Public Debt and Asset Preferences

Jüttner, D. Johannes Article Public Debt and Asset Preferences Kredit und Kapital Provided in Cooperation with: Duncker & Humblot, Berlin Suggested Citation: Jüttner, D. Johannes (1986) : Public Debt and Asset Preferences, Kredit und Kapital, ISSN 0023-4591, Duncker & Humblot, Berlin, Vol. 19, Iss. 3, pp. 386-399, https://doi.org/10.3790/ccm.19.3.386 This Version is available at: https://hdl.handle.net/10419/293062 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in EconStor may be saved and copied for your personal and scholarly purposes. You are not to copy documents for public or commercial purposes, to exhibit the documents publicly, to make them publicly available on the internet, or to distribute or otherwise use the documents in public. If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ Public Debt and Asset Preferences By D. Johannes Jüttner, North Ryde, Australia I. Introduction The public debt, its size, funding and maturity have long been of concern to economists, policy makers and laymen alike. Even during those years of yore when demand management with its emphasis of flow variables commanded our respect, the discussion about the management of the national debt did not entirely fall into oblivion. In recent years, the size of the national debt and, to a lesser extent, its maturity composition have reemerged as controversial policy issues. Many governments in the West attempt to contain, with varying degrees of success, public indebtedness and all regard the conquest of this difficult task as a panacea to achieve lower interest rates. The maturity composition of the public debt may pose another conundrum for monetary policy. Unless budget deficits can be financed by issuing long-term government securities, it is feared that sizable amounts of short-term or "floating" debt might interfere with the appropriate conduct of monetary policy. One of the most pronounced warnings in this regard was expressed by Henry Simons (1944) who made the then and now radically sounding proposal that the authorities should only issue two types of debt, money and long-term bonds, lest the unique features of money be destroyed. They should, in other words, abstain from blurring the sharp distinction between money and relatively illiquid long-term securities. This would occur when a motley array of short and medium-term securities were created. In view of the considerable difficulties many countries have in containing budget deficits, in financing them and in refinancing maturing debt with anything else than very short-term securities, surprisingly scant attention has been paid in more recent years to issues relating to the public debt and debt management. This study attempts to shed some light on the question of the relative size of the public debt and its main determinants and it investigates some of the implications of a changing maturity structure of the public debt for monetary policy and financial flows. In the next section (II) we discuss definitional issues and aspects of the importance of the public debt in OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.19.3.386 | Generated on 2023-01-16 12:53:15 Public Debt and Asset Preferences 387 the economy. Then (III) we analyse the maturity structure of the public debt. This is followed (IV) by an analysis of the relationship between short-term and long-term debt and other financial assets. Subsequently (V) we estimate the impact of a shortening of the debt maturity on the demand for liquid assets and interpret the results as maturity crowding in. Finally (VI) the findings are summarized and the conclusions of the study are presented. II. The Size of the Public Debt - Some Aspects of its Importance 1. Definitional Issues For the purpose of this study we define the term public debt as the volume of certain government and semi-government securities on issue redeemable in Australian dollars. These include Treasury bonds and bills, special bonds, Australian savings bonds and their respectively associated inscribed stocks, furthermore Treasury notes as well as miscellaneous securities such as drought bonds, but income equalization deposits are excluded. This definition differs from the Treasury's concept of "Government Securities on Issue"1 in that it excludes securities repayable in overseas currencies, that is, Australia's foreign debt. The inclusion of Treasury bills in the national debt raises some thorny issues. Public Treasury bills create, and internal bills transfer, funds between Government agencies. Internal Treasury bills are issued as security for the investment of the Commonwealth Trust Fund and mature on 30 June of the year of issue. Public Treasury bills, their name notwithstanding, are not issued to the public but exclusively to the Reserve Bank for periods of not more than three months. Both securities carry an interest rate of one percent and the latter may be regarded as providing an overdraft facility for the Treasury with the Reserve Bank. Ordinarily they are issued to bridge the gap between the timing of tax receipts and Government expenditures and thus are short-lived in nature. They are repaid when tax-revenues have been collected or proceeds from the sale of notes and bonds are received. Whether or not bills for such purposes are outstanding at a particular date depends on the timing of receipts and expenditures. However, as roll-over possibilities for bills exist, they have at times been used for deficit-financing 1 A booklet "Government Securities on Issue" is published annually as part of the budget papers. It lists all public securities which have been issued by the Commonwealth and State Governments and remained on issue at a certain date. Debt statistics of local and semi-government authorities and data on debt of instrumentalities that is guaranteed by Government are contained in the Reserve Bank Bulletin. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.19.3.386 | Generated on 2023-01-16 12:53:15 388 D. Johannes Juttner purposes. To the extent that they are used in this way without adding to inflation, bills should be regarded as part of the public debt. The sale of Treasury bills by the Government to the Reserve Bank, provided the receipts are spent and not used to replenish Treasury deposits there, raises base money immediately and eventually the money supply. Bill financing of Government expenditures is then tantamount to the printing of money. It may be legitimately included in the public debt as a non-interest-bearing component, provided the money creation does not cause prices to rise. Inflationary finance which is associated with the creation of public debt, on the other hand, is essentially equal to taxation. In this case bills cannot be regarded as adding to the public debt although nominally they increase it. As debt outstanding is a stock variable, its value thus being calculated at a point in time, it would be impossible to distinguish between bills that are issued as a temporary financing device and those that are created to either satisfy the demand for money or tax through inflation. For this reason bills have been included in the public debt. The arbitary element in this procedure is attenuated by the Government's policy strategy of controlling monetary aggregates as this strictly limits the scope for resorting to inflationary means of deficit-financing. However, one might ask whether the creation of base money in this case which is neither inflationary nor interest-bearing, contributes in any meaningful way to the public debt although formally it constitutes a liability of the Government. It can be shown, however, that under quite acceptable assumptions there is no difference in principle between the financing of a deficit through printing of money or the sale of bonds. First, in the absence of distributional effects, the taxes levied to service interest-bearing debt are exactly offset by the interest payments to the public so that for the economy as a whole one presumed difference between the two financing methods disappears. Secondly, under both financing methods real resources are transferred to the Government when the deficit arises. Thirdly, whether or not money or debt-financing imposes a burden on future generations depends on the social productivity of Government projects which gave rise to the debt. If the return from such a project "pays for itself" any burden can only stem from distributional effects when taxes are levied to pay for the interest and the repayment of the principal. Provided, of course, the debt is ever redeemed. It is highly unlikely that non-interest-bearing debt will be repaid. The foregoing arguments appear to support the views, first, that under certain conditions there is essentially no difference between noninterest (base money) and interest-bearing (notes and bonds) public debt, secondly, that the stock of bills (which results in the creation of money) and interestOPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.19.3.386 | Generated on 2023-01-16 12:53:15 Public Debt and Asset Preferences 389 bearing debt are a permanent feature of our financial system. They should therefore be counted as debt. A definition of the public debt broader than the one used here would have to embrace the present values of all future Government liabilities, regardless of whether they are evidenced by financial securities or not. For example, the promise to pay old age pensions falls into the category of a debtcomponent not documented by any financial claim. Although such a claim is neither tangible nor fungible, it represents a clearly defined current or future commitment of the Government and as such it forms part of people's wealth and determines, inter alia, their consumption and accumulation decisions. The unavailability of data covering this aspect of the public debt seriously impedes statistical, econometric or any other type of empirical work in this area. For instance, it is highly doubtful whether the demand of the private sector for the stock of government securities could be satisfactorily explained without including these claims against the government in the estimation approach. The reason being that government bonds and social security entitlements are likely to be substitutes in individuals' portfolios. 2. Relative Size of the Public Debt The accompanying Table 1 contains annual data regarding the amount of Commonwealth Government as well as local and semi-government securities on issue for the years 1965 to 1983 Total (1) includes and total (1') excludes Treasury bills on issue. In order to furnish the reader with a rough idea as to whether the public debt has expanded slowly or excessively, a ratio total public debt to GDP at current prices has been calculated. Although no criterion exists which favours a specific value of the ratio, it appears that public debt has become less of a burden for the economy as debt has grown at a lower rate than nominal GDP. Growth in nominal GDP does fulfil the useful purpose of a reference benchmark as the creation of financial assets is linked through the flow of funds to saving which equals investment which in turn determines the growth rate of the economy. Therefore, for the economy as a whole the growth rate of financial assets, roughly speaking, equals the growth rate of GDP at current prices. The ratio of total public debt to GDP has fallen appreciably from 0.60 in 1965 to 0.36 in 1983. Taking a longer-term perspective the fall in this ratio is even more spectacular. Its values for 1910, 1920, 1930, 1935,1940, 1945, 1950 are 28.7%, 72.7%, 82.3%, 110.1%, 93.7%, 150.1% and 96.7% respectively. It appears that the two World Wars and the Great Depression were primarily responsible for OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.19.3.386 | Generated on 2023-01-16 12:53:15 390 D. Johannes Jüttner Table 1 Public Debt and its Relative Importance Public Debt Common-Local Totals GDP at (1) Public Debt wealth and Semi-Current (2) Money (M3) Government Government (1) (IT Prices (not correct Securities Securities (2) for seasons) $m $m $m $m $m 1965 8,695 3,417 12.112 11,304 20,323 0.60 1.17 1966 9,134 3,672 12,806 12,044 21,568 0.59 1.17 1967 9,677 3,976 13,653 12,883 23,744 0.58 1.16 1968 10,358 4,310 14,668 13,842 26,004 0.56 1.15 1969 10,815 4,679 15,494 14,621 28,941 0.54 1.11 1970 11,625 5,018 16,643 15,612 31,996 0.52 1.12 1971 11,946 5,425 17,371 16,331 35,940 0.48 1.10 1972 12,592 5,910 18,502 17,462 40,060 0.46 1.06 1973 13,479 6,485 19,964 18,938 47,214 0.42 0.91 1974 14,274 6,921 21,195 20,264 51,366 0.41 0.86 1975 16,587 7,636 24,223 23,213 61,773 0.39 0.85 1976 19,013 8,618 27,631 25,614 72,826 0.38 0.85 1977 21,420 10,154 31,574 28,783 83,165 0.38 0.87 1978 23,287 11,738 35,025 31,669 90,340 0.39 0.89 1979 25,752 13,733 39,485 35,815 102,163 0.39 0.90 1980 27,250 16,249 43,499 39,189 114,755 0.38 0.88 1981 27,820 19,071 46,891 43,835 130,813 0.36 0.85 1982 28,072 22,254 50,326 47,561 147,942 0.34 0.82 1983 32,053 25,437** 57,490: ** 56,278** 160,806 0.36** 0.83** * Excludes Treasury Bills. — * * Estimates. Source: RBA Bulletin December 1983. the extraordinary high values which occurred during the first half of this century.2 The extent of the decline of the stock of public debt relative to GDP is not fully revealed by available data. Official statistics seriously overstate the amount of debt outstanding as they are based on face and not on present value of securities on issue.3 These observations are obvious and have been 2 Source of securities of all government authorities and gross domestic product at current prices for these earlier years is Butlin (1977). 3 Special bonds provide the exception from this rule; they are included at their redemption value. Furthermore, for Australian Savings Bonds the face and market values are identical as ordinarily no secondary market exists for such securities. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.19.3.386 | Generated on 2023-01-16 12:53:15 Public Debt and Asset Preferences 391 made by others before. Both Buchanan (1958, pp. 196 f.) as well as Boehm and Wade (1971, p. 319) criticise the face-value method. The estimation technique employed by the authorities assigns the same weight to securities with the same face values regardless of their market prices. The upward trend in interest rates over the period of observation is responsible for this fall of the market values of the outstanding stock of debt. Although economic theory4 remains mute about the "correct" size of the public debt in relationship to GDP or other relevant economic variables, it appears to follow from the homogeneity assumption of asset demand5 that portfolio investors expand (or contract), ceteris paribus, their asset holdings according to a scale variable such as permanent income or wealth. Provided observed national income approximates this variable, we would have expected a rise in the debt-to-income ratio, as the face-value of debt represents an inflated variable. HI. Maturity Structure of Public Debt In recent years the maturity structure of the public debt has shortened rapidly, and it is interesting to inquire into the causes which give rise to this development. Obviously, when we discover that the underlying forces are still at work, public debt will tend to become more and more liquid. Several points are important in this context. The average maturity for the period 1965 - the earliest date for which observations are available - to 1973 amounts to 118.3 months and the quarterly maturity values fluctuate between 106 and 128 months over the same period. From 1974 onwards maturity declined from an average value of 126 to an average of 54 months in 1983. The observed changes in the maturity structure of the public debt are the outcome of past and current demand and supply decisions of the monetary authorities and portfolio investors. The passage of time reduces the maturity of the outstanding debt, provided we are not dealing with perpetuities. The decisions to supply and take up new securities of a certain maturity depend primarily on expected yields. However, according to the pure expectations theory long rates are an average of current and expected short term rates. 4 Fiscal theory discusses whether Governments should borrow rather that tax and retire rather than convert debt. See Buchanan (1958) for an account of the various arguments. With the advent of portfolio theory and the drifting into disrepute of anticyclical deficit spending, the emphasis of the debate appears to have shifted away from the area of fiscal theory into the realm of monetary policy. 5 See Brainard and Tobin (1968). OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.19.3.386 | Generated on 2023-01-16 12:53:15 392 D. Johannes Juttner The maturity of the bond should therefore be immaterial to the investor. This might be true during periods of moderate interest rate fluctuations, but this theory appears to break down or to be only applicable for shorter maturities during periods of rapid and significant interest rate changes. Tentative empirical evidence appears to support the view that increased interest rate volatility appears to heavily tax the forecasting ability of investors. The evidence suggests that during the 1960s and the beginning of the 1970s short and long-term interest rates on public debt did not exhibit a discernible trend, whereas from about 1973 onwards rates fluctuated strongly around a steep upward trend. The time profile of the maturity of the public debt follows a roughly similar pattern. It is probably no coincidence that the downward trend in maturity occurs at a time when interest showed an upward trend, although after the steep rise in rates in the second half of 1973 and the first half of 1974 the maturity of the public debt lenghtened at first. This happened because investors generally believed that interest rates had culminated. In order to take advantage of what were then considered to be very high interest rates by historical standards, investors bought longterm securities, especially those with a maturity of 10 and 20 years and ran down their holdings of notes and short-term bonds. As a consequence of the lenghtening of portfolios, the average maturity increased to 137 months in the second quarter of 1974 which incidentally, is the highest value on our record. The decline in interest rates which indeed followed, seemingly justified investors' decisions but the subsequent rises, again creating considerable capital losses for holders of Government securities, appear to have discredited the notion that historically high interest rates mark their turning points. Instead these are now often merely viewed as stepping stones to new peaks. Investors did not immediately revise their interest rate expectations upwards after the 1973/74 surge, but apparently did so only gradually as the Government's occasionally successful issue of long-term bonds afterwards shows. Given these circumstances it appears that investors only became slowly cognizant of the increased riskiness of investments in Government securities. Risk in this case reflects market risk which is due to interest rate volatility. To the extent that market yields contain an inflationary expectations premium, market risk also captures purchasing power risk. Risk may be measured by the variance of the rate of return on bond portfolios. For a given rise in interest rates, the capital loss on such securities varies directly with term to maturity. Therefore the risk premium in interest rises with term to maturity. Investors vacated the longer end of the bond market because to the majority of risk-averse investors, the risk-premium contained in long interest rates was not large enough to compensate them adequately for the higher risk they would incur. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.19.3.386 | Generated on 2023-01-16 12:53:15 Public Debt and Asset Preferences 393 IV. Maturity and Substitutability of Assets Monetary policy actions typically change, on the margin, the economy's desired composition of its portfolios of assets where liabilities are included in this term as negative assets. The public debt constitutes part of these portfolios. The efficacy of monetary policy depends importantly on the degree of substitutability amongst assets. One characteristic of assets, determining their degree of substitutability, concerns term to maturity. Monetary policy and debt management may shorten or lengthen the maturity structure of the outstanding debt. Such maturity changes have similar effects on the portfolio compositions of investors, and, eventually, on the consumption and spending decisions of the economy. 1. Substitutability of Assets - Three Views Linkages between the maturity structure of the public debt and asset demands are known to exist. One view regarding this relationship was suggested by Keynes (1936), Patinkin (1965) and Leijonhuvfud (1968) who assumed perfect substitutability between long-term government bonds and capital and lumped short-term debt together with money. When economic agents are indifferent between holding cash, various bank deposits and short-term government debt, an increase in the latter component of liquid assets must be offset, for a given desired volume of liquid assets, by a commensurate decrease in the two former components, in order not to disturb equilibrium in this market. A reduction in the average maturity of the public debt which pries away bonds from the long-term debt-capital category thus creates an imbalance in the money market which has its mirror-image in an excess demand for bonds. Consequently the long-term bond rate can be expected to fall, stimulating investment. This categorization of assets has been criticized by Tobin (e.g. 1963) who regards long-term bonds and capital as imperfect substitutes and he is inclined, if not to include short-term debt outright in the stock of money, so to regard it as a close money-substitute. When in this case the proportion of short-term, at the expense of long-term, debt is increased, a negative excess demand for liquid assets is likewise created. This disequilibrium situation may result in a reduction in the interest rate on bonds and may lead to a decrease in the required rate of return on capital.6 Of course, a monetarist 6 Whereas in the Keynes / Patinkin / Leijonhuvfud case a shortening of the maturity structure of the public debt of the type described above always lowers the longterm bond rate, - the liquidity trap case aside -, the same result does not necessarily 26 Kredit und Kapital 3/1986 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.19.3.386 | Generated on 2023-01-16 12:53:15 400 D. Johannes Jüttner Keynesian Economics and the Economics of Keynes, New York, 1968. — Luckett, D. G.: On Maturity Measures of the Public Debt, in: Quarterly Journal of Economics, February 1964. — Patinkin, D.: Money, Interest and Prices, 2nd edition, New York 1965. — Simons, H.: On Debt Policy, in: Journal of Political Economy, December 1944, pp. 356 - 61. — Tobin, J.: An Essay on the Principles of Debt Management, in: Fiscal and Debt Management Policies, CMC, Englewood Cliffs, 1963. — Tobin, J.: A General Equilibrium Approach to Monetary Theory, in: Journal of Money, Credit and Banking, February 1969, pp. 15 - 29. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.19.3.386 | Generated on 2023-01-16 12:53:15