Winner of the New Statesman SPERI Prize in Political Economy 2016

Sunday 8 March 2015

Austerity: Nick Rowe's not so silly question

Nick Rowe has a silly question for those who oppose austerity. Actually he really means it is a question involving silly numbers: would you still advocate fiscal stimulus in a liquidity trap (with interest rates stuck at some lower bound - the ZLB) if government debt was ten times annual GDP?

It is not a silly question for two reasons. First, thinking of this kind of unimaginable extreme is often a useful way of clarifying ideas, which is what Nick is trying to do. Second, this is a variant of question I was actually asked in No.10 Downing Street half a dozen years ago. What follows is a better version of the answer I gave on that occasion. To make things easier, let’s assume GDP is 100, so government debt is 1000, but the negative output gap is near 10%, so GDP could be 110. Let’s also assume that the government does not want to default, and that it is willing and able to service or even reduce that huge debt once the output gap is closed. Finally, and this is critical for the answer I give, assume government debt is in the currency that is issued by the country’s own central bank.

One way I like to frame this issue is to think about different time frames. A large output gap is an immediate problem which can be dealt with quickly using fiscal stimulus if interest rates are at the ZLB. A high level of government debt is a medium to long term problem, which is much less costly to solve when interest rates are not at the ZLB. [2] So it is not a matter of trading off two conflicting objectives (see this recent post for example). You can satisfy both objectives by doing stimulus now and austerity later.

Does debt being ten times GDP change this logic? There are four main potential costs associated with high government debt. The first is that, by generating high real interest rates, it crowds out private capital. However at the ZLB long term real interest rates are likely to be low, not high. Second, paying the interest on that debt requires higher distortionary taxes. (In macro terms it is the distortion that matters here - if the debt is owned domestically the money is just being circulated.) However if there is an output gap the possibility that people are not supplying labour because income taxes are too high is not a current problem either.

A third issue with debt is the ‘burden on future generations’. How real that is or not, dealing with excessive debt is going to screw the current generation (who have to suffer the higher taxes or lower spending to get debt down), so asking them to also suffer continuing unemployment is hardly fair.

The final problem is that the markets might suddenly take fright that the tax burden implied by the debt is too large in political terms, and as a result the government may default. So the funding that enables the government to roll over the 1000 in debt might dry up. Now imagine two scenarios. In the first, the government eliminates the 10% output gap by means of a fiscal stimulus worth 10% of GDP, say. That increases the debt from 1000 to 1010, but GDP rises to 110, so the debt to GDP ratio falls from 10 to 9.2. In the second, there is no stimulus but austerity instead, involving a budget surplus of 10% of GDP. So debt falls from 1000 to 990. Even if we make the outlandish assumption that austerity on this scale does no further damage to GDP, which stays at 100, the debt to GDP ratio falls to 9.9. Which scenario is going to worry the markets more?

Suppose, despite this, the funding does dry up. You have your own independent central bank, so you print the money to cover the stimulus and any debt rollover required. That might require a lot of money creation - perhaps as much as central banks have actually undertaken as a result of Quantitative Easing (QE)! Just as with QE, the world does not fall in. Will that not lead to massive inflation? No, for exactly the same reason QE does not. The moment the output gap has been eliminated, and interest rates are off the ZLB, you can start the austerity programme that begins to roll back money creation. That stops the output gap becoming positive and therefore stops inflation. [1] People sometimes throw in an exchange rate crisis at this point, but as Paul Krugman has repeatedly pointed out, this does not change the basic logic.

So I think the answer to Nick’s question is not the answer he thinks. The logic is that every time and whatever the numbers you first eliminate the output gap and get off the ZLB. Only when that is done do you start taking action to reduce deficits.

[1] Various contributors to this blog tell me this is the key contribution of MMT. The fact that I do not describe it as such is simply because I also think this is what mainstream macro implies.

[2] As I like to point out to market monetarists, what they call monetary offset has always been central to the anti-austerity argument.


  1. Thank you. Very nicely done.

  2. Very good piece, but there seems to be a typo: "which stays at 10". Surely GDP should be 100, if austerity leaves it unchanged?

  3. Thanks Simon. Yep, that's why I asked the question. (And Mother always said I should be at No 10.) And it's good to see a good coherent answer.

    Your answer does raise a stock/flow question though: "How long does it take using the deficit afterburners on the ZLB runway before the plane reaches take-off (or cruising) speed?"

    Assume the model gives us a fiscal multiplier of one. That's a flow divided by a flow. And there's a 10% output gap, so we need a 10% deficit/GDP to close it.

    At one extreme, if we need to run an extra 10% deficit/GDP ratio for only one week to escape the ZLB permanently, the debt will only increase by 0.2% of GDP, so debt/GDP falls when GDP increases by 10%. No worries.

    At the other extreme, if we need to run an extra 10% deficit/GDP ratio for 10 years, the debt will increase by 100% of GDP, so debt/GDP rises when GDP increases by 10%. Worries.

    AFAIK, theory doesn't give much of an answer to this question. It depends on how long it takes to change expectations to flip the economy from the bad ZLB equilibrium to the good normal equilibrium.

    1. It must depend on the alternative, and how long we would have to wait for Mr Micawber's alternative policy to work. (Assuming, for the sake of argument, monetary policy won't work.)

    2. I don't think its a matter of expectations, but of balance sheet adjustment. Based on experience this time, 5 year max. But why worries, given that you can always money finance.

    3. Yup, it is about balance sheet adjusment, how much time it will take to adjust private balance sheets so they can grow debt again. That is the crucial point for duration and level of needed deficit spending to correct deficit in jobs, deficits in education, deficit in quality health and deficit in quality of infrastructure. Only then economy can cruise on its own with private debt growth as the source of demand.

      Or just raise minimum wage. Or implement debt jubilee so that balance sheet is adjusted by tomorrow and hopla.

    4. Simon: money-financed deficits are better than bond-financed deficits (if AD is too low). But let's do a back of the envelope to see how big a difference it makes.

      Assume the currency/NGDP ratio is around 5%. If we have a 5% deficit/GDP for one year that will permanently double the stock of currency (so it would be money-financed), we would need to permanently double the implicit NGDP target.

      For any plausible increase in the implicit NGDP target, like 10%, we would only get an increased stock of currency of 0.5% of GDP. Which won't finance a very big deficit for very long.

    5. On second thoughts, I wonder if my back of the envelope calculation is an underestimate of the Present Value of money finance in a growing economy? Not sure.

    6. Nick, I think Simon means something different by "money financing". I think he means "the central bank guarantees government debt against default". It's not a commitment to a higher price level necessarily, but it excludes paths of monetary policy under which the government would default. So it's a partial loss of independence for the central bank, since it allows fiscal policy to override monetary policy under some conditions.

  4. Thanks, interesting piece. What if interest rates are not near the lower bound? Reduce interest rates further then target the remaining output gap? As a political economy matter your central bank might have other objectives..

  5. (There's a second problem, which I like to think of as "the Koo Problem", but I only note it parenthetically. "Japan's debt/GDP is so high that Japan can't afford to escape the ZLB, because if it escaped to ZLB real interest rates would rise and debt service costs (that are zero at the ZLB) would be so high Japan would default, so we must stay at the ZLB forever!"

    To my mind, if Koo is right, then Japan is already dead anyway, and postponing lifting off the ZLB is just postponing the Day of Reckoning, and the longer Japan postpones it and the higher the debt/GDP rises, the greater the chance that Koo is right. So let's get off the ZLB asap and cross our fingers.)

    1. Koo is probably the only English speaking economist who understands Japan (that includes a lot of Japanese who have spent most of their lives abroad and who have studied at MIT, part of the cosmopolitan elite and repeats back what the gadgets they learned there tell them). Koo was in Japan during the 1990s and went through all the policy discussion which almost entirely in Japanese (without MIT gadgets) about low interest rates with high government debt and 'balance sheet recessions'.

      However, I think even Koo needs to dig deeper into how high large government deficits are absorbed and the relationship between banks, corporations and the government in Japan. There is little chance of a 'debt crisis' in this very closed economy and JGBs will remain premium assets. All that has happened is that the government sector absorbs a higher level of savings in the economy. This might not be to everyone's taste, but it does not auger a crisis. Savings may be running down with ageing, but that is what they are there for. The Japanese predicament is greatly overstated.

    2. That's why at the ZLB you issue a disproportionate amount of long-term debt to the public. It imposes large losses on investors, but gains to the government, as interest rates rise. If at the ZLB you had high long-term interest rates or only the central bank would purchase long-term bonds, then you were presumably already in a state of fiscal dominance, and you may just need to accept that your choices are raising the price level until it's consistent with the debt outstanding. Now, if the public is willing to purchase low-coupon, long-term bonds, you could run into the political problem that raising rates then has a powerful constituency against it, but well, there tend to be constituencies against everything.

    3. Nick Rowe
      Japan is doing it the wrong way so they got stuck. Japan never fixed banks from corporate defaults because instead of bankrupcy for nonperforming loans they save banks just enough to survive but never offer to help private balance sheets adjust. Like Sweden did.

      Only way that Japan can exit Koo's predicament is to replace monetary policy with capital requierments for banks. BOJ sets interest rate that Japan has to pay. If it leaves it at 0 and controls credit issuance with other means, like capital ratio or give strict ammounts of new credit (which can be the source of corruption and nepotism) then Japan can inflate. Banking Reserve ratio does not control credit issuance (MMT - credits create deposits which cover any reserve ratio, and higher ratios reduce funds for government debt), only capital requierments can when people are willing to borrow.

      So, only the strict regulation of capital levels of banks can sustainably replace monetary policy while public debt service is at 0% interest rate.
      Replacing monetary policy with taxation is cumbersome and volatile as Ralph Musgrave wrote bellow.

  6. Very nice, I've wanted to this kind of calculation for a while now, but was, well... too lazy to do it.
    However, the basic question itself (government debt at 1000% of GDP) is one of those theoretical questions that economists like to concern themselves with but which have no relevance in reality. After all, what kind of economy must that be that achieves such a high debt load, what kind of government creates such a situation, and who are the lenders who are willing to lend so much money to create such a high debt burden? The only somewhat realistic scenario in which something like this might happen is a natural disaster, or an unexpected disastrous war that eradicates around 90% or 95% of GDP, yet the government conducts its business as usual.

    1. The man in the street is often the lender who picks up the tab. Just look at the recent 'bribe' of 4% interest rate bonds given to the elderly. Interestingly, they recently also paid off old World War one debt. I wonder if the new debt at 4% is cheaper than the old debt? Hopefully it is, but if it is not, surely Osborne should be held to task for exchanging cheaper debt for more expensive debt so he can give a political bribe?

  7. Whaat?
    Your note number 1) is false. That is nothing new and it is not from MMT and i never herd any MMTer saying such.

    "That stops the output gap becoming positive and therefore stops inflation. [1]" That is pure Keynes with deficit in downturns and surplus in upturns, even Friedman was using it. No MMTer said that is insight from MMT. Contractionary fiscal policy is contractionary what is new there?

    Insight from MMT is that those four possible problems with debt are not problems at all. Those problems come from false loanable funds theory which is main line of attack of MMT.

    There is no:
    i) crowding out
    ii) interest on debt paid with taxes
    iii) burden on future generations
    iv) bond vigilantees

    i) There is no crowding out of funds by government. MMT explains that private debt is THE SOURCE for government debt, they do not compete for the same source. Acctually MMT never says it so clearly but i do.
    People do not lend to governments, institutions do and they lend those funds that are requerd by law to be there for that, to lend to governments. You have heard of reserve requierment? Have you?

    Credits become deposits when go back into banks and then bank is requerd by law to hold it at Central Bank. There is alot of excess of what is requierd by law and banks have to have it at CB so they lend it to governments. That is what MMT contributes, it's main point.

    Only way to become crowding out is when deleverage and credit defaults happen. This destroys reserves that were used to lend to government. Example is Greece where this destroyed banks which used to fund government so interest rates jump. Defaults were destroying USA banks first but they saved them and prevented deleverage which would surely force rates up.

    Credit defaults is what destroy funds for government borrowing. There is no crowding out unless that also starts deleveraging process as you Simon understand it, but it is acctually defaults on mass scale, not repayment of debts, even tough both destroy bank reserves which is the source for government funds.
    That is why USA has instituted bankrupcy laws for public that saves banks from credit defaults which also saves reserves, and also leaves property in owners hands. Free lunch for all, that what bankrupcy is.

    ii) every country pays interests on debt with new debts, not with taxes. No country can sustain paying interest service with taxes so nobody does it. Not only old debts are payed with new debts but also the interest is covered with new debts.
    Anybody can check this only if their ideology allows them to. It was time past to stop believeing ideology and propaganda that was true only in Gold standard times, 80 years ago.
    Please UPDATE informations.

  8. iii) There is no burden on future generations.
    Government debt can grow indefinetly and it is NEVER repaid, unless deleverage is allowed.
    Since private debt grows nominaly as prices and wages grow indefinetly and this debts create money and deposits that have to be placed in bank reserves which government borrows, there is ever need to repay public debts. And no country ever does it. That is also easy to check if only ideology alows you to.
    But there are times when imperial powers decide to destroy a corrupt country and then force it to pay. They can try, and they will keep trying but never succede,Greece is a great real time example. But the truth is that they are not going for money they want only to punish and hurt for purpose of control, that is it.

    No decent country ever lowers its total nominal debt, it must not or it will destroy its economy. Why? Because banks NEED government debt, they requier it. Listen to Greenspan when USA started lowering public debt and his paniced words. This government surplus meant that private had to go into deficit to pay for it.
    Sectoral ballance aproach is also one of MMT main points but it is not original.

    iv)There is no bond vigilantees. Even tough MMT never states it clearly, I do: Interest rates for government debts is what monetary policy decides. So, interest rates are set up by independent Central Bank. 'Independent' here means that there is no fixed exchange rate or huge debts in foreign currency which prevents CB from following Taylor rule and Philips curve. Fixed exchange rates are forced upon weak countries which binds their monetary policy and they can not ease when recession starts, they have to rise rates in reccessions which rises rates for government debts too and Greece goes down the drain, because EU nations have no independent monetary policy.
    There is no bond vigilantees for 5 old empires that use floating and have no debts in foreign currencies; USA, UK, Canada, Japan, Australia and Swiss. Thats 6. Germany is also an old empire so their bankers have to follow orders from government.

    Independent CB means independent monetary policy from fixed exchange, not independent from government. Independent from government is also propaganda that is comming from those old empires to others that are forced to fix echange rate and owe in foreign currencies. It is the colonialist weapon in merchantilist wars. And those empires are always winning. greece is excellent real time example.

    Thank you.

  9. So SW-L is essentially saying, “run whatever deficit is needed to cut the output gap to zero, using printed money if need be, and ignore the debt”. Well that’s what MMTers, me included, have been saying since the crisis started, and what Keynes meant, when he said “Look after unemployment, and the budget will look after itself”.

    And it’s what leading MMTer Warren Mosler means by his “Mosler’s law”, which states, “There is no financial crisis so deep that a sufficiently large tax cut or spending increase cannot deal with it”. (See the top of his site.)

    Re austerity, SW-L says “You can satisfy both objectives by doing stimulus now and austerity later.” It’s certainly a common belief that some sort of pain or “austerity” is needed to pay back debts incurred when implementing stimulus. In fact (at least in the simple case of a closed economy) no such austerity is needed. Reason is as follow.

    If the excess amount of paper assets in private sector hands (debt and/or base money) induces the private sector to spend too much and cause inflation, then some of those assets will have to be taxed away from the private sector: but only enough to avoid excess demand. I.e. assuming the amount of tax is exactly right, the economy will just continue working at capacity, thus no austerity in the sense of standard of living cuts is needed.

    1. Thanks on MMT - that is what I meant. Also austerity was the wrong word in "doing stimulus now and austerity later". I should have said deficit reduction later. Perhaps (and this is with a nod to another Nick post) we should reserve the word austerity for deficit reduction that (needlessly) reduces output.

    2. Fair enough. You do then indeed come out in the same place as the MMT folks.

      The difference I suppose is that they get there by a much more direct route. They start, as it were, with your trump card--that the monetary can simply print (or rather keystroke) whatever funds are required to implement the most optimal demand-management policy.

      The result of that starting point is that considerations about the stock of debt, interest rates, crowding out, and burdens on future generations etc., are revealed as rather jejune.

      Once the whole apparatus of sovereign debt-issuance and 'borrowing' and 'market' interest rates for sovereign debt--once all this is understood to be a purely voluntary set of policy choices on the part of the sovereign (a kind of pantomime of the fiscal and monetary operations of a government that actually is constrained to raise the funds it would spend, in a way monetary sovereigns are not), then the idea that the sum of these operations could limit the sovereign's degrees of freedom falls away.

      At that point the right response to Nick Rowe's question is to point out that it is founded on a misleading analogy between monetary sovereigns (currency issuers) and other economic agents (currency users).

    3. "run whatever deficit is needed to cut the output gap to zero, using printed money if need be, and ignore the debt"

      You are probably doing MMT a huge disservice by bringing in "output gaps". If there is involuntary unemployment, that is already an indication that the market is not clearing perfectly. That is all Keynes talked about, and that is enough. One thing MMT must not fall for is artificial construct to make what Keynes calls "pretty and polite techniques" - that is autistic models which sometimes are not so pretty in their consequences.

  10. The question I would ask is whether you would kill your sister if they became a serious problem.

    Now the traditional answer of the anti-sororicidians is "no", there is always a better option, but as a thought experiment let us imagine that your sister was about to detonate a bomb in a maternity hospital killing hundreds of mothers and infants and the only weapon you had to hand was a grenade. Would you kill you sister then?

    I think you might say "yes" to this question and if so surely we are just "haggling about the price". The fact is that sororicide is a legitimate policy choice that needs to be discussed.

    1. But what is the sister here? Is it public debt, or private debt (which noones cares about but it is the main issue) , unemployed people or bad economy? They are arguing about what is sister from your analogy, not should sister be killed which is what you want to talk about.

    2. "I think you might say "yes" to this question and if so surely we are just "haggling about the price". The fact is that sororicide is a legitimate policy choice that needs to be discussed."

      The reasoning isn't the problem, the problem is your impossible wish to both maintain that "sororicide is always bad" and that you are a rational individual who would act to save the lives of large numbers of lives. Or in other words why the absolutist morality you learn as a child, so you'll behave yourself (or because you were raised religiously), do not suffice for adults in positions of great responsibility.

  11. SW-L. Please tell me you are NOT teaching the fiction you posted above to fee paying students at Oxford. It is becoming obvious to me, and a few others on this site, that you have very little idea how a sovereign fiat currency system operates. It is also becoming obvious that attempting a sustained rebuttal of such nonsense, for educational purposes, seems a futile endeavour.

    1. Anonymous, are you sure that you are expert on fiat currency systems and know more than a professor at Oxford? What are your bona fides that make you certain that you understand things better than SW-L? What makes you can expert in macro. (Full disclosure: i am part-owner of a hedge fund that makes successful macro bets.)

    2. "attempting a sustained rebuttal of such nonsense, for educational purposes, seems a futile endeavour."
      No, it wouldn't be futile. Please educate those of us who agree with SWLs analysis with your own insights - being sure to carefully explain how/where/why his analysis is incorrect of course.

    3. "that you have very little idea how a sovereign fiat currency system operates"
      judging from this quote i would say that he means that loanable funds theory is nonsense, which i also hold as nonsense. Lonanable funds theory becomes aplicable only when deleverage is allowed to happen. Only when bank reserves start to fall is when such nonsense becomes true and conditions of Gold standard start to apply on government debts, so called Mundell-Flemming's IS-LM-BoP model.

      QE solved issue of falling bank reserves, didn't it. And as i recall Bernanke's talk to Congress is that QE is to allow cheap government borrowing for stimulus because monetary policy did all it can. But Congress refused to take responsibilities and started austerity (deficit reduction) because as GOP declared that their only job is to make Obama a one term president.

    4. Thanks for this Jure Jordan and Anon 12.16 please spell this out. I often find when I read macro they talk about "budget constraints" and "an aggregate amount of funds" (implying that government debt can crowd out private sector investment)" without defining what these things really are. They only time I can think when they do apply is under the Gold Standard where the money supply is tied to gold reserves. Sargent also said "the (!) budget constraint makes government debt sustainable". I would really be happy if someone could explain what macro-economists are talking about and what is the historical or other evidence of this "budget constraint". (In the 1970s you did have simultaneous high inflation, high interest rates, government debt and unemployment, but I doubt you could pin the problem down to high government expenditure and debt - I would suspect that was quite irrelevant and a purely ideological matter.)

    5. Can we leave the detailed argument till after the election; bit busy at the moment. Meanwhile have a read of Bill's "101" collection. This will start you on your road to Damascus conversion from a La-La Land New Keynesian, to Post Keynesian MMT.

      Regards from Anon at 12:16

    6. "from a La-La Land New Keynesian, to Post Keynesian MMT"

      It does not matter if it is La-La land as long as it is micro-founded. If you do not have a constraint on the money supply how can you get the optimisation conditions?

    7. Anon at 19:29.
      Only real "budget constraint" that i can think of for sovereign government (you did not specify for what country) is that they accept annual budget in advance.
      After annual budget is accepted it can rarely be changed because of democratic politic sluggishness (it takes time to deliberate) while economy can change fast (oil price) or monetary policy can change economic situation. So while economy demands fast fix in budget allocations, they can not work fast.

      So, budgets are accepted and signed annually while during that year economy might demand big change. There are automatic stabilizers that are implemented during Great Depression to automatize the process, not to leave it to politicians.

      So, there is inside 'budget constraint' in the way of how it is accepted but i do not know about outside constraint on the size of the budget in good times and in sovereign countries. Only the beliefs that those writing and accepting an annual budget have is the constraint. If it goes too big and allocated badly it can potentialy cause high inflation but there is Central Bank that can corrrect that.

      There is no chance that in times of worldwide deflation, size of the budget can cause inflation. Not even the size of 100% of GDP of budget could.

      How is that? For sovereign countries the old good formula MY=QP, only for sovereign countries again, Q is the Quantity of the whole world because everybody accepts Dollars, Pounds, Yen, Euro and Swiss Franc without reservations and as many as you offer them. They will sell you everything they can produce for those currencies, not for other ones. Acctually they are desperate for such currencies since they do not know how to employ their own people so they are waiting for empires to provide AD for them.

      MV=QP Price will not go up since Q is practicaly unlimited (except for oil and rare earth metals).

      Completely different story is for non-sovereign governments.

    8. " Please tell me you are NOT teaching the fiction you posted above to fee paying students at Oxford. It is becoming obvious to me, and a few others on this site, that you have very little idea how a sovereign fiat currency system operates."


      If only those Keynesian macro-economists would stop making accurate predictions about how the economy will perform you would be correct.

  12. What if a government is indebted in foreign currency that the central bank canNOT print? Or the private sector is FX indebted, hence fright that causes capital flight and depreciation comes with bankruptcies and bank failures?

    Would economies operating under such constraints - and they are the vast majority - not have a legit reason to worry about fiscal space, even when they suffer from sizeable output gaps?

    Another aspect I'm missing is that fiscal impulse can rarely be switched on and off as needed, as it generates entitlements, expectations and political pressures. These can persist long after the output gap is closed - especially in economies with weak institutions. In this case, concerns about private sector crowding out and distortionary taxation would remain relevant.

    1. Henry Kaspar,

      I assume that “fiscal space” is the idea that there is a limit to what a government can borrow before its creditors lose confidence and start upping the rate of interest they charge in a serious way. On that basis, fiscal space in the case of a country that issues its own currency is nonsense.

      If creditors DID START upping the interest they charge where such a country had a significant output gap, all that country needs to do is cease borrowing and print money instead. (In fact even in the absence of concerns about fiscal space, I don’t see the point of a government borrowing money when it can print the stuff.)

      Re your “capital flight and depreciation”, that printing MIGHT cause a loss of confidence in the currency. But the pound sterling lost 25% of its value in 2008 and the sky didn’t fall in.

    2. @ Musgrave

      It would help if you would react to the question I have asked, not to questions I have not asked but to which you happen to know an answer.

      Most countries are indebted in currencies that they do not issue, as there is not sufficient demand for domestic currency assets. The UK and the U.S. are huge exceptions in this regard, not the rule. Don't have countries indebted in FX a point when they are concerned about being unable to sell their debts?

      As for depreciating by 25 percent, again, this is unproblematic for the lucky few like the UK. But what if your private sector is indebted in FX - as is the case in most of Asia, Latin America, Eastern Europe? Aren't these economies right to be concerned about depreciation ruining their corporations, households and banks? Or do you think 'fear of floating' exists for no reason?

      I'm puzzled how folks treat unlimited demand for assets in a country's own currency as a god-given - rather than a hard-earned privilege that is conditional on trust in stability-oriented macro policies. Whoever has dealt with emerging economies is aware of how precious and rare that privilege is, and under what tight real constraints the vast majority of countries operate that don't enjoy it.

    3. Kaspar
      I assume you are asking about Greece and Russia?
      Russia is the clear case where outsiders are conducting merchantitlist attack for the purpose of control and colonization. Greece is the same case but with different excuses.

      There are many worries when such economic attack is causing capital flight, monetary policy is countercyclical in such countries with FX debts. Due to poor economic performance bank reserves of FX is falling down and threatens solvency, states are then forced (another countercyclical policy) to borrow more in order to save banks not for economic stimulus. In order to borrow more then usual they have to offer higher interest rates while economy is shrinking. Creditors do not loose confidence but Central Bank does. That is where it starts. CBs raise rates for FX debts but that also translate rates to domestic lending which kills domestic private borrowing due to high cost and fear of loosing a job.

      Yes, nonsovereign states are fiscaly limited and their only option is to reduce savings that take money out of economy. Their only option is to increase taxes on savers and distribute to debtors for a long time. It is the only policy solution to fiscaly constrained governments. Redistribution.

      To do redistribution, some are doing it with hyperinflation which is damadging to all, while smart way is to ban private debts in FX and switch to domestic currency like Austria did recently and Hungary few years back. And then grow AD with redistribution.

      Also those states have to form state owned developement banks for reindustralization offering low interest credits and state should form corporations that produce previously imported goods financed from those banks. Debts go onto banks not onto the state account.

      Those states also do not have bankruptcy laws that advanced nations have which saves banks and debtors when they loose jobs. It takes many years to fix these problems.

    4. Kaspar,
      you are right about the great advantage that former empires enjoy with having no debts in FX. There are about 6 countries that enjoy such privilege and they are former empires. Why other countries can not have independent monetary policy?
      Because it is the new stealth way of colonization, since 1970's.

      Those old empires force others to trade only in their currency, they do not want debts in some old colony currency and they easily find oligarchs that they put into power in those colonies to accept such arrangements and whenewer former colonies rebel about something else they can be crushed with debts in FX, other states that also blindly cooperate with old empires just refuse to refinance old debts in FX and country is economicly crushed, no matter level of debts in FX. There are cases where countries are forced to default with only 23% of GDP in debts.

      Whoever lives in those old empires can not see what is going on and as you said: " Whoever has dealt with emerging economies is aware of how precious and rare that privilege is"
      They can not understand it how different it is when they have excuses to force it upon others. But those excuses are produced as a consequence of centuries of colonializm upon those countries.
      Just like Klansmens work on slaves produced lack of knowledge and degradation of former slaves that is still used as an excuse to keep them down as inferior.

      Where the most of the Greek debt comes from? From 50 years of UK causing a civil war there and coups after communist government took power. While other countries could develop economicaly and create, Greeks had to fight to stay alive. Is it wonder then that they had high debts from long ago and as everybody should check out for themselves, no country can ever lower its public debts.
      Greek debts are from years of maltreatment by UK and west and now they use that as an excuse to punish them for those debts.

    5. @Musgrave

      How long before potential lenders will figure out that the hypothetical country in question has a habit of "fixing" their ever returning outrageous debt problems through depreciation? They will then incorporate this knowledge into the interest rates they charge. You can't beat the markets forever so honesty is the best policy, unless you plan to burn your bridges, but since countries don't die of old age that's not really an option for them.

    6. Kaspar,

      Sorry about answering the wrong question. I’ll try again.

      Yes, you’re right: countries without their own currency have much less fiscal space than monetarily sovereign countries. Indeed what EZ countries with output gaps do is to a large extent to simply sit out the output gap and hope that the gap brings internal devaluation, which hopefully closes the gap (after years of austerity).

      As for developing countries, you make a good point (I suspect) about their not being able to exploit their monetary sovereignty in the same was as for example the US and UK can.


      You ask “How long before potential lenders will figure out that the hypothetical country in question has a habit of "fixing" their ever returning outrageous debt problems through depreciation?”

      If a country with its own currency sticks two fingers up at creditors and prints money instead so as to close its output gap, there WON’T BE any of the “depreciation” to which you refer. That is, as long as there is an output gap, there is little reason for inflation to rear its ugly head. Alternatively, if the money printing is excessive, then obviously inflation gets excessive.

    7. Anon 05:49: "You can't beat the markets forever".
      Actually, one thing we're learning at the moment, with the 'flexible' lower bound (see Krugman's recent posts is that you pretty much can - if you're a government issuing internationally traded currency and there are purchasers who HAVE to hold debt for one reason or another. Institutions must 'know' that future interest rates will be higher yet they still seem to be locking themselves into near-zero interest bonds that can only depreciate.

      The interesting question at the moment is just when or how the unconstrained money issuers identified by MMT (if I've understood the comments on this blog) become the hyper-inflationary central banks of Zimbabwe or Weimar Germany. I don't discount the neo-colonial explanations of Jure Jordan above but will there come a day when wealth producers (those firms in the developing world that actually produce things that people actually want to buy) choose to either exchange their paper assets for real property (land or tradeable goods) in the indebted countries or shift their money holdings to Malaysian, Chinese or other currency? That will signal the moment when "1000% debt" becomes a problem.

    8. David Sweet
      If i may explain where hyperinflation comes from.
      Only cases with hyperinflation is where countries suffered large productive capacity destruction.

      Weimar: France ocupied the most industrial part of Germany before inflation started. Hyperinflation started in August of 1921:
      "In March 1921, French and Belgian troops occupied Duisburg, which under the Treaty of Versailles formed part of the demilitarized Rhineland. In January 1923 the whole Ruhrgebiet was occupied as a reprisal after Germany failed to fulfill World War I reparation payments as agreed in the Versailles Treaty. The German government responded with "passive resistance", letting workers and civil servants refuse orders and instructions by the occupation forces. Production and transport came to a standstill and the financial consequences contributed to German hyperinflation and ruined public finances in Germany and France, as well as several other countries" from Wikipedia.

      In Zimbabwe, the very productive land owned by white farmers was distributed to people into small parcels which destroyed production levels and hyperinflation started in order to import and feed people.

      In Yugoslavia, republics that separated from Yugoslavia turned their money into leftover Yugoslavia and exchanged for Deutsche Mark and split cash with Milosevic. That was one two punch: destruction of over half of productive capacity while retaining all the money. Bringing old dinar from Slovenia and Croatia and exchanging for DM and taking it out.

      Ukraine: Crimea separated and accepted ruble. What to do with all Hryvna left there? Take it into Ukraine exchange for Euro or $ and take it out. Also the most developed part, Donbass is also split from Ukraine just like Ruhr from Weimar Germany. Donbass still keeps all Hryvna expecting to receive 10 months late of social transfers from Ukraine, but they are starting to use three other currencies, so expect more Hryvna into the rest of Ukraine.

      Post WWII Hungary: Soviets were issuing their own new currency into Hungary while leaving the old one in the economy - World Record hyperinflation. But also huge demand from Soviets in grain as pay for "freeing Hungary" from Germans which they ˝paid˝ with new money.

    9. @ Musgrave

      Thanks for getting back. We're on the same page, at least conceptually.

      As for countries using excessive monetary financing for fiscal deficits, demand for assets in this country's currency would soon drop, and the correpsonding risk premium would provide a strong incentive for indebtedness in FX.

      More generally, I agree that in depression, monetary financing of public spending is in principle the most effective and least costly way to close the output gap: it guarantees that the monetary impulse translates into demand. But I also believe that only countries with very strong institutions could pull this off in a sustainable manner, as investors would need to believe that the country does this only in depression. In all other economies, such a move would provoke distrust, provoking a drop in demand for currency, and thus inflation and dollarization.

  13. Would you ask the same questions if that government didn't issue debt at all? let's say bank reserves are 10 times annual gdp and negative output gap 10%?

  14. This example probably does highlight the need for viewing the problem in a general equilibrium. Importantly, I think we are assuming this is a closed economy. In which case, if we also assume household wealth is composed of only base money and bonds, the obvious question that arises is why with private sector wealth > 1000% of GDP, is demand not higher?

    Some sort of weak Ricardian equivalence becomes plausible. Or, as may be true in Japan, intermediation obfuscates the value of household wealth. In which case, monetisation through QE and paying zero interest on reserves may create lift-off.

    In this example, as in Japan, I would not recommend either austerity or further fiscal stimulus.

    Analysing Japan is what first pointed me in the direction of cash transfers using the monetary base. The monetary base is not a liability of the state, so even weak Ricardian equivalence should not hold. The only issue is does it raise inflation.

    The BoJ should formally cancel the debt it has purchased with QE and start making payments of 2-4% of GDP each year to the household sector. Demand will likely rise - the empirical evidence overwhelmingly points that way. If the output gap closes and inflation rises too much, either the government can tighten fiscal policy, or the BoJ can raise reserve requirements (which is analogous).

    I suspect framing matters in macroeconomics. I also think base money is unique (sorry MMTers, it needs a special category in the ledger!). If you can create base money, you can always create demand. Fiscal priorities (including infrastructure) should be set independently. Cyclical demand management should be left to central banks with appropriate tools.

    1. "The monetary base is not a liability of the state,"

      Of course it is. What else is it? Central Banks are created by aliens?

    2. Krisjan,

      I don’t see in what sense monetary base is a “liability of the state” because the state is not obliged to give holders of monetary base anything in exchange for their holding. In fact the state can grab base money off domestic holders of base money via tax whenever it wants.

    3. In the same sense bonds are. They are state liabilities that you can use to get rid of your tax liabilities. You can't do that with bonds but you can always get the state money for the bonds. If state didn't issue bonds at all and just isued money, would you say that state hasn't issued liabilities? Of course It has.

  15. "The final problem is that the markets might suddenly take fright that the tax burden implied by the debt is too large in political terms, and as a result the government may default. So the funding that enables the government to roll over the 1000 in debt might dry up. Now imagine two scenarios. In the first, the government eliminates the 10% output gap by
    means of a fiscal stimulus worth 10% of GDP, say. That increases the debt from 1000 to 1010, but GDP rises to 110, so the debt to GDP ratio falls from 10 to 9.2. In the second, there is no stimulus but austerity instead, involving a budget surplus of 10% of GDP. So debt falls from 1000 to 990. Even if we make the outlandish assumption that austerity on this scale does no further damage to GDP, which stays at 100, the debt to GDP ratio falls to 9.9. Which scenario is going to worry the markets more?"

    Not getting this. Why (except for incompetence/ignorance) would one not look past the debt/GDP ratio? With the 10%-of-GDP surplus the debt is actually being paid off instead of merely being serviced. With the one-off 10% GDP growth there'd be some more tax receipts to pay off the debt as well but it would be far less than 10% of the original GDP per year. With the austerity route the GDP/debt ratio would be lower than with the stimulus after about 10 years and then it would continue to fall and the yearly due interest would continue to fall with it. Of course the best course of action would be to first pass stimulus and then go for surplus-generating austerity as soon as the GDP increase has been anchored in the real economy.

    As always, it's about what happens in the long term that matters. Fiscal policy is not just about fixing immediate problems but about maintaining an intricate system that has to last and that runs on trust.


    1. You are thinking in one year term. Can 10% surplus pay off 100% of debt in one year? What income will there be next year, and then next, and then next, 100% debt can not be paid in 50 years, you have to think that long term.
      But let's say that 100% surplus will pay off all debt. Why not do it, to use your logic?
      What happens? Will any mony be left in the economy to run? Who would have it?
      To help you with answer: only 0.1% of population will have any money, nobody else.

      Only problem with debt to GDP is that people might understand it as you do. That is the only problem. There is no problem with public debt as you think, problem is when people want it reduced while people suffer.

      To you, people's suffering is not important but some accounting is.
      If people suffer in such country that is reducing the debt as you want it, what do you think their trust in their's country is?

      If people suffer in such country they do not want it. Why do you think there is so many immigrants flooding Developed nations? Because their former country is torturing them with policies you want. That is when trust (that you talk about) leaves. Is the system working for you or not? What do you care about public debt?

    2. Kaspar
      What is really interesting is that many economists from empires "advised" those former colonies and those economists started believeing that even former empires should adopt such policies as just and proper economic thinking and they come back and teach such theories that should apply only to former colonies and over time the students become presidents of Central Banks and do it to their own country because it was forgoten why such policies were bad and abandoned long time ago.
      A time comes when what they do to other countries bites them back.

      So economists like Simon WL have to perseviere in fight to explain realities to those that have forgoten it.

    3. @Jure Jordan

      I don't know what your rant is about. Simon explicitly stated the hypothetical scenario where a 10% surplus would not tank existing GDP, so I'm allowed to use that assumption, and no one said anything about a 100% surplus. Moreover redistribution (which can take the form of infrastructure projects that provide jobs) can ease "suffering", no one has to starve when GDP contracts a few percentage points and then at least people know what to expect instead of having a government with huge debt being a plaything of chaotic markets and investor sentiment (the average might look fine but there will be large ups and downs when interest levels go up or down by even tiny amounts, if there's anything that's heartless towards the common man it's assuming that he just has to suck up those ups and downs with his own means: don't eat this year, but make it up by eating doubly next year, or something like that). Finally the whole point I was reacting to was how how potential lenders and the financial markets would perceive high levels of government debt. It was about an "is", not about an "ought" and in no way implies a value judgment or my personal opinion (except the last sentence of the first paragraph where I actually come out in favor of temporary stimulus).

    4. Using 100% surplus as an extension of your logic was to present the problem as clearly and simply as possible. It obviously did not help.

      You misplace where the trust in your country is. That is why i tried to explain it.

      There is no "a government with huge debt being a plaything of chaotic markets and investor sentiment". It all depends on Central Bank policy. Private investors (not people, it is banks and their reserves) have to invest in gov debt by law.
      If gov is weak to force them to follow the law then your assumption might become true.

      Interest rates for Government debt is what Central Bank decide. There is no private investor that can change that for sovereign governments (those 5 former empires)

      I explained this in two comments about loanable funds theory, yestrday at 6:32 and 6:51 and more precise under point iv)

    5. Anon - I think you kind of answer your own question with your last sentence, SWL does say that once you're off the ZLB you start to consider balancing the budget. The market's interest would be in the long run debt to GDP ratio which would generally be smaller under a programme of stimulus to close the output gap followed by austerity to balance the budget compared to straight up austerity.

    6. "There is no "a government with huge debt being a plaything of chaotic markets and investor sentiment". It all depends on Central Bank policy. Private investors (not people, it is banks and their reserves) have to invest in gov debt by law.
      If gov is weak to force them to follow the law then your assumption might become true.

      Interest rates for Government debt is what Central Bank decide. There is no private investor that can change that for sovereign governments (those 5 former empires)"

      This is just plainly false. No one can force a private entity to buy government debt and there are lots of countries where the central bank cannot just buy government debt (because of currency, or outright bans). When domestic parties do not have sufficient capital to buy enough government debt, even if they wanted to, the whole thing becomes even more messy.

      @Andreas Paterson

      I know that's what SWL generally means but I think it's quite an assumption. In the real world it is difficult to distinguish stimulus spending from profligacy, governments (that often govern for 4 years or even less) can undo decisions of past governments and past behavior of countries plays a role. In this regard it seems as if economists are sometimes very naive, just assuming every actor in the world is rational, trustworthy and law abiding.

    7. Anon at 8:47
      What is private entity? And what is bank reserves and why banks have them?

  16. Why did the UK have to go begging to the IMF in the 1970s?

    1. Because at the time UK was still under Fixed exchange rate, or more familiar: under Gold Standard rules. And George Soros did it a great favor by teaching UK about such stupidity. They were forced to accept fiat money.
      Once learned the lesson, UK refused to accept euro because EZ is set up as such destructive constraint, maybe even worse then Gold Standard.
      If Soros did not teach UK the lesson at the time and entered EZ, UK will be something like Ireland or Spain today with unemployment of 15-20% with huge debts that forever binds it into peonage. Fiat money just simply ignores that debt.
      You can thank Soros for avoiding that.

      My answers to Henry Kaspar give detailed explanations.

    2. Jure - I'm pretty sure George Soros antics happened in the 90s with the UK's attempts to peg the pound to the deutschmark rather than the 70s.

  17. A wonderfully simple explanation, SW-L.

    The argument used by the pro-austerity camp about not passing on our debt to our children is surely applied in the wrong direction? We are actually paying for the nice lifestyles our parents enjoyed with guaranteed pensions and enormous free capital appreciation from house price increases, as well as many other tasty benefits we can only now dream about. And yet this Government continues to feed them with non-means tested automatic pensioner benefits and 4% interest bonds and more.

    But that's a different story...

  18. A very good article and good conversation. I just wrote a text which tries to understand the moral aspect of MMT style money issuance to pay for state expenses. The result was, of course, that it is OK. Then the toy society I used turned out to be useful in considering simple models of deficient demand and defend a Keynesian approach. See

  19. The final word:

    1. So, you want corelation to mean causation and call it "coincidence".
      What causes Deficit to rise without any action from increasing budget? That is causation.

      What is other spending beside income, government and trade in NGDP? If all that is level, what else can raise spending? If you looking for causation then look there.

      What outside price can affect domestic prices? And what is the biggest price changer domestically? If you want causation answer these please.

      Real coincidence you search for, where causation and corelation corelate is private debt growth acceleration and unemployment.
      Another one is margin debt acceleration and stock prices.

  20. In my humble opinion, this is an excellent essay. there is one other relevant point. Fiscal stimulus does not have to have anything to do with public debt, because it does not have to involve deficit spending. A balanced budget increase in expenditures should stimulate. This is true in the IS-LM model and still more strikingly true in, say, the Smet-Wouters model in which the effect is identical if the spending is tax or debt financed.

    It seems remarkably difficult to get people to admit that, according to all Keynesians, there are different multipliers, so the exact same deficiit is consistent with a stimulatory or contractionary shift in fiscal policy. It is a very elementary point and assertions contradicting it are gross elementary errors. The fact that Rober Lucas made this error doesn't make it less disgraceful.

    I have the impression that your favored stimulus is balanced budget spending shifts -- brining taxes and public investment forward in time so deficits aren't involved and neither is the present value of public spending. Maybe I recall incorrectly, but, in any case, such a policy would be Keynesian fiscal stimulus and would have nothing to do with deficits or debt and would imply lower taxes when the maximum non inflationary output is supply limited.

    1. I agree, but the problem is that the concept of a non-zero balanced-budget multiplier is even harder to get across to non-economists than a non-zero government expenditure multiplier. Almar

    2. Great point. I said previously that option is the only option for Greece where they have to run balanced budget. Redistribute allocation of budget toward more stimulative spending. Redistribution is a taboo word so you go with all kinds of econometric mumbo jumbo to say the same thing.
      By consenting to taboos, it is acctually more confusing even tough you want the proper thing. It is not helping. Be confident.

      Also do not forget that reduction of allocation to less stimulative spending will reduce NGDP while increase RGDP. It will aleviate suffering but it might reduce stock prices. Stock prices greatly are affected by government spending which was being increased in since supposedly stock indexes instill "confidence".

      So, you are distinguishing real economy from speculative economy. Do you dare to openly say it?

    3. sorry should have read your comment before i made mine

      yes we can have a balanced budgeet multiplier by taxing the rich and investing in programs that help the poor and middle class, causing and increase in aggregate demand

      but we can only do this if we are at less then full employment or in other words have an output gap

      if we are at "potential gdp" then there is no multiplier

      but at that point, there is no output gap, so one can just tax and pay down the debt

      unless of course doing so, leads to an output gap, in which case there will be a multiplier again

      so that we can then tax the rich and use the money to pay for programs for the rich and poor increase the aggregate demand and eliminating the output gap

      but at that point, there is no output gap, so one can just tax and pay down the debt

      unless of course doing so, leads to an output gap, in which case there will be a multiplier again

      so that we can then tax the rich and use the money to pay for programs for the rich and poor increase the aggregate demand and eliminating the output gap

      and so on

  21. if we are at full employment, the no problem , just tax everyone until the debt is paid down

    if we are not at full employment, then there is a multiplier

    so that means all taxes are not created equal

    tax the rich, use that money for programs that benefit the poor and the middle class

    and this will increase aggregate demand

    so only if you believe that tax increases have the identical effect at all income levels

    do you accept the premise that we all are austerians

    so who do we owe the money too??

    and who kept poor and middle classes income so low that all they could do was borrow

    and who kept congress from taxiing so government had to borrow to programs for poor and middle class

    and incidently to keep the economy viable

    so tax them and use that dirty work, redistribute some of the wealth to increase aggregate demand without increasing the debt and deficit

    1. dirty word, redistribute that is

  22. Your very clear example has an intersting unstable conclusion: heavy indebted countries should increase their debt, low indebted countries should lower their debt.

    This conclusion stems from basic mathematics: Only when the numerator is bigger than the denominator (as in the given example), the increase in both GDP and debt, leads to a better ratio.

    When the debt is smaller than GDP, an equall rise in both debt and GDP worsens the debt to GDP ratio. (example: debt = 10, GDP = 100, ratio = 0.1, then when 10 extra debt is spent resulting in a new GDP of 110, the new ratio is 20/110 = 0.18). As most countries have a debt lower than their GDP, your example suggests that extra lending to increase the GDP worsens the debt to GDP ratio.

    The result is inherently unstable: heavy indebted countries (DEBT > GDP) should increase their debt and low indebted countries (DEBT < GDP) should reduce their debt.

    Side remark on temporal effects: the excess government spending wil not lead to a temporary surge in GDP, but to a structural rise. If not, the debt to gdp ratio only improves during one year, afterwards the ration worsens.


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