How public debt is managed is a critical question for any national government acting on behalf of its current and future citizens. It is of particular importance to a newly independent country making choices about its approach to public spending and taxation.
The statecraft of a new country must include debt management and choice of the issuance of debt instruments. Like defence and education, public debt is a public good for which an independent Scotland would need to build institutions, including a debt management office and a monetary authority (Tetlow and Pope, 2022).
This article sets out some principles, relevant for all countries but particularly for a newly independent country, to consider when designing future fiscal policy strategies.
What is fiscal policy?
Fiscal policy represents a government’s choices related to public expenditure and the revenue raised from taxes or debt issuance. Its fundamental objective is to manage society’s risks by securing the provision of public goods that would otherwise not be supplied to a sufficient degree by the market. It also ensures that risk is shared across different sections of society and/or with future generations.
The difference between aggregate tax receipts and expenditure is the government deficit (or surplus). The extent to which this adds to (or takes away from) aggregate demand can mitigate the scale and impact of the business cycle. The outcome from fiscal policy over time is a sequence of fiscal deficits (rarely surpluses).
In this article, we focus on the necessary technical frameworks to manage an independent fiscal position.
Post-negotiation of whatever share of existing UK public debt an independent Scotland might take on, the Scottish national public debt at any point in time would then be the accumulation of deficits and interest rate payments due on outstanding debt.
Managing that debt is a critical question for any national government acting on behalf of its current and future citizens, and of particular importance to a newly independent country.
Should the fiscal framework of an independent Scotland focus on minimising public debt?
A fiscal framework policy must be designed to ensure that the government is able to deal with risks as they emerge and has sufficient access to the tools at its disposal (Dornbusch and Draghi, 1990).
In practice, this means the ability to borrow against future tax receipts, where access to the pool of savings is guarded by international capital markets. The mindset in this case, as for any loan market, is whether the borrower can pay back the loan in the manner expected.
But when we are in the realm of sovereign debt, the question is as much about the capacity of the state to manage its overall affairs as the simple accounting of revenues and expenditure that face any firm.
Fundamentally therefore, fiscal policy involves the management of social risk and it must confront the question of uncertainty over future states of nature. Specifically, this includes the level of GDP, the level of required expenditure and the impact and timing of (distortionary) taxes.
Fiscal policy involves expenditure decisions made today in response to unfolding events, as well as strategies for the repayment of debt over the long run. As a result, the framework and institutions matter greatly for belief, or credibility, in those strategies, which ultimate feeds into the costs of debt service.
The response to the question of fiscal credibility – to pay interest service and repay debt – by policy-makers in most countries has been to try and shore up the plans for debt repayment by setting up mechanisms for expenditure control.
This was done first to conform to set plans for expenditure in line with a medium-term economic strategy. But latterly, it has become subsumed in a ritual that assesses whether the government will meet a particular path for the deficit and a level of public debt relative to income. (In the March 2021 Budget, Chancellor Sunak effectively suspended the rules put in place by his predecessor but one, Chancellor Hammond, in 2016.)
The overall objective is to give the impression of rules-based policies that conform to the expectations of financial markets that public debt will be repaid on schedule. The plans and the act of planning has some considerable merit as they can force government departments to confront their individual inefficiencies and jointly meet a given expenditure target.
The actual practice of expenditure control and planning turns out to be quite different. In the UK, we find that expenditure plans and expected revenue receipts are significantly affected by revisions to our expectations of the level of economic activity (Chadha et al, 2021).
This is because of both surprises in the evolution of demand in the short run and as a result of the difficulty of understanding long-run trends in productivity capacity.
It is also clear that certain elements of planned expenditure, such as public investment, have been hard to implement over time. This is a result of the difficulty of identifying appropriate projects, garnering local political and business support, and identifying sufficient social returns.
It is also the case that there are revisions from changes in political preferences, for example, when a different party is voted into government.
All of this means that when the government alters its fiscal expenditure plans, it is signalling something about its revised view of the state of the economy and/or its preferences on how it wishes to meet risk in the economy.
What is the role of public debt management?
It is helpful to go back to basics briefly. Let us start from the proposition that taxes are distortionary, in other words their incidence influences our decision to work, spend, produce and invest.
What matters here are not only the tax rates themselves but also their timing. The government will seek to raise a present value of taxes that retains the ability to respond to future shocks - what is frequently called fiscal space. It will aim to do so in a manner that minimises the distortionary effects of those taxes – what economists call deadweight losses. This observation has direct implications for debt strategy.
First, changes in tax rates should be smoothed over time to limit the distortionary implications in any one period. This means that a sequence of budget deficits rather than increases in taxes should accompany temporarily high episodes of public expenditure.
Moving forward beyond the current Covid-19 crisis, governments are likely to seek to run budget surpluses when public expenditure returns to normal. With no future movements in tax rates, the level of public debt is capped by the expected sequence of future surpluses levied on the future tax base.
But there is an important caveat to this point. If public expenditure is going to be permanently higher, then tax revenues must rise in accordance. If we think that the public sector is going to be larger - perhaps to meet the demands of an ageing population, the needs for human capital formation or to plug infrastructure gaps - then we have no alternative to raising tax rates.
Either way, public debt will increase when there is economic distress, which raises the question of which debt instruments should be used.
Can debt instruments help the management of economic uncertainty?
The choice of instruments matters when there is uncertainty about future states of nature. When setting fiscal policy today, we do not know the future path of public expenditure. Equally, we do not know the size of the economy, nor the rates of return demanded by financial markets.
These combined uncertainties matter for the problem of minimising the distortionary effects of current and future taxes. By appropriate choice of instrument, these effects can be limited.
Governments would ideally like to issue debt instruments that match payoffs to the risks that they face. For example, they would wish to limit payoffs from the bonds issued when government expenditure is high and output is low, as well as to limit the sensitivity of debt issuance to changes in the costs of funding.
Ideally, government debt would be arrayed across possible instruments to limit the variance in the sequence of real payments on debt. It then becomes a question of how much nominal debt versus index-linked, short-run versus long-run debt, and foreign currency versus domestic debt. And then whether there is a case for other debt instruments, such as GDP-linked debt.
Public debt and aggregate supply and demand
Across the world, most public debt is issued on a nominal basis. This means that the interest payments are known in actual cash terms, so the government does not face uncertainty about the amount of cash transfers (Barro, 1997).
But there is considerable uncertainty about the real value of these cash transfers because we do not know the price level in the future. Nominal debt therefore implies considerable uncertainty in the sequence of real financing costs, and therefore on future taxes.
Debt interest that is index-linked to a measure of the price level offers a solution. It allows the issuer to know the real value of interest rate payments. But it leaves the government subject to nominal uncertainty as the actual cash amount of the payment cannot be known until the relevant price index has been published.
In terms of aggregate demand and supply shocks, the implications of issuance of these two types of debt are instructive (see Table 1).
A government planner may like to hold nominal debt in the presence of dominant positive demand shocks but would be concerned about the possibility of a negative supply shock.
That said, the holder of these bonds may be concerned about the payoffs in these states of nature, and may require compensation for the risks of variability in real returns or the possibility of default.
Some holders of debt may have nominal liabilities and would value income streams that are fixed in nominal terms. Index-linked bonds offer certainty about real obligations but are still subject to risk on the variance in the tax base or GDP.
Governments like to choose a mix of nominal and index-linked bonds depending on how well matched tax receipts are to nominal shocks and the extent to which holders of debt want nominal or real returns to be guaranteed.
Table 1: Shocks and instruments
|Real payments fall; tax base increases
|Real payments rise; tax base falls
|Real payments fixed; tax base increases
|Real payments fixed; tax base falls
|Real payments rise; tax base increases
|Real payments fall; tax base falls
|Real payments fixed;tax base increases
|Real payments fixed; tax base falls
Governments can also secure some certainty from future variations in required rates of return by issuing long-term debt. At the same time, they would not want to have a large amount to re-finance in one future year. This is because it may leave them open to rollover risk should that year coincide with disruptions in capital markets or some political risk.
The solution is to ensure that there is a similar quantity of debt at every issued maturity. Consequently, in any one year, the expected rollover is a constant and small fraction of the overall public debt stock.
If there is an excessive need for debt to be issued in any one year – as was the case in 2020 because of Covid-19 - the central bank can allow a temporary overdraft (in the case of the Bank of England via the Ways and Means account) or re-ignite balance sheet policies and buy debt temporarily under the mantle of quantitative easing. This is possible provided that there is a credible framework for monetary policy (Chrystal, 1999).
Is there any value in GDP-linked bonds?
Ideally, a government would like to issue instruments that have low payoffs when expenditure is high and also when output is low.
An appropriate framework for debt would seek to limit these issues if they changed the incentive to deploy public debt. There is, for example, a danger that, if instruments reduced the real costs of debt issuance, government may over-issue debt.
Indeed, the lowering and convergence of public debt costs for all member states in the euro area and the elevation of public debt levels prior to the global financial crisis of 2007-09 seems to have played a key role in the subsequent euro crisis (Dureé and Smets, 2014).
That said, because there is in general a negative correlation between high government expenditure and output, issuing debt where payments are linked to GDP may offer an extra degree of freedom for debt issuers.
In this case, for example, by linking real payments to GDP growth deviations around a trend, the government will gain extra fiscal space in a recession and pay it back in an upswing.
The payments will move in line with the tax base and provide some hedge against uncertainty in the tax base. This will allow the government to offset the risks faced.
There is a practical problem of ensuring that an appropriate measure of GDP, which is not revised, provides the appropriate payoff index. Furthermore, there is the possibility that holders of debt might value payments in a recession and would therefore require a premium for reductions in payment when they would value them most.
It is also the case that a country with a credible monetary framework has a close substitute by being able to change the costs of funding in line with economic prospects. In the case of a negative shock, it can reduce its policy rate and thereby hold down issuance costs further along the yield curve. But with large enough shocks, the policy rate may not be able to fall enough, whereas linking payments to GDP itself may provide a cleaner hedge. Recent research has shown that this creation of fiscal space may be particularly helpful to countries that are bumping up against an informal debt limit. This is because the savings on debt interest allows transfers to poorer households to continue (Chadha, Kwon and Shibayama, forthcoming). This allows poorer households to maintain their living standards despite a temporary fall in income. It also helps to prevent an amplification of the original income shock, which would occur if their expenditures fell in line with their income, as it would also reduce income for better-off households.
Debt management is a rarely discussed aspect of fiscal policy, including in debates about the fiscal sustainability of an independent Scotland.
But it is the choice that must be made whenever any government sets an expenditure plan. If Scotland were to become independent, future Scottish governments would face a choice of how much to tax now and accordingly what kind of debt at what maturity to issue as a message about future taxes.
The fiscal policy debate in Scotland has concentrated unduly on issues such as Scotland’s estimated net deficit position or how much public debt it might inherit.
But the reality is that public debt is issued to support economic adjustment. Its evolution and costs are the result of the continuous revelation of states of nature that might mean that higher interest rates are perfectly affordable as the economy is booming, or that even low levels of debt pose problems as they are may be rolled over into markets that do not wish to hold them.
An independent Scotland would, in time, need to set out a clear strategy on debt and the issuance of instruments alongside statements about planned levels of expenditure.
Where can I find out more?
- Designing a New Fiscal Framework: Understanding and Confronting Uncertainty: National Institute of Economic and Social Research occasional paper by Jagjit Chadha, Hande Kuçuk and Adrian Pabst.
Who are experts on this question?
- William Allen, NIESR
- Francis Breedon, QMUL
- Jagjit S. Chadha, NIESR
- Martin Ellison, Oxford
- Andrew Scott, LBS