Not too long ago when the Australian government ran a budget surplus, the Howard administration announced a plan to stop govenrment borrowing. That was around 2003. The financial industry was unhappy with it and lobbied the government to abandon that plan, citing havoc it would cause in the Australian financial market. The lobby was succesful. The Australian government continued to borrow even in times of fiscal surplus.
The idea how absence of government bonds in the local market may cause havoc is simple. All interest rates are more or less dependent on interest rate of a risk-free asset. In most cases, a risk-free asset is a sovereign bond of a reputable government, which more often than not, members of the Organization of Economic Cooperation and Development, the OCED, which is a grouping of the most developed as well as the most influential economies in the world.
It is risk-free in a sense that these governments, and in this case, the Australian government, would not default on their obligation to service the debts. Given the certainty that it provides, others instruments are priced with the rates of sovereign bonds considered. In other words, government bonds provide benchmark interest rate for the financial industry to use for other purposes ranging from simple lending and saving activities to complex derivatives.
How much disturbance would it cause if a government ceases issuing bonds?
I am quite concerned with this question because as a libertarian of largely minarchist tradition, the argument provides a hurdle to smaller government.
Firstly, by connecting the centrality of sovereign bonds as risk-free asset to the health of the financial industry and the economy at large, it legitimizes government intervention in the market.
Secondly, in time of budget surplus, it prevents valuable resources from being used in other areas. Borrowing imposes cost and the cost is being borne for no productive spending at all. It is like Santa Claus throwing money to the streets, except that it is the taxpayers that ultimately pay for it. It is not so much an issue in time of deficit because such deficit spending is grounded on other rationale, regardless whether that rationale is acceptable or not.
Thirdly, borrowing in times when the government has little use for extra fund introduces an unnecessary opportunity cost. “Oh, extra money! Let us spend it”. After all, with interest charged on that idle money, surely there are better ways to utilize it. That involves reinvesting that borrowed money into investments that provide higher returns. Or funding new government programs that veer away from the role of a limited government. That is not a libertarian-friendly idea.
Returning to the question, how much disturbance or havoc?
I would argue not much since the market will adapt to a scenario without government bonds in the local market.
It is true that without government bond in the market, market players will not have a risk-free asset to base their pricing on, within local context. I am sure they will be able to substitute it with other assets locally however. It will not be risk-free but it is still high quality assets. That probably may cause cost of borrowing to go systematically up since the minimum interest rate in the market that forms the base of all pricings increases to correspond with greater risk faced by market participants. Nonetheless, the industry will find an alternative benchmark.
Furthermore, that alternative benchmark does not have to originate from the local market. Other governments do borrow and some of the most reputable governments, as far as fulfilling their debt obligation go, borrow massively. Save for foreign exchange rate fluctuation risk, there is no reason why the rate at which reputable foreign governments borrow cannot be the benchmark.
I suspect the argument against zero-debt made by the Australia financial industry players is about protecting their revenue rather than problem that it might cause to the market’s ability to price assets.