If all governments are borrowing to fight Covid, who is lending?

Earlier this month, comedy writer and director Armando Ianucci tweeted out: “Genuine questions: if most countries are borrowing heavily to pay for the pandemic, who are they borrowing from, and is there some mechanism in place to agree to write off most of each other’s debt?”

These questions are important. They play into other anxieties visible in the media and in our politics about whether we can “afford” to borrow on such a scale to fund emergency measures, and if we can, how we are going to “pay the debt back.” Massive government borrowing has taken the UK’s national debt to above 100 per cent of GDP.

The anxieties stem from the understandable difficulties the average person has grasping how modern money and public finance works, the reasonable tendency to grapple with the topic using our personal experience—in this case of our household finances—and the temptation from time to time for the government to play on that analogy to suit its own purposes.

So how does the borrowing process really work? Not as you might think.

First, not all governments are borrowing to fight the pandemic. Some, like China, have suppressed the virus and opened their economies back up. Others, like Norway, have large stores of wealth that they can use to fund their own programmes and lend to other governments.

Those governments which are borrowing to combat the pandemic are doing so from citizens at home and abroad—typically those in middle and old age and the rich—who have accumulated savings and need somewhere to put them. Government borrowing in this country happens at "auctions," where the Debt Management Office sells bonds that entitle you to a face value sum in a set number of years (known as the maturity of the bond). The bonds are normally sold at a discount on the face value, and the difference between the purchase price and what you get at the end of its lifetime is the equivalent of an interest rate. Government bonds have also been bought in large quantities by central banks, through a process known as Quantitative Easing.

At the moment, the borrowing is working out for most governments, and you can tell that all sides are relaxed about the process because it is taking place at very low interest rates—in some cases even at negative rates, which means lenders are paying governments to borrow money from them.

But a reasonable person might well ask: what is really going on? After, all, to provide people with what they require through the pandemic, surely we need food, energy and other goods, not bits of paper or the digital equivalents?

In a modern economy, saving happens by people acquiring claims to things (to pick a symbolic example, imagine it’s food) in the future. When they get old, say, they draw down those savings by swapping the claim for what they want. In the meantime, either they, or someone on their behalf (like a pension fund) manages where the claims go—perhaps putting them into shares in a company, or swapping their claim into money and then buying government bonds.

Ultimately the government is able to turn that into food (or whatever) because what it gets for the bonds is more claims (money!) that it can hand to recipients of government support, who then pass it on to people who are prepared to give up their time to manufacture the food, hoping that when they need to buy things themselves, they can turn that claim (their wages) into their own food, and so on.

This is not a magic money tree. Resources are not conjured from nothing. It is a system that relies on governments not debasing the money (too much, anyway) and not abusing their privilege to issue the bonds.

While everyone has faith that the authorities will not mess with the promises encoded in the money and bonds, there should be no anxiety about whether borrowing can continue at this pace, or when paying down the debt needs to occur. In theory the debt can be “rolled over” indefinitely. When government bonds fall due, governments can simply issue more to a new cohort of savers, and use the funds to pay back the old cohort of savers who now want to cash in.

This is not to say that there is no limit to how far the bond and money issuance can go on. There is a fiscal limit. A lot of damage was done by a spreadsheet error in an academic paper by economists Carmen Reinhart and Kenneth Rogoff, suggesting that there was something unusually damaging about accumulating more than 90 per cent of GDP in government debt. And as we and other economies have cruised safely past 100 per cent (Japan is currently at about 250 per cent), we have learned that the fiscal limit is further away than we thought. But there is a limit nonetheless, and it is bound up in people’s views of the ability of the government and the economy to make good on the claims savers hold.

If the Bank of England’s creation of money isn’t calibrated to be consistent with its inflation target, or even if it was but people panicked that it wasn’t, the financing plan would start to unravel. And if the real value of debt gets too far out of line with the economy’s capacity to pay the interest on it, likewise the demand for those government bonds will fall and rolling over the debt will get more expensive, and ultimately prove impossible.

There is no mechanism in place to “cancel” the debts. Debts of governments that get into difficulty, or which repudiate them after a change in regime, say, do sometimes get cancelled, or their repayment obligations negotiated down. But this doesn’t need to happen here, despite the scary numbers involved.

Following the Second World War, when debt ran up to 250 per cent or so of GDP in the UK, it was “paid down” by a combination of inflation; explicit taxes and those implicit in the government forcing the rates at which it borrowed below what the market would freely choose; and economic growth. Inflation erodes the real value and burden of the claim citizens have on the government. Real growth boosts real tax revenues relative to the debt outstanding.

The “pay back” can happen in the same way this time. Conditions will be more favourable for a while because interest rates are so low; but on the other hand, the outlook for growth is not so great. Inflation is not a very efficient way to claw back the debt, but even 2 per cent annual inflation indefinitely will make a small dent.

You can think of the borrowing and money issuance privilege as a historic collective endeavour to create the circumstances where, if things get really bad, as they have now, governments of the day can draw down on the funds that it makes possible. And in fact, since the health not just of ourselves, but also of future generations, depends on us suppressing the virus, and funding research into vaccines and therapies, the borrowing is not just for those alive now. But there is an obligation too to afford those who come after us the same borrowing privilege. They will have their own disasters to fight, not least associated with risks we foisted on them via our neglect of the climate.

At the same time, we should be wary of governments like our own weaponising this concern to justify a less generous state. Such arguments are made in bad faith, or at best based on bad understanding of money and government finances.