Rethinking Public Debt
Time to Change the Narrative: Public Debt Isn't What You Think It Is
An inescapable element of decisions and discussions on the Budget and fiscal policy is public debt.
High levels of government debt are perceived to constrain the ability of the government to spend - just like a household. As a result, debt reduction becomes the primary policy objective of government over housing, education, healthcare, infrastructure, and fighting poverty. Don’t forget, ‘reducing debt to prudent levels’ is a key part of the ‘Principles of Responsible Fiscal Management’ contained in the Public Finance Act 1989.1
High levels of public debt are purported to have an impact on intergenerational equity, where future generations are ‘burdened’ with the need to pay back the debt - just like you would in a household.
These ideas are based on a false conception of what public debt actually is.
As we know, the government is not like a household in any sense. Above all else, the government is self-financing. Households aren’t. This means that we have to reevaluate our understanding of what public debt is and the role it plays in our economic system.
Today, we touch on five points that you should know about public debt. These are:
Any Type of Public Debt is an Asset Created by Government
Public Debt is a Default Risk Free Asset for the Non-Government Sector
The Sale of Government Bonds Is an Asset Swap
The Reserve Bank Has the Ability to Control Interest Rates
Public Debt Isn’t As Important to Interest Rates as What It Has Been in the Past
Just like taxes, bond issuance does not increase the ability of the government to spend money.
This is another factor in why we need to reconceptualise government expenditure. We need to move away from the idea that ‘saving’ by not spending on crucial public services like healthcare now to ‘pay back debt’ will somehow help future generations.
We are already seeing the adverse effects of these choices.
Keep that in mind when you’re reading Budget 2025 commentary or watching politicians wax lyrical about ‘debt reduction’.
1. Government Debt is an Asset Created By Government
Public debt in the form of bonds and bills are assets created by the government that are traded with financial market participants.
The first thing to note in the conversation on public debt is that we are talking about bonds denominated in New Zealand dollars and issued by the New Zealand Debt Management Office (NZDMO). If we are talking about foreign debt, then the ‘household’ analogy applies.
Just like taxation, bond issuance drains the settlement cash level (SCL).2 Also, it’s worth remembering that bond issuance (and taxation) occurs independently of the government expenditure process. Remember here too that the government spends settlement cash. Draining it obviously doesn’t help the government when it comes to spending it!
As the government can not run out of money to meet financial obligations in New Zealand dollars, the size of the debt, either nominally or relative to GDP, does not pose a solvency risk to the government like it would for a regular household.
2. Public Debt is a Default Risk Free Asset for the Non-Government Sector
The crucial thing to remember about public debt is that it is a default risk free asset for the non-government sector.
Don’t believe me? Then maybe you’ll believe the Sydney Futures Exchange (SFE).3
As a bit of backstory, the Australian Government were running consistent fiscal surpluses throughout the 1990s. By the Australian Treasury’s logic, they didn’t need to issue government debt because the government was saving and paying back debt. Australian government debt declined from 19.1% of GDP in 1996/1997 to 5% in 2001/2002’. As a result, the SFE got cross when the issuance of Commonwealth Government Securities (CGSs - Australisn government debt) was threatened by the Australisn Treasury, so they made a submission during the review process.
The SFE noted that the disappearance of the CGS market would impede on ‘the opportunity to invest in ‘(default) risk-free Australian dollar denominated securities’ (2002, p. 4).
Moreover, the SFE also noted that this would
remove or make even scarcer the ultimate domestic ‘safe haven’ security during periods of extreme volatility in financial markets, producing an economy with a higher risk profile that is more vulnerable to financial panic (2002, p. 4).
Government bonds are essentially just corporate welfare, offering a default risk free source of income for pension funds and other financial institutions. The benefit the public gets from public debt is through it providing a basis for market interest rates and a safe, interest bearing, store of value for the non-government sector.
3. The Sale of Government Bonds is an Asset Swap
Maybe the most interesting thing about government debt that all commentators miss is that government bond issuance is an asset swap. The assets in question here are the bond itself (obviously) and settlement cash.
The banks referred to as as the primary dealers, who have accounts at the Reserve Bank (ESAS accounts), exchange settlement cash (which earns interest at the OCR) for government bonds (which earn an interest rate higher than the OCR).
The primary dealers get:
A default risk free asset that they are going earn money on (principal on maturity and interest payments while they hold the bond)
An interest-bearing asset that’ll earn more than their settlement cash balances
When viewed in this light, it is no surprise that bond issuance is oversubscribed. For example, in Bond Tender No. 947, a five-year nominal bond (tendered on 15 May 2025 and maturing on 15 May 2030) with a volume offered of $200 million NZD received $1.199 billion NZD worth of bids.
Investors must be really worried about the solvency of the New Zealand government – not!
It’s probably worth pointing out here that the Reserve Bank is decreasing the level of settlement cash over time from an abundant to an ample level of settlement cash, so banks are incentivised to get rid of their settlement cash and trade it for government bonds.
4. The Reserve Bank Has the Ability to Control Interest Rates
The public debt market serves as the basis of market interest rates. For instance, mortgage interest rates are based on the interest rate of long-term government bonds. Influencing these long-term interest rates was the whole point of quantitative easing (QE).
As demonstrated by QE, long-term interest rates are controlled by the Reserve Bank. If Nicola Willis’ nightmare scenario occurs where ‘bond vigilanties’ sell bonds (thereby raising interest rates) because ‘the New Zealand Government can’t repay its debt’, then the Reserve Bank would step in to bring interest rates in line with their expectations in order to preserve financial stability.
5. Public Debt Isn’t As Important to Interest Rates as What It Has Been in the Past
This is where it gets technical, but it is also perhaps the most important because it demonstrates that bonds are kind of useless in our economic system.
To provide some clarity, bond issuance serves a monetary policy function rather than a fiscal policy function.
Bond isssuance used to help the Reserve Bank in meeting the Official Cash Rate (OCR) target.
The objective of bond issuance matching the size of the fiscal deficit was to limit the level of the SCL which in turn influenced the OCR. Bonds would also be used in open market operations (OMOs) to influence interest rates when necessary.
After 2020 however, bonds don’t have the ability to impact on the OCR as what they have in the past.
So, what changed?
Before 2020, the Reserve Bank targeted the OCR by influencing the SCL. Specifically, the OCR would in between two other interest rates, where the RBNZ would act to keep the OCR in the middle of them.
This was called the ‘corridor system’.
A high SCL has the impact of lowering the OCR. On the other hand, a low(er) SCL has the impact of raising the OCR. The RBNZ aimed to offset these movements by trading bonds, aiming to raise or lower the SCL depending on what the conditions were.
After the large-scale asset purchase programme (LSAP – the name for QE in New Zealand) raised the level of settlement cash immensely in 2020, the Reserve Bank started charging the OCR on all settlement cash balances.
This is called the ‘floor system’, where the OCR acts as the interest rate floor.
The shift to the floor system is actually really, really, really important because it shows that public bond issuance is now effectively useless in maintaining interest rates.
This was captured really well in the paper ‘The Self-Financing State’, where Berkeley et al. (2022) noted that:
The price floor renders the actual quantity of reserves in the inter-bank market largely irrelevant to the achievement of the short-term interest rate target [the OCR] and, as such, any necessary operational link between quantities of debt issued and the net balance of the Exchequer's [The Treasury] spending and taxation flows is broken (2022, p. 17).
You won’t hear Nicola Willis talking about that in the Budget I bet.
Time to Change the Narrative
This has been a very information heavy post with a lot to wrap your head around.
The basic thrust of it can be summed up in the five points presented at the start.
All the talk of ‘running up the debt clock’ from the Taxpayers’ Union to the talk of intergenerational equity is simply the wrong way to conceptualise public debt.
When we’re talking about intergenerational equity, it makes sense to talk about the impact of underfunded healthcare and education systems on future generations. It doesn’t make sense to talk about a how a self-financing government can’t repay a default-risk free asset, denominated in the currency it issues, that it created in the first place.
Future generations will be burdened by the lack of adequate healthcare, education and infrastructure. Current generations already are. They won’t be burdened by the public debt, the repayment of which is able to be met at any point in time regardless of the fiscal position.
It’d be silly if I didn’t make a brief comment on credit rating agencies. I genuinely can’t understand why ratings agencies, who oh so accurately gave highly unstable mortgage backed securities (MBSs) AAA ratings in the lead up to the 2008 Global Financial Crisis, are still listened to when it comes to government credit ratings. This is a remarkable failure of common sense.
Section 26G(1)(a) and s26G(1)(b) are the key stipulations of the legislation.
Conversely, bond maturities add to the settlement cash level.
To view the SFE submission in full, download the 7.65MB file and open ‘cdmr-001’.
Thanks for this Morgan. It would, I suggest, be much more readable if terms were written in full rather than as acronyms. I find it surprising how lttle extra space is taken by writing terms/titles in full v much more readable.
This is an excellent and timely call to rethink the prevailing narrative around public debt. You compellingly highlight how the relentless focus on debt reduction has come at the expense of vital public goods, particularly infrastructure and the health system. These are the very foundations of societal well-being, yet they continue to be undermined by orthodoxy.
Even for those indifferent to the needs of future generations, the consequences are already evident in the everyday challenges faced by current ones. Too bad to have such a long life expectancy, am I right?