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.

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