Winner of the New Statesman SPERI Prize in Political Economy 2016

Friday 11 January 2013

The long run government debt target

In a recent post I had an imaginary interviewer asking “But surely no government can keep on borrowing more forever.” To which my suggested reply was “Of course not. But the right time to cut government borrowing is when the economy is strong, and the cost of borrowing is high.” This prompted a little discussion in comments about the long run desirability or otherwise of government borrowing. What I have to say here is only about the long run, and has no immediate relevance while we are still in a recession.

I have to stress here that by long run, I really do mean very long run. It is the period to which Keynes dictum applies. Why? One of the most robust ideas when it comes to government debt is that it should adjust very slowly, and absorb any shocks coming from the economy along the way. The reason, which is just tax smoothing, I have discussed at greater length here. Which prompts an obvious question: if any long run debt target is meant to be achieved in centuries rather than years or decades (I did say very long run), do we need to worry too much about it? This turns out to be a rather good question.

What little literature there is on this issue contains the ‘steady state random walk debt’ result. What this means in ordinary English is that it can be optimal to have no target for government debt. Perhaps a better way of putting it is that the costs of adjusting towards any target outweigh the long run benefits of achieving it. Imagine a recession raises debt. To get debt back down we need to increase taxes in the short run by a lot. Alternatively we could make no attempt to reduce debt, but instead just raise taxes by enough to pay the interest on the extra debt. That will mean raising taxes by less, but having to do so forever. So in one case (debt targeting) taxes rise by a lot in the short run, but not at all in the long run, while in the other (debt accommodation) taxes rise by a little forever.

You might think the second (debt accommodation) alternative must be worse, because the pain is ever lasting, but you would be forgetting about discounting. Which is better depends on the size of the discount rate relative to the size of the real interest rate. It turns out that if the two rates are equal, the second alternative (debt accommodation) is optimal. And it just so happens that in our benchmark macroeconomic model, where agents care about their children and so effectively live forever, the two rates are indeed equal.

Obviously this ignores default, which might put an upper limit on debt. There are other, potentially important, caveats, which I have discussed elsewhere. However the basic result relies on the exact equality of the discount rate and real interest rate. If the real interest rate is even slightly greater than the discount rate, and there are good reasons for thinking in the long run that it might be, then it makes sense to adjust to a debt target, although the adjustment should be very slow. So what should this target be?

The simplest answer is also the most extraordinary – the government should aim to hold assets, not debt. The long run debt target should be negative. The reason is that with lots of assets, the government could pay for all its spending out of the interest on those assets, and as a result taxes could be abolished. Well, maybe not all taxes: some are designed to influence incentives. But most taxes are designed to raise revenue, and these distort incentives, so if we could get the revenue another way that would be great. (Even if you think the preoccupation of many economists with the negative incentive effects of taxes is overdone, it must be worrying that in the US the costs of complying with individual and income tax requirements for 2010 has been estimated to be 1% of GDP.)  

Now many of you will think that I’ve entered that imaginary world that is the one economists like to dream about, but which is a million miles from reality. If so, have a look at this chart, which is of government net financial liabilities in 2007, before the recession. (Source OECD Economic Outlook)

Norway is a special case, of course, but note Australia, Denmark, Finland.... Now I do not know much about the reliability and comparability of these net debt figures, but Australia’s gross debt was less than 15% of GDP in 2007, and both they and New Zealand had a clear policy to reduce debt towards zero, although for different reasons than the one suggested above.

Turning government debt into assets may seem an impossible goal now, and it is a goal we should be ignoring in a recession. However once the recession is over, and given that adjustment should be very very slow, it is not so obviously a ridiculous target.  If we combine incredibly slow adjustment with an incredibly ambitious target, we might end up with something reasonable – which is to aim for a gradually falling debt to GDP ratio once the recession is over.

There are lots of qualifications I would want to throw at this result, but this post is already long. (Those who are interested can read this working paper.) The only one that I have come across which completely overturns this idea is the literature on safe assets, but that definitely requires another post. So let me end instead with an amusing (at least to me) little story. I was recently giving this working paper in a UK economics department. One of the department’s members is a well known and for me inspirational macroeconomist, but notoriously right wing. At first he liked the message of my paper, which was that government debt should come down. Until, that is, he saw where it was leading – to an economy where the government owned a large proportion of assets, and therefore inevitably a large proportion of the capital stock. I think this had unfortunate resonances for him!   


  1. Australia and New Zealand are also special cases because of their natural resources. Australia's low debt in particular is due to its mining industry. Developed countries without such abundant natural resources would find it much harder to reduce debt and build up assets.

  2. Shame we've been selling off government assets cheap for decades in the UK, then.

  3. If it is true that a large (more accurately, increasing) government positive savings balance is optimal, then one or both of the following must be occurring in the macroeconomy:

    Increasingly negative private savings balance (a transfer of private assets to government in this case?). This does have implications, e.g., for retirement amongst other things. And/or:

    Decreasing foreign savings vis-a-vis the home country, that is a persistent home country current account surplus with the row.

    If the three balances do not equal zero in every period, the model will not give good results. This is a static analysis of course, but without a convincing dynamic growth story that honors the same constraints, the model still will not give good results. Depending on your response, I may or may not read the paper.

  4. “The government could pay for all its spending out of the interest on those assets, and as a result taxes could be abolished.” Not sure about that. Government already does charge interest on the bulk of it’s assets doesn’t it? E.g. an interest charge in respect of the capital investment in motorways and roads is presumably included in the road fund tax and/or fuel duty. Ditto for hospitals and national insurance contributions.

    If I’m right there, then that just leaves the question as to what the sense is in government inducing the private sector to hold more government liability that the private sector would voluntarily hold at a zero rate of interest. I say there is no point. Milton Friedman said the same.

    A possible reason is the “safe assets” argument (alluded to by Steve above). I.e. those saving for pensions must be able to accumulate assets. My answer: “no they don’t”. They can go for a pay-as-you-go pension scheme.

    I’m happy to consider any more alleged justifications for government debt. I’ve got my fly swat at the ready to use against such justifications, but I’ll employ it as humanely as possible.

  5. Because the government has the ability to distort incentives, it is possible for the government to accumulate assets with the goal of abolishing taxes even before it starts to pay down the debt--the United States, for example, has a hefty capital gains tax, which effectively means that the government can make a profit by borrowing money and investing it invest in private capital. Since the government isn't affected by its own capital gains taxes, it can accumulate enough arbitrage to eventually lower all taxes to zero and pay off the debt.

  6. Just to be clear, a slow adjustment in the long run might be a fairly fast pay down while the economy is growing normally, because you need to average with recession time. ?

  7. Simon Wren-Lewis: "Obviously this ignores default, which might put an upper limit on debt. There are other, potentially important, caveats, which I have discussed elsewhere. However the basic result relies on the exact equality of the discount rate and real interest rate. If the real interest rate is even slightly greater than the discount rate, and there are good reasons for thinking in the long run that it might be, then it makes sense to adjust to a debt target, although the adjustment should be very slow. So what should this target be?"

    Given debt in a country's own fiat currency, default is unnecessary. As for the real interest rate being greater than the discount rate, can't the gov't simply issue currency (zero interest debt) to bring the average rate down?

    Simon Wren-Lewis:"The simplest answer is also the most extraordinary – the government should aim to hold assets, not debt."

    That is the most attractive solution. But in the end it may mean nationalization of land.

    Currently gov'ts inject money into the economy by running deficits. If it holds assets then how does it inject money into the economy? I suppose the model is the Pennsylvania colony in the decades before the American Revolution. It injects money into the economy by lending. But doesn't that make counter-cyclical policy more difficult? During good times people will be eager to borrow, and during bad times they will not want to borrow.

  8. Three problems.
    1. If there was no requirement to pay taxes why would anyone accept the government issued fiat currency? It would have no intrinsic value. As far as I know there has never been a fiat currency without a government-enforced tax obligation in the same currency. Seems like a risky experiment.
    2. What would take the place of government debt as a safe financial asset?
    3. Whenever the US government has tried to reduce its national debt this caused difficulties. Indeed, all 6 depressions in US history were immediately preceded by multiyear government surpluses and large reductions in the national debt. How will this be avoided?

    1. 1. It is government income/revenue that backs it up. Of course most of that is usually tax, but it doesnot have to be that. You need money to pay it doesnot say it will have to be taxes.
      Examples: some of the oilstates. And say Monaco could issue an own currency that would be credible imho (mainly doesnot do so for practical reasons as far as I can see it).
      Problem of course where to get such high other income from, but if you would manage to do so, imho it looks even safer than taxes as yields can more eassily be stabilised.
      2. There is no safe financial asset. it is always basically a defined as safe financial asset. Financial institutions will have to come up with a solution for that and with the formulaes that use that. It should not be that difficult. Anyway it is used as such because it was there and not the other way around.
      Anyway2 the defined safe financial asset regime has to be changed anyway as it is clearly not doing what it is supposed to do. Simply because a lot of these safe assets are in no way safe but very risky. It has created one of the biggest risks we have in todays world.
      3. Of curse this is an issue. However look at what you are stating and the conclusion would be that debt can never be reduced. Which is also hardly a sustainable situation.

    2. Government debt represents the net financial assets of the non-government sector. Ask the question another way. Why do these assets need to be reduced to zero?

    3. Your point No.1 is an interesting one, but I disagree. It’s certainly true that thru history many or all currencies have been created by governments to facilitate tax collection. But I suggest there is a deeper underlying reason why that works: it’s that money is what is often called a “social construct”. That is, a form of money works if it is generally accepted as money. Indeed the definition of money is something like “Anything widely accepted in payment for goods and services.” Thus the governments which introduced currencies to facilitate tax collection only succeeded because there was a fairly widespread acceptance that that was a reasonable thing to do.

      Thus if a government ceased to collect tax or indeed more or less ceased to exist, it would still be generally accepted that the form of money it had set up was useful (better than barter and all that). So the form of money would just continue. However your point about it being a “risky experiment” is no wholly invalid: I’m not 100% sure you are wrong.

    4. @Anton
      You could invest in foreign and non-financial stuff most SWFs do. Seen the size required that will be necessary anyway. And so do the citizens of those countries.

      Might also be a better answer to aging let people work for you abroad (and iso paying tax for pensions and alike there is a yield from an investment), they will not have to move and you donot have all sort of social problems coming with imigration.
      And why as an other alternative not use somebody else's money (like Iceland is planning).

      It goes so slowly it doubt that there is much risk (other than losing a long period), but anyway the next decades it could be similar as the preferred policy of many (reducing gov debt to what many see as more sustainable levels).

  9. Like the idea but some remarks.
    1. Accounting. Have a look at your chart and directly one notices that it is simply by no way properly presenting the nett value of the countries. How can you have an effective economic policy in this respect when it is very easy to move costs/assets/liabilities from BS to Off BS (or P&L similar for costs).
    Looking at some hot topics we have Euro rescue liabilities/costs that donot count as such. ECB (indirect assets/liabilities) manages to make a bookkeepingprofit on Greek bonds it bought for around 70 and which are selling in the open market for 30.
    Imho any target will only work properly if these things are no longer possible.

    2. Debt would not be a problem basically if it didnot carry interest with it and repayment obligations can cause a default. Partly you can print yourself out of trouble, but that is never a perfect solution (you likely face after that high interestrates and/or high inflation or as we see in Europe at the moment you 'chain' another sector to a financially dodgy government (and we all go down together)).
    Therefor at the end of the day. Markets will determine for a large part this position. And markets seem not really to look that much to the nett position, but more to things like: gross debt; growth potential/general state of the economy.

    3. Liquidity. A lot of the assets are simply not liquid.
    Meaning likely you have to do it with the proceeds theron in bad times and are not able to use via a sale the proceeds therof to plug the hole.
    Plus at the same time likely when you need them most (bad economic times) the prices are probably at a low point.

    4. Looking at todays yields and todays governmentspending, difficult to see how to get so much assets that the yields can finance all or nearly all government spending. Will mean heavy cutting in that department.

  10. Does the capital stock satisfy the demand for stores of value? The traditional attitude, which is so rarely questioned that we are not even aware of making an assumption, is that we could be richer if we could just accumulate more capital, but the urgency of present needs and desires always stymies us. This has no theoretical basis. If capital goods are cheap and most people live a long time after they retire, it is perfectly possible that the steady state value of the capital stock can be smaller than steady state aggregate retirement savings. In such a world government debt usefully increases the supply of stores of value. This point was made by Samuelson's overlapping generations model, but in that context it looks like a cheap trick related to paradoxical aspects of infinity. This is a serious concern that should be addressed quantitatively when discussing the desired quantity of government debt.

  11. I am still perplexed why most governments do not copy or at least do something like what Iceland did to their banks? Are the people in Iceland's government the only smart people on Earth? Debts were vaporized and the government policies redefined and overhauled for the sake of the country. It was truly amazing!


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