Is there such a thing as too little government debt?
I've recently been thinking about government debt dynamics from a somewhat different perspective. There has been a great deal of concern, deservedly so, about high and rising government debt levels - US public debt is nearing 80% of GDP and a number of other large economies are even higher (e.g. Italy, UK, France, Japan, Canada, Brazil). Certainly there are multiple concerns about high debt levels: fiscal stability of course, but also issues with crowding out other investment and other knock-on macroeconomic effects. Clearly some countries are able to maintain substantial debt nearly indefinitely (e.g. Japan, Singapore), but even they will likely face a reckoning with demographic and growth headwinds - domestic savings culture will only get you so far.
However, 'too little' debt can also be a problem. While it seems like this is a silly concern - few countries are substantially driving down debt-to-GDP ratios at the moment - there are two factors that can make government debt effectively scarce:
1. Some countries that are rich in natural resources have either low or dropping debt levels (obviously Gulf states, but also places like Australia, Israel, and Norway).
2. Unprecedented monetary easing through unconventional monetary policy - notably QE - has taken a huge amount of debt off the market and put it on central bank balance sheets. Thus, in some countries much of new issuance (and a lot of old) is now not available for the rest of the economy. This may change - certainly the Fed in the US is contemplating a partial unwinding of QE, though the size of the final balance sheet is still under discussion - but in the future low-growth environment we may see QE being employed more and more as policymakers continue to hit the zero lower bound with interest rates. A corollary of this is that if your market is dominated by retail investors who hold bonds to maturity and rarely trade it, you may also face similar issues with an effectively small bond market. There's also the unique issue with US debt that large amounts are held by other central banks and governments as foreign exchange reserves and sovereign wealth pots, which takes a few trillion dollars off the market right off the bat.
So why is this a problem? Countries with either low/dropping debt levels or who have effectively monetized the debt through QE have stronger fiscal positions, which should bode well for future generations, no? In principle this analysis is correct that lower debt is generally a good idea (provided it hasn't come at the expense of growth-inducing public investment), but I think there are some real concerns about a debt level that drops too low.
First of all is the issue of liquidity. Government debt markets work so well (especially a market like that for Treasuries) because the supply of debt is both deep and liquid - there are lots of people who own and trade the debt, so it's easy to unload (with low bid-ask spreads) as well as easy to buy bonds with the desired maturity. Finance/treasury departments around the world spend a lot of time structuring their bond offerings (in size, duration, and frequency) to assure that this is the case. In general, better liquidity means the debt can be sold more cheaply, and it also becomes a safe haven asset, which is particularly valuable. If you have too small of a market or too granular issuance, liquidity will dramatically suffer and volatility will spike.
The status of bonds as safe, liquid assets also means that they are used extensively as capital buffers - both by financial institutions but also for things like collateral in various agreements. Corporations use them as cheap stores of excess cash. Etc. The problem arises, though, that because so many capital requirements are now explicitly tied to high quality assets like government bonds, a huge part of issuance is now eaten up by pension funds and insurers and banks and the like who must carry substantial amount of bonds on their balance sheets. If government debt levels drop too low, there won't be enough high quality capital to go around, causing a credit crunch. There have already been brief warnings of this kind of dynamic; in recent years there have been spikes in prices for certain maturities that were in short supply because everyone was needed them for capital requirements. Financial musical chairs rarely works out well, and when people are competing for limited debt issuance with a central bank, bad things can happen.
All of this means that the effective size of sovereign debt markets might be much smaller (and less liquid) than it appears - if most of outstanding debt and new issuance is gobbled up by central banks, foreign governments, and financial institutions, the 'real' market that actually has a choice about using sovereign debt is quite small and may be crowded out.
This isn't to say that governments should use this logic as an excuse to put off fiscal reforms; obviously most of the developed world has unreasonably high sovereign debt levels; some analyses have argued that at debt-to-GDP ratios approaching 80-100% you start to see real effects on the economy (though there's a lot of give in these numbers). But I wonder what the lower bound should be. I don't think, for example, that US debt-to-GDP should ever drop to 10%; that would probably be ruinous. But public debt was running in the 30s back before the crash and as low as the 20s in the 70s and early 80s. It's possible that things were just fine then, though with substantial changes to financial technology and regulation it might need to be higher now just to meet finance needs.
It's also possible that this is a largely self-correcting issue. Falling sovereign debt-to-GDP generally means the economy is growing well (and the government may even have its fiscal house in order) - this might ease some of the constraints on the supply of debt just when it's needed - central bank deleveraging, better yields requiring less capital as buffers, safe haven assets in lower demand, etc. But I wonder if this will be the case in the future. We have an overabundance of savings in the world, and lots of it is parked in sovereign debt (especially US debt); I'm not convinced that if supply of said debt continues to thin this capital will go elsewhere. A liquidity crisis in US debt is probably the scariest financial crisis I can imagine.
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Originally Posted by Loki
