On enforcing fiscal responsibility through fully-amortized loans

The main idea: switching government (or at least regional) borrowing to fully amortized schedules only would greatly limit the propensity to acquire leverage beyond reason.  

0. Posts on this blog are ranked in decreasing order of likeability to myself. This entry was originally posted on 16.10.2021, and the current version may have been updated several times from its original form.

 1. Problem: balloon loans

1.1 As far as I know, all borrowing taken out by governments the world over is repaid in bullet / balloon format, where the principal is fully repaid in one single payment at the end of the loan term, and only interest is payable up until that time. Some of those loans run for 50 years, just so we are clear.

1.2 At the other end of the repayment schedule spectrum, you find a fully amortized loan, whereby the borrower repays both the principal and interest on it in a series of equal repayments throughout the term of the loan (ask Excel). The issue and solution should now both be obvious.

1.3 Borrowing in the form of balloon loans creates almost all of the issues with public financing we all know and love. For one, it creates an incentive to borrow at the shorter term possible, as most of the time curves are such as to require higher interest for longer duration. But interest is the only thing actually repaid with balloon loans, as they are universally turned over when time comes to make the final balloon payment.

1.4 The tendency to turn over and seek the shortest term possible then creates a major issue with refinancing risk, i.e. the chance that come repayment no one will be eager to lend you the balloon again. Hence, Greek crisis etc.

1.5 Balloon loans allow for far lower repayments rates up until that very last balloon repayment, which in turn allows for borrowing far in excess of repayment capacity. It is known everywhere that balloon repayments could never be actually repaid were they to come due and not be turned over.

 

2. Solution: fully amortized loans

2.1 All of the above would be solved easily by banning all borrowing by less than fully amortized schedules at the public level.

2.2 With fully amortized loans, it pays to seek the longest possible loan term, as that translates into the lowest repayment. Ideally, all governments would go back to borrowing in the form of infinite term loans (consols), arguably the most honest form of financing.

2.3 Longer loan terms would limit interest rate risk and improve outlay predictability. Refinancing risk – the bugaboo of modern government finance - would become zero overnight, with nothing left to refinance.

2.4 Default risk would be greatly limited, as some of the principal is being repaid at all times. There is a reason mortgages are fully amortized, as banks actually care about default probability.

2.5 Whilst the same total borrowings would translate into dearer annual repayment with a fully amortized schedule, you can’t ask for fiscal responsibility without having some real limit to borrowing ability. There you go.

2.6 Now, in practical terms, no government in their right mind will ever agree to limit itself to fully amortized loans only, due to the above. So, any such reform can only be taken if imposed by national governments to regional, municipal or public borrowers that issue loans guaranteed by the national government itself.

2.7 So there you have it Australia, Switzerland and what not: go forth and let the market decide on the proper level of federalization by limiting all borrowing by subnational actors to fully amortized schedules only.