Economic Myth Of The Week: Governments can borrow more cheaply than the private sector

Polticians like to justify the massive increases in government spending during a downturn on the vague notion that government investment will not only kickstart the economy but also that the government can borrow more cheaply than the private sector. I have resisted the temptation to use any speechmarks in that sentence because just about every word has to be taken with a pinch of NaCl.

What they cheerfully ignore is that it is important to look at the marginal cost of borrowing, not the overall average. Let's compare and contrast two broadly similar countries using the same currency, Germany and Italy:

Germany has a debt-to-GDP ratio of 63% and Italy has a debt-to-GDP ratio of 103%. The interest rate on a ten-year German Bund is just under 3% and Italy pays about 1.5% more, i.e. 4.5%. While it is almost certainly true that Italian businesses have to pay more than 4.5% interest, this is not the whole story ...

For simplicity, let's assume that both countries have a GDP of €1,000 billion. Germany has debts of €630 billion and pays €19 billion in interest; Italy has debts of €1,030 billion and pays €46 billion interest. Further, let's assume that Italy only has to pay the higher rate because it has a larger debt-to-GDP ratio and is thus a riskier bet (every additional ten per cent of GDP appears to increase the average rate by 0.4%, in this example), so we could divide Italy's debt into two tranches; the first tranche of €630 billion costs €19 billion in interest (same as Germany), and the second tranche of €400 billion costs it €27 billion in interest (€46 billion minus €19 billion). €27 billion divided by €400 billion = 6.75%, so the marginal effective cost of every additional €1 that the Italian government now borrows is >6.75%, quite possibly more than what an individual Italian business would have to pay.

The maths gets progressively worse; if a highly indebted country like Italy borrows another ten per cent of GDP, the average rate might increase to 4.9% (4.5% plus 0.4%); €1,130 x 4.9% = €55 billion; the marginal rate of interest on that additional €100 billion is 9% (you do the maths).

I can't do the same exercise for the UK as there are no similar-sized economies that use Sterling, but the same logic applies. And it applies in reverse as well; paying off £100 billion in government debt (or not running it up in the first place) would save the taxpayer £5 or £6 billion a year in future debt service costs, not just £3 or £4 billion.

Just sayin', is all.

UPDATE: in case this is too abstract, I have also done workings showing that home buyers with high loan-to-value ratios are paying a marginal interest rate well in excess of ten per cent, see here.