to grow and expand.

Having sought feedback from market participants who overwhelmingly opposed the elimination of the CGS, Costello rather reluctantly kept the bond market and with the excess funds, established the Future Fund.

The key reasons for maintaining CGS, that is keeping gross government debt at a particular level, was to have a risk free security that would be the benchmark for the pricing of all other debt and that would underpin the three and 10 year bond futures contracts.

I remember it well. A Treasury team headed up by Blair Comley came to RMIT as part of a wide consultation and asked our opinions too. My argument then was that if the Howard government wanted to hamstring a future Labor government they should shut down the Australian government bond market. On economic efficiency grounds, however, a government bond market was necessary for benchmarking purposes and the creation of a risk-free rate. Some of my colleagues disagreed arguing that the banking system could synthetically create a risk-free rate and made a submission to that effect. My view still remains that you cannot fake market prices. So I agree with The Kouk when he says:

Why borrow money if you are running a budget surplus?

This is because there is a requirement for Australia to have a high grade, liquid and tradeable government bond market that grows in size over time, in proportion to the size of the economy.

Very big ‘But’ coming up.

The Australian government is not currently running a budget surplus. I’m all for the existence of a government bond market to enhance economic efficiency – but not to finance waste or current consumption. The Kouk seems to believe the budget will be in surplus this financial year.

One issue that the Gillard government has not yet addressed is what to do with the money it raises from the bond market, that it clearly wont need as the budget returns to surplus.

That is an addition problem over and above the continuing budget deficit – the Gillard government and the Rudd government before it have a tendency to simply waste money.

The next issue is this:

In total, foreigners have bought $56 billion of our government bonds over the past 12 months – exceeding our second-largest export, coal. And in doing so they’ve driven the Australian dollar to levels that defy economic models and threaten the ability of the free-floating exchange rate to re-balance the economy as export revenues fall.

High quality paper is an export industry.

But it’s not just reserve managers creating demand. There are other classes of investors with deep pockets and big appetites. Japanese retail investors have been big buyers of Australian bonds for years and are regarded as a key provider of support when the currency dips.

“Australia’s economy can be easily explained to [Japanese investors] especially big investors. They accept the success of the mining story,” said Yoshidi Ishide of Daiwa SB Investments, who has run a popular $A bond fund for Japanese investors, most of whom are around retirement age.

“Australian fixed-income markets gave us good yield, return and currency [appreciation], and this is why the retail market likes Australian fixed income,” he said.

Sounds fantastic, but I wonder why you’d be talking about the mining boom when selling Australian government paper. Buying government debt exposes investors to the Australian tax system not the mining industry per se. Of course the mining industry pays a lot of tax but in the grand scheme of things Australia is a service economy.

That raises the next point: Australia doesn’t just need a deep liquid government bond market it also needs a deep liquid corporate bond market. A large government bond market is likely to crowd out a corporate bond market. So government should sell enough paper to ensure a risk-free rate but leave the private sector to meet additional demand for Australian paper.

So back to the original point: Having a government bond market that is a fixed proportion of GDP is a good idea. Hopefully that implies that the dollar amount of gross debt rises over time (as GDP rises). Increasing debt levels to finance reckless spending, however, is not good practice. So the next time the government comes to the Parliament seeking to increase the debt ceiling, the opposition should fix the ceiling as a proportion of GDP and force the government to live within that constraint.

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19 Responses to Gross government debt should not be zero

  1. 2dogs

    “talking about the mining boom when selling Australian government paper”

    Good point. We should change the basis of the currency from debt to the domestic market portfolio.

  2. Sleetmute

    Yeah, Sinc. This became an issue when The Kouk made one of his typically fatuous political comments in response to Hockey’s stated desire to pay off government debt. Frankly, I think the sensible thing to do would be to issue Aussie bonds and invest the proceeds in US bonds. Simple. I don’t care if we lose 2% on the yield; better than wasting the lot on some stupid spendathon.

  3. Thomas Esmond Knox

    So if GDP rises, Australian Govt borrows more money, and if GDP falls, Australian Govt pays some or all back?

    More clarity required on whether debt should be foreign or domestic.

  4. .

    On economic efficiency grounds, however, a government bond market was necessary for benchmarking purposes and the creation of a risk-free rate.

    Pffftt…

    Some of my colleagues disagreed arguing that the banking system could synthetically create a risk-free rate and made a submission to that effect. My view still remains that you cannot fake market prices.

    They argued incorrectly, it could create a low risk rate that was no artificial at all, unlike the “risk free” rate.

  5. DriftForge

    The concept of government debt being risk free needs some revision for a start.

    Secondly, we have to have a debt market so that other participants have something to refer to? What sort of justification is that? In the absence of government bonds, something will arise. Market needs will be filled etc.

    Finally, if we do want have a bond market as a reference, surely that is a function for the Reserve Bank, not the Treasury?

  6. .

    Well I suppose you need a bond market for liquidity and to smooth out funds, like an overdraft that is promptly paid off. The idea that the CGS market is a net economic wealth generator and the bigger it is, the better off we are is loopy stuff.

  7. Sinclair Davidson

    More clarity required on whether debt should be foreign or domestic.

    Makes no difference.

  8. Steve D

    So, should the Howard Government have taken a leaf out of the ALP book (“anything that hamstrings the competition once they assume office has to be A Good Thing”), just to make life difficult for the ALP? What would have been the likely outcome after 2007 without the bond market?

  9. Steve D

    And it seems to indicate, once again, that stability is a desirable trait in Government, unless you’re a journalist.

    How hard will it be for the Abbott Government to retire the bonds as they progressively attack the debt

  10. Jono

    Are we really that certain that the markets wouldnt function without having issued government bonds representing the risk free rate ?

    Something here smells fishy.

  11. Sinclair Davidson

    Jono – they can function without a risk-free rate. They function better with one.

  12. .

    Risk free rate?

    Governments default. The US has defaulted more than once. All the risk free rate can ever be is a proxy rate, which the capital market can do on its own.

  13. Tom

    In total, foreigners have bought $56 billion of our government bonds over the past 12 months – exceeding our second-largest export, coal. And in doing so they’ve driven the Australian dollar to levels that defy economic models and threaten the ability of the free-floating exchange rate to re-balance the economy as export revenues fall.

    FMD. So the ludicrous overvaluation of the AUD has less to do with mining and everything to do with the orgy of government debt since 2007 – $255 billion and counting. Therefore, Swan’s spending addiction paid for on credit is mostly to blame for the collapse of manufacturing industry we’ve seen in the past two years.

  14. Fleeced

    In total, foreigners have bought $56 billion of our government bonds over the past 12 months – exceeding our second-largest export, coal.

    We need a super-bonds tax!

  15. Driftforge

    Tom, more the high return on our dollar given we were one of the few stable countries left with a rationally high interest rate.

    May also want to add in the amount of bank debt bought similarly.

  16. Eyrie

    Risk free rate? How many governments have defaulted on their debt or inflated it away? They do control the inflation rate after all.
    Who would lend money to an organisation run by criminal psychopaths anyway, at any interest rate?

  17. Tel

    I have found it difficult to explain to people that when gross government debt is increasing, this pushes the Australian dollar upward. Seems obvious, but there you go.

    Governments don’t cope with nuance, so regardless of where the optimum might sit, if there is room for loopholes or sneaking around any imposed limits then that’s exactly what they will go for. As a consequence you need very darn simple principles if you want any hope of containing the numpties and don’t worry about optimization because it just ain’t going to happen.

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