Winner of the New Statesman SPERI Prize in Political Economy 2016

Saturday 27 October 2018

Why should someone who is anti-austerity care about debt

Most of the posts I have written about austerity have been aimed at countering the idea that in a recession you need to bring down government deficits and therefore debt. But what if you accept all that (you are anti-austerity). Why should you care about debt at all? Why do we have fiscal rules based on deficits? Why not spend what the government needs to spend, and not worry that this resulted in a larger budget deficit?

The story often given is that the markets will impose some limit on what the government will be able to borrow, because if debt gets ‘too high’ in relation to GDP markets will start demanding a higher return. You can see why that argument is problematic by asking why interest rates on government debt would need to be higher. The most obvious reason is default risk. But for a country that can create its own currency there is never any necessity to default.

However there is another reason to demand a higher nominal interest rate on debt, and that is if you think there will be additional inflation in the country. Spending more without raising taxes will tends to increase inflation. But if the government or central bank is sure to raise interest rates to offset this inflationary pressure then the concern about inflation disappears.

In MMT inflation is also the fundamental constraint on how far you can raise spending without raising taxes. MMT also says that you do not need to worry about the deficit, but this is only true if - as they advocate - fiscal policy rather than monetary policy controls demand and inflation. Under MMT the link between the deficit and inflation is direct (assuming no change in the composition of either) .

When inflation is controlled using interest rates the situation is fundamentally different. There is now no single point at which the deficit is consistent with stable inflation. In the short term there are a whole range of interest rate/deficit combinations that keep inflation stable today (e.g. high deficit and high interest rates or low deficit and low interest rate). Does this mean we do not need to worry about the deficit and the debt it leads to because monetary policy will always take care of inflation?

The answer is no, if we think about dynamics. What happens if we choose a high deficit high interest rate combination because we want higher government spending without paying more in taxes? There are two important dynamic effects here. The most basic is that a high deficit raises the stock of government debt. Because of interest rate payments on that debt the deficit rises further. In addition raising interest rates to stop inflation will itself tend to raise debt interest payments. This is an unstable debt interest spiral. You cannot say why not fund the additional debt interest payments by creating money, because that will tend to reduce interest rates and raise inflation.

This means that over the longer term you have to adjust spending and taxes to keep government debt relative to GDP stable, That does not mean debt has to be stabilised at a particular level, but just that if there is not a compelling reason to do otherwise you need to keep debt stable rather than rising upwards. A recession is one such compelling reason, and there are others (like adding to the public sectors stock of assets).

Stability does not mean deficits have to be zero because we have to allow for the growth in GDP. The maths is simple (see [1]). Take the stock of debt to GDP as a fraction of GDP (say 0.8), multiply by the trend rate of growth of nominal GDP as a fraction (say 0.04), and you approximately have what the total deficit should be as a fraction of GDP to keep debt stable (0.032), which is a deficit of 3.2% of GDP. .

There is always the temptation for politicians to raise debt now, and let future governments stabilise debt at a higher level. In the past the US under Republicans and other countries (but not the UK) tended to let this happen in the 30 years before the GFC, and economists call it deficit bias. Fiscal rules began life because it was hoped they would reduce deficit bias.

So why not raise the level of debt by spending more for a period, and then stabilise it by cutting spending or raising taxes a generation later? Here we have to note that the stabilising deficit (the deficit that keeps debt to GDP stable) includes debt interest payment. What we call the primary deficit is the total deficit less interest payments, You should now be able to see the problem with allowing debt to increase and stabilising it later. If you raise the level of debt to GDP and then stabilise it, debt interest payments will be higher and the level of the primary deficit left over is smaller than the one you started with. This is one sense in which letting debt rise today takes from future generations. [2]

This is why it is never a good idea to increase the stock of government debt without good reason, as Trump is doing, because it either cuts spending or raises taxes in the long run. This logic does not mean that future GDP is any lower (although there may be other theoretical reasons why higher debt can reduce output), but it means that if debt to GDP is stabilised, debt interest rates will be higher and so something else has to adjust to compensate, which means higher taxes or lower spending. [3]

There is an important caveat to this dynamic, which becomes clear if you do the maths. You only get a debt interest spiral if the nominal interest rate exceeds the growth rate of GDP (call the difference between the two the ‘very real interest rate’). If the very real interest rate is negative, extra debt for a given deficit allows a higher primary balance. Journalists sometimes look at the level of debt interest as a share of GDP (currently 2% in the UK) and say government spending could be 2% of GDP higher (or taxes lower) if we didn’t have to pay interest on debt. But if you could somehow magic your debt to zero so debt interest rates were zero, the stabilising deficit would fall from a current level around 3% to 0, requiring a 3% fall in the primary balance. This reflects that the current very real interest rate is negative.

Does this mean we do not have to worry about the debt interest rate spiral, and therefore debt? Only if we know that the very real interest rate will stay negative. This is unlikely to happen, particularly if interest rates are having to rise to combat the inflationary effects of high deficits. Because debt levels should never be adjusted down quickly, it is best to act as if the very real interest rate will become positive at some point.

This is not the only reason why raising government debt to GDP in the long run can be detrimental, but this one is simple because it depends only on some basic economics, algebra and logic. This and other reasons will never be enough to justify cutting deficits in recessions, not even close. But being anti-austerity does not mean we can forget about debt completely, as long as we are using interest rates rather than fiscal policy to control demand. (On why you might want to do that see here.)

[1] G is government spending, T taxes, r is the nominal interest rate, and B the stock of debt. Little letters mean as a ratio of nominal GDP (Y). x is the growth rate of nominal GDP, delta means change in. We ignore money for reasons given in the text. The budget identity is

G - T + rB = deficit = delta B

So dividing by GDP gives

g - t + rb = deficit/Y

In continuous time (or approximately otherwise) we can write

deficit/Y = delta b + xb

So for delta b to be zero, deficit/Y = xb

Or equivalently g - t + (r-x)b = 0

[2] More strictly in this case it takes from future generations the benefits of public spending or adds to the cost of taxes, and transfers it to bond holders.


  1. Oxford economics — still at the proto-scientific level
    Comment on Simon Wren-Lewis on ‘Why should someone who is anti-austerity care about debt’

    Simon Wren-Lewis summarizes: “This is not the only reason why raising government debt to GDP in the long run can be detrimental, but this one is simple because it depends only on some basic economics, algebra and logic.”

    The fact of the matter is that to this day economists do not get basic economics, algebra and logic right. Simon-Wren Lewis is no exception. He is too stupid for the elementary algebra that underlies macroeconomics.

    To make matters short: The central problem of the MMT policy of permanent deficit-spending/money-creation and a permanently growing debt is NOT inflation but distribution. In political terms, MMT policy benefits WeTheOligarchy and NOT WeThePeople.

    The macroeconomic Profit Law, which is unknown to the Oxford economist Simon Wren-Lewis, says Public Deficit = Private Profit and this follows straight from the TRUE sectoral balances equation (X−M)+(G−T)+(I−Sm)−(Qm−Yd)=0 which compares to the FALSE Post-Keynesian/MMT balances equation (X−M)+(G−T)+(I−S)=0.#1, #2, #3

    Neither MMTers nor Mainstreamers ever got profit right. As Mirowski put it: “... one of the most convoluted and muddled areas in economic theory: the theory of profit.”#4 This is why economics never rose above the proto-scientific level and why the debate about austerity and budget-balancing is so utterly absurd.

    Oxford economics, is particular, is a scientific failure.#5

    Simon Wren-Lewis argues: “However there is another reason to demand a higher nominal interest rate on debt, and that is if you think there will be additional inflation in the country. Spending more without raising taxes will tends to increase inflation.”

    This is the standard argument against MMT and it is patently false. Deficit-spending/money-creation causes a small one-off price hike but NO inflation.#6, #7 So, as a matter of principle, public debt can grow steadily for an indefinite time without ever causing inflation.

    Economically, the permanent growth of public debt is a program for the self-alimentation of the Oligarchy. Whether they are aware of it or not does not matter, but de facto MMTers are the agenda-pushers of Wall Street.#8, #9

    Egmont Kakarot-Handtke

    #1 Wikipedia and the promotion of economists’ idiotism (II)

    #2 Truth by definition? The Profit Theory is axiomatically false for 200+ years

    #3 Back-of-the-envelope proof:
    If the total wage income of the household sector is 100 in a given period and the household sector spends all on consumption, then the macroeconomic profit of the business sector is zero.
    If the total wage income of the household sector is 100 and the household sector spends all on consumption and the government sector applies deficit-spending/money-creation of 10, then the profit of the business sector is 10.
    Generalization: Public Deficit = Private Profit.

    #4 For details of the big picture see cross-references Profit

    #5 Where economics went wrong (II)

    #6 MMT was right all along: Gov-Deficits do NOT cause inflation

    #7 Economics as tireless production of proto-scientific toilet paper: inflation theory as an example

    #8 MMT and the overall political corruption of economics

    #9 Mission impossible: economists join WeThePeople

  2. "This is one sense in which letting debt rise today takes from future generations. [2]"

    "[2] More strictly in this case it takes from future generations the benefits of public spending or adds to the cost of taxes, and transfers it to bond holders."

    It is an issue of distribution, It is all public spending. Even the question of who benefits is politically decided. You advocate the demand control with CB interest rate setting(a political choice). MMT says your assumptions about inflation are questionable at best since higher interest rates usually mean higher government payments to bond holders and possibly higher deficits.

  3. All of this focus on the Federal Debt is totally misguided. It's measuring tea leaves. Deficit spending - absolutely as it can affect inflation. But the debt is totally irrelevant. Its the same as the stock of money, reserve deposits, and private debt for that matter. It represents stakes in the wealth of the economy. And it really doesn't matter who owns the stakes. (It will be rich people in any event.) The important thing is to keep people working (if they want or need) - increasing the size of the wealth. The pup posted a blurb on the Federal Debt from an intergenerational equity standpoint recently:

  4. Indexation removes the inflation constraint. Print money at least as fast as prices rise, and distribute the new money equally. Then real purchasing power does not decrease.

  5. "But for a country that can create its own currency there is never any necessity to default."

    I stopped reading here Simon. Printing currency is socialising public debt through inflation.

    Beyond politically disgusting, it is useless in a world where domestic content (read value-added) of price-sensitive exports is necessarily low.

    This holds unless a country can ensure foreign demand for domestic currency denominated assets and export inflation regardless of issues assets.

    Assuming this happens with a handful of high output, net importing countries in the world we should ask ourselves what is the elasticity of demand to higher labour costs (inevitable as currency depreciation and current account deficits erode real earnings - I'd look for a gist into the history of France since the XIX century).

    Finally, even if this would work in those economies where demand is inelastic (maybe two or three of that handful), we'd be condemning people to lower real income in the short-term and economic decline in the medium-term as (imported) investment inputs would become so expensive (and excluding on FDI, so would foreign inputs to exports).

    What you describe was done by so many a European Country in the past before the Euro - and a reason why the Euro was so lauded.

    Kind Regards

  6. The whole premise of this calculation is based on Neo-Liberal theology of issuing money as debt.

    If we continue to pursue this direction of travel then we will continue to stagnate the economy and rely on those who already have the money within the economy to dictate the future.

    The whole reason for rejecting this bankrupt model is because it solves nothing and perpetuates poverty.

    If we look at the real impact on inflation, it comes from many sources, one is the profit motive itself, as soon as you introduce profit into the argument, then it becomes obvious that prices will be higher than if a services or goods are sold at cost. The old efficiency nonsense argument has long been kicked into the long grass, when we look at costs within the NHS today compared to before the Tories and Neo-Liberal politicians such the Libdems and New Labour introduced the market into it.

    To accept that the government can only spend into the economy through issuing debt, is absurd in the 21st century.

    Quite clearly I accept that we need government, I do not accept that markets or financiers know best. I want and need government to spend into the economy to stimulate sustainable growth which means a withering of the the financial sectors interests, built mostly on Ponzi schemes of one type or other.

    Fundamentally our government does not need to rely on borrowing its own currency in order to invest in infrastructure or the well being of the nation.

    Milton Friedman to use Mark Blyth's own words was a fake economist, who propounded the fallacy that all government had to do was to set the framework, just like your arithmetic does and the market will do the rest.

    Well reality is not like that, people are not robots, they are not programmed to like or react to given formulae. Events such as those on any engineering machine shop, require human intervention to ensure that the machine operates in accordance to the programme, you can't for example predict mechanical or electrical failure, all of which can alter the outcome. It also relies on the human capacity of those employed to recognise where the fault lies and how to solve it. Even artificial intelligence has its limits.

  7. Govenment spending will automatically generate additional tax. The amount will depend upon on how it is spent. So claming the new taxes have to equate to the spending is wrong. The amount of extra tax generated should be predictable. Giving someone 5 weeks benefit to tie them over to universal credit will be almost completely paid back in taxes. While buying trains from Germany will not generate any taxes in the UK

  8. Thanks a lot for this short explanation. It has clarified this issue for me so that I don't say silly things to people in future.

  9. "In MMT inflation is also the fundamental constraint on how far you can raise spending without raising taxes."

    Wrong. In MMT there is no "fundamental constraint" on government spending - if you disagree please cite your (MMT) source? As far as I can see, avoiding inflation is an intentionally imposed constraint, not a "fundamental" one.

    MMT states that the fundamental constraint on what can be achieved by spending (government or otherwise) is the real resources available in the economy. Engaging in additional spending when all real resources are already utilised will result in inflation. The problem is that you and most macroeconomists just assume (usually without evidence) that "Spending more without raising taxes will tends [sic] to increase inflation", but fail to account for or acknowledge that (a) there is no working theory of inflation, and (b) there are resources currently lying idle which mean that government can certainly engage in non-inflationary spending if by that spending it brings just those resources into use at or below the pre-existing price level for those resources. Whether other spending is always inflationary or not is up for debate, it is probably still more complicated than that, but the point is that inflation is not simply a function of the deficit and the monetary policy settings that you go on to discuss: inflation must be a function of all expenditure in the economy (whatever the source) and the utilisation of real resources in the economy.

    I am sure you agree that understanding inflation is really important and very difficult. But I have to say, you and everyone else will get nowhere when starting from blanket assumptions that are illogical and plainly falsifiable (even if the rest of the profession casually and uncritically repeats them). But you are different because soon you may very well have a huge impact on the economic policy of the sitting government (and indeed you likely have some less direct impact at the moment).

  10. "Debt" describes a situation wherein one entity owes another "property-owned-by-the-lender".

    A government that shunned debt could still pay in money that it created itself. Carried to extreme, there would be no need for taxes. If no taxes, all the created money would become the property of those who government paid.

    A government that shunned debt could be a government that owned everything (a communist government?) or it could be a government that owned nothing.

    The money printed could represent (in the first case) a transfer of wealth from government to private ownership, or, (in the second case) an increase of money stock of dubious value in private ownership.

    It seems to me that (in real economies) the desired condition is a stable reference of money to property.

  11. Rather than trying to keep debt / GDP stable at some (arbitrary) level, why not try to keep debt service costs / GDP stable at some arbitrary level ?

  12. "You cannot say why not fund the additional debt interest payments by creating money, because that will tend to reduce interest rates and raise inflation." No, the central bank can always keep interest rates as high as it wants them by doing what they do now--paying interest on reserves. No government with its own non-redeemable currency needs to borrow to "finance" budget deficits. The deficit spending will add to bank reserves but the central bank will continue to keep interest rates where it wants them.

  13. In effect this formulation uses a debt-related fiscal rule instead of an NPV based spending rule. Why is the firmer to be preferred?

  14. This is helpful. The debt burden, as Domar pointed out, is the tax needed to service higher debt-GDP ratios. But how does this "take from future generations"--there's the rub. If you really believe in a full-employment growth (i.e. ignoring cycles) model and there are no changes in technology (we are in a Classical, not neoclassical world), debt doesn't affect the path of capital--so no intergenerational effect at all. But it does affect (regressively) the distribution of wealth between capitalist agents (bequest savers) and worker agents (life cycle savers). The burden of debt falls on the shoulders of workers. This is not a reason to use debt to stabilize demand but it is something the MMT crowd seem to be ignoring.

  15. "However there is another reason to demand a higher nominal interest rate on debt"

    There is a third reason why the interest rate on debt should be higher. It determines interest rates on savings and that determines people's propensity to save for old age. It is in everyone's interest that people have sufficient savings so that they don't need extra support from taxpayers once they are too old to work.

  16. Simon -when you say 'When inflation is controlled using interest rates the situation is fundamentally different.'

    This assumes that raising interest rates is, indeed, a counter-inflationary measure. Research from MMT economists and heterodox economists such as Richard Werner seem to point the other way. For example, if we see the interest rate as a 'price-setter' plus the stream of interest payments on bonds then this could be seen as an inflationary pressure.

    Do you have a view on this alternative interpretation?


Unfortunately because of spam with embedded links (which then flag up warnings about the whole site on some browsers), I have to personally moderate all comments. As a result, your comment may not appear for some time. In addition, I cannot publish comments with links to websites because it takes too much time to check whether these sites are legitimate.