Thursday, November 17, 2011

A FAQ On Malaysian Government Debt: Part I

[Click here for Part II, here for the full FAQ, and here for the condensed version]

There’s a lot of misconceptions and misunderstandings regarding the level and sustainability of government debt, which has been seriously skewing the public discourse not just about Europe and the US but here as well. [For examples, here, here, here, here and here].

Rather than arguing the points one by one, I’m putting up this FAQ as a central reference point, with some faint hopes that we might move on to a better informed debate about the issue. It’ll be available as a permanent page (see the menu on the top right of every page on this blog), and I’ll update it from time to time. The focus will be on the Malaysian situation, but some of the general principles are applicable elsewhere as well.

First the raw data (RM millions; sample period 1970-2012, with 2011-2012 data based on estimates):


Up to 2Q 2011, government debt in total has reached RM437 billion, or approximately 53% of nominal GDP:


Based on Budget 2012 numbers, total government debt outstanding should reach just over RM495 billion by the end of 2012.

The average rate of increase for the last 40 odd years has been about 11% in log terms (log annual changes):


And on a per capita basis (RM):


Based on 2012 numbers, the per capita debt should reach a little over RM 17,000 per person by the end of that year.

Finally, the fiscal deficit (ratio to nominal GDP):


You’ll see from the above that it’s not unusual for Malaysia to run a fiscal deficit – in fact it’s been the norm, except for a short period in the mid-1990s.

Now on to the FAQ:

Q1. Government debt is like household debt – if we spend more than we earn, we’ll go bankrupt

A. That’s the common sense view, and its one that’s commonly held. The problem is that it’s also mostly wrong.

Here’s where the misconception lies – if you’re a household, you earn income based on your work and investments. For a company, income depends on selling the goods and services it produces. For both parties, that income represents the upper limit of what can be paid to service debt. It’s also – and this is the important point – determined by conditions mostly outside your control. You have to depend on someone else to determine your wages; the prevailing interest rate or investment rate governs returns; and market supply and demand (most of the time) limits what a company can sell.

But that’s not true of government generally. It’s “income” comes largely from direct and indirect taxation – the rates of which are determined by the government itself. So in a very real sense, governments don’t face the hard constraints that households and companies do. Instead its a soft constraint of what level of taxation citizens are willing to bear.

But even if governments come up against such a limit, there’s also the little fact that most governments also have a de facto monopoly on the issuance of money. As long as a government’s debt is denominated in its own currency and it retains control over issuance of that currency, government debt can always be paid off.

Third and more importantly, if government spending is directed towards investment which raises the productive capacity of the economy e.g. spending on education, that effectively raises the future tax yield, which indirectly allows a higher burden of present debt.

In the end, the real limit to government borrowing (and spending) is neither taxation nor the printing press – its the ability of an economy to produce goods and services. Which leads to the next point.

Q2. Bigger and bigger amounts of government debt is inflationary

A. It depends – and the size of debt isn’t the factor here, it’s what the money raised from debt issuance is spent on.

Consider a closed economy (i.e. no external trade) with three separate sectors – households, companies and the government. All three sectors produce and consume goods and services. Inflation occurs when demand for goods and services from all three sectors exceeds production. The only way for government spending to be inflationary is when it causes total spending from all three sectors to exceed that limit.

Now consider a case where households and companies suddenly want to spend more while the government maintains its level of spending. We’ll now have a case of excess demand and inflationary pressures even though the government is not spending any more than it did before.

Suppose the opposite case where households and companies suddenly want to save more instead. Under those circumstances, an increase in government spending up to the limit of the productive capacity of the economy will not be inflationary since its only taking up the excess supply that households and companies don’t want.

But inflation actually represents another way for governments to reduce their debt burdens and is often termed “implicit taxation” – if governments spend to the point where inflation increases, that effectively reduces the real burden of debt, and not just for the government but for all debtors. That’s because debt is contractually determined at the point of borrowing (in the past), but payment is usually in current tax dollars (which with inflation has lower purchasing power). Inflation also raises nominal growth, which generally means more tax dollars for a given level of real output.

Historically, with the exception of actual defaults, government debt has often been paid off through two channels – inflation and economic growth.

Q3. The Malaysian government has been running a deficit for years – but it should only be running a deficit in bad times. In good times, it ought to be saving and paying down debt

A. There’s another implication from the discussion on Q2 – whenever there’s an imbalance in the savings/investment decisions of households and companies, the opposite situation must prevail in government spending and investment for an economy to be maintained at full output and income generation.

If households and companies are saving more, the government has to dissave. Otherwise, demand will be deficient, and household and company surplus falls, which makes their saving pointless. If on the other hand households and companies are overspending, then the government has to save. Otherwise you’ll get inflation.

So it’s not just a binary decision of good times (save)/bad times (spend) for government expenditure, which is the popular notion of Keynesian economics. It’s more than possible to have a situation of economic growth but with excess saving in the household and corporate sectors. Excess government spending then helps maintain that growth situation with full employment, but with the side effect that it requires government spending to exceed its revenue.

Let’s take it one step further by adding an external sector (i.e. trade) to our though experiment.

In aggregate, if a country is running a trade surplus, then production in the economy exceeds consumption – in short, the economy as a whole has excess savings. The opposite is also true, in that a trade deficit indicates an economy that is consuming more than it produces. So far so good.

Plug in the conclusions from the preceding discussion and you get the following – excess government spending is not a big problem with a trade surplus, but a government should cut back its spending with a trade deficit. In the former case, whether the government should run a deficit or not depends on whether external demand is sufficient to provide full domestic employment. In the case of a trade deficit however, the advice is unequivocal – you have to run a budget surplus unless you’re willing to tolerate higher inflation. Hence the consistent concern over America’s “twin” deficits over the past decade.

Technical Notes:

Data on Federal Government borrowing and expenditure from Bank Negara’s Monthly Statistical Bulletin and from the Economic Planning Unit. Population estimates from EPU and the Department of Statistics


  1. u need to get on to tweeter bro...gua semangat jadi market agent lu nih

    re the mid 80's number i tot it went all the way up to 108% of GDP (not sure if its nominal)