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Deficit!?! does it really matter?

by on 14/04/2020

The word deficit rises with negative connotation among many politicians, economists and even ordinary people. Year 2020 will be all about deficits. The deficits will become enormous even in comparison to the already huge deficits we could observe in countries as US, Japan,  Italy, etc. before the outbreak of Coronavirus. So let’s try to explain the essence of this term.

Investopedia defines deficit as;  an amount by which a resource, especially money, falls short of what is required. A deficit occurs when expenses exceed revenues, imports exceed exports, or liabilities exceed assets. A deficit is synonymous with shortfall or loss and is the opposite of a surplus.

In a deficit, the outflow of money exceeds the inflow of funds. A deficit can occur when a government, company, or individual spends more than is received in a given period, usually a year. 

Reading the definition above, we have to add and clarify few issues; Deficit has to be covered by loans given by someone who is ready to lend, so the result of persistent deficit is accumulation of debt, but also savings. The debt needs a borrower but also a lender who is in cooperation with him. Someone, who  creates surpluses, and is ready to use it, to cover the debt of the deficit creator. The result is, the borrower accumulates debt, and the lender accumulates savings. 

Money is the most common form of debt expression, but deficit can have other than monetary forms. Dificite happens, when some entity, a person, community, business, company, country, uses, usually on temporary basis, more value than it creates, or exploits more of the disposable resources than can be renewed by natural or man made processes. Accordingly, by definition the use of all natural resources are deficit creating processes, be it raw material mined out of earth, or accumulating ecological imbalances, as  accumulation of greenhouse gasses in the atmosphere or acidification of oceans. 

The deficit accumulation process has some very unique features. Many times deficit becomes an addiction, and then it has tendency to increase and even inflate. The entity may run on ever growing deficit and for an outside observer it may still appear as, “business as usual”. Then one day, one lender refuses to give new additional credit, or refuses to revolve the existing credit, and the borrower is exposed to insolvency. Then the collapse of the entity is inevitable. 

Public debt, created by governments with sovereignty to print money, are very different from all the other debtors, (let’s call them private entities).

Private entities can be businesses, companies, corporations, communities, non sovereign public entities, households, or even ordinary private people. 

If a private entity makes debt, it has to generate in the future enough income, to repay the debt, while sustaining its economic activity and its daily necessities.

Loans of a private entity can have two purposes,  either to finance investments or consumption. The difference between these two is not always obvious. For example; if someone borrows a loan to purchase an apartment, this apartment can be either for self use, or to be rented to others. The rented apartment obviously will create stable income, that will help to repay the loans, while the loan of apartment for self use, has to be paid from other source of income. 

What’s obvious, debts of private entities have to be repaid, and if the entity defaults on repayment, it may end in insolvency, or in other words, no capacity to fulfil its contractual obligations. 

A very different story is the debt of a governments with sovereign authority to issue currency. Here we have to emphasize the difference between countries, with sovereign right to issue unlimited amount of currency, and countries without it, as are the Eurozone countries. The Eurozone countries live in kind of anomaly, that they do have authority to manage independently their own fiscal policies, (tax collection and budget expenses,) or in other words, they can create deficits and accumulate debt, but are dependent on the Eurozone monetary policy to cover this deficit. This discrepancy caused the Greek economic crisis, when Greece accumulated unsustainable budget deficits and debts, financed by private commercial banks loans. While USA is doing the same for decades, and still it can sustain its economic policy, based on deficit without consequences, in case of Greece, it had to default on loans. ⁰But we can observe other countries, like Argentina or Russia, with their own currency, and still had to default on their debts. This needs explanation. 

The following chart shows the ratio of debt to GDP of world major economies. All the major economies clearly increased their ratio of debt to GDP already before the corona virus outbreak.

Even if this process is common to all the countries, there are different kinds of debts. As to 2019, four major economic regions, US, China, Euro Zone, and Japan have very different composition of their debt. The first three economic regions are with debt of about 250% of the GDP, while Japan’s debt is about 380%. While 220% of GDP of the Japanese debt, is government debt, the US government dept is about 107%, Euro zone 85%, and the Chinese government debt is less than 50%. As to nonfinancial corporate and non corporate debts China is an exception with debt of 151% out of GDP, while USA about 75%, Euro zone about 108% and Japan 102%. 

GovernmentHouseholdsCorporationsTotal
US1077575257
Euro Zone8258108258
China 5054151255
Japan22059102380
Total world239

These differences are significant and need interpretation. As to Japanese government debt, it is result of the stimulus that started in 1990, after the collapse of the property markets and following stagnation of the economy. The government tried to prevent economic crisis with high unemployment, that would follow collapse of the financial markets. The Chinese anomaly of high non financial corporations debt started after 2008 collapse, when China introduced loose credit policy. These two government policies had deep consequences. Japan did not emerge from stagnation since 1990, and in China the over investment reduced the efficiency of the investments. One of the consequences of the lose credit policy, are the ghost cities. 

Government debt, or national debt: net accumulation of the federal government’s annual budget deficits. This deficit is covered by issuing government securities, or other contractual liabilities of the government to the lender. The bonds are freely traded in bond exchange market. 

The repayment of these securities in the future will be in local currency. It means, a sovereign state, with its own currency can always repurchase this debt by “printing money”. This is the stage, when public debt caused by government’s deficit, changes to cash money or in monetary term liquid assets. 

Printing too much money causes necessarily decrease of currency value, in form of inflation. Inflation can be comprehensive, or specific. If there is enough production capacity potential and opened freely competing markets, there will be no inflation of currently produced ongoing processes. On the other hand, the prices of accumulated value holding assets, (shares, real estate and sometime even cryptocurrencies), will go up.

https://tradingeconomics.com/country-list/government-debt-to-gdp

What government-public debt means in practice? Japanese public debt started in 1990, and since then for 30 years only grew? Does it have impact on the real economy? It didn’t cause inflation, but prevented deep unemployment and decrease in economy. Public debt, big as it can be, not necessarily brings inflation in comprehensive way, but it does create anomalies, as high property prices, or boom and bust in share prices.

Debt of private households: debt of private households is mostly in form of mortgages, leasing, credit cards debts, and overdrafts. Private households have limited capacity to accumulate debt. The main reason for the subprime crisis of 2007-2008 were the mortgage loans given to the households, that exceeded their reimbursement capacity. 

The 2008 crisis started with unsustainable debt of private households in the US, that picked up at 2007 to level of above 100% of the GDP, and since then it dropped to level of 75% of the GDP. At 2019, the other major economies household debts were between 50-60% of the GDP. The US household debts had reducing trend, and seemed to be sustainable. 

https://tradingeconomics.com/country-list/households-debt-to-gdp

Debt of the non financial corporate businesses:  The non financial corporate and non corporate business sector differs from country to country. Chinese corporate debt grew since 2008 to unprecedented 150% of the GDP and has still upward tendency. Yet Chinese public debt is all by local banks, and relatively low government and household debts. At time if crisis caused by defaults on corporate business debts, the government will have the capacity to bail out the banks, and nationalise this debt, as it happened in the other big economies. 

The following table represents Non-Financial corporations debt to surplus ratio of leading OECD countries. The non-financial corporations debt to surplus ratio provides an indication of the capacity of non-financial corporations to meet the cost of interest and debt repayments with the operational profits generated. Debt is calculated as the sum of the following liability categories: currency and deposits, debt securities, loans, insurance, pensions and standardised guarantee schemes, and other accounts payable. Gross operating surplus (GOS) is the value added and generated by production activities after deduction of compensation of employees. The sector non-financial corporations includes all private and public enterprises that produce goods and non-financial services to the markets.

LOCATIONValue
CAN7.9 
USA7.7 
FRA6.6 
GBR6.5 
JPN6.1 
CHE5.4 
KOR5.1 
AUS5.0 
ITA4.8 
ESP4.4 
ISR3.2 
MEX3.2 
DEU3.0 
POL2.6 
TUR2.3 
CZE2.0 

https://data.oecd.org/chart/5UVG

External debt held by foreign countries: this debt is accumulation of trade deficit with foreign countries. The trade deficit has to be balanced by foreign investments in local assets, it can be investment into government or corporate securities, equities or direct investments. If the foreign investments don’t cover the trade deficit, the difference has to be financed by reserves of foreign currency the country holds. But this solution is temporary. Usually, before the reserves of foreign currency dry out, the local currency has to be devalued in relation to other currencies, that enables to balance the deficit. But devaluation may cause in some occasion side effects, very different from solving the problem of trade deficit. The first is, price increase of the imported goods and services. This may cause increase of wages and allowances, that may cause hyperinflation, with annihilating effect on the local currency value. Other side effect may be capital runoff from the country. This may cause in extreme cases default of the country on its debts, that can have devastating long term negative effect on the credibility of the country. 

Since the debt in foreign currency has to be repaid in that currency,  and the local government has no authority to print it, maybe the most sensitive  issue about the debt is, if it is local in local currency or external in foreign currency. Countries with sovereign currencies accumulate enough reserve currency in one of the leading currencies, US dollar, Euro, or the Japanese Yen, to be able to repay the debts in foreign currency. This policy forces all the other economies, that have no reserve currency, to export more goods and services, or needs to attract foreign investments, to have capacity to repay the debt to foreign countries. This gives a big economic advantage to USA, its currency, the US dollar is the main world reserve currency, also used as currency for international financial transactions. 

Gross External Debt Position of major economies

RankCountry($ Mil.)Per capitaUS dollars% of GDP
1United States20,263,76858,20094
2Euro area16,723,18637,49689
3United Kingdom8,491,386127,000313
4France6,470,49087,200213
5Germany5,800,94565,600141
7Japan4,243,56828,20074
10Italy2,471,61142,300124
11Spain2,390,37248,700167
13China1,971,6571,32615
17Australia1,484,18260,800126
20Brazil697,2283,20030
24India543,00038319
28Russia468,8493,70028
29South Korea462,0627,50027
30Mexico457,9563,30038
31Turkey446,8602,98334
34Argentina283,5678,28066
38Czech Republic194,14613,00070

Source: World Bank’s Quarterly External Debt Statistics SDDS, 10/17/19 update.

United States External Debt

The deficit in their essence are result of excess spending and too low rate of savings. Government and private savings are complementary and integrated in this issue. There are countries like Japan where the private savings are high and public savings with huge deficit, as contrary to it China, that has huge private debt, but very low public debt. And then you have USA, that has relatively high private and public debts. All these economies, in spite of these anomalies, functioned relatively well before the Covid-19 crisis, (full employment, stable currency and low level of inflation).

On the other hand countries, as Turkey, Russia, Argentina, India function very poorly, in spite of their relatively low debt ratio. Why is it so? 

How come, USA, with its huge external deficit to foreign countries, is the provider of the main reserve currency, while Russia, Turkey, Argentina, with low external and internal debt have difficulty to sustain the stability of their financial market? And above all, in spite of relatively high US debt, its currency is stable, and even with tendency of appreciation at times of crisis.

                    U.S. Dollar Index

published by the Federal Reserve

USA is historically highly credited, while Russia, Turkey, Argentina, are not. Is it all about credibility of the country, it’s legal system, its institutions, its political culture, its tolerance to others, or it is some kind of magic that no one can explain?

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