Winner of the New Statesman SPERI Prize in Political Economy 2016

Saturday 12 January 2019

Should we worry about temporarily raising government debt? - Blanchard’s AEA Address

This post not about the main part of this address, although as its my area and interesting I may write about it later. Instead I’m going to talk in a non-technical way about its premise, because that alone has implications that may be well known among economists but not elsewhere. The following is based on his presentation.

Should governments worry about temporarily paying for things by borrowing? One standard answer is yes, because although nothing obliges government to pay off this extra debt (it can be rolled over), it has to pay interest on that debt which requires higher taxes. If the government didn’t raise taxes to pay the interest on the debt, but instead just borrowed more to pay the interest, you would enter what is sometimes called a debt interest spiral, where debt goes up and up and eventually explodes.

But does a slow explosion in debt matter if the economy is also growing? A government (like a firm of individual) should look at debt as a ratio to its ability to pay, and the easiest way to do that is to look at the debt to GDP ratio. A company would not worry about increasing debt if its profits were rising even faster. For a given stock of debt, its growth rate is given by the rate of interest on the debt. So GDP rises faster than debt if its nominal growth rate (real growth plus inflation) is greater than the rate of interest on that debt. In shorthand, g > r.

Typically economists like me tend to assume that this is not true, and instead r > g. But the starting point for Blanchard’s lecture is that currently, and on average in the past, g > r. There has been only one decade since the 1950s when this hasn’t been true, and that is the 1980s when governments were pushing up interest rates to bring inflation down. Most of the time g > r. So the fact that g > r today may be the rule and not an exception.

Why do economists typically assume r > g when the opposite has generally been true? One answer is called financial repression, which is a label given to attempts by governments in the past to keep interest rates ‘artificially low’ in conjunction with various credit controls. The idea was that in a financially liberalised world where interest rates are used by central banks to target inflation there will be no financial repression, and real interest rates will be higher. So it made sense, the argument went, to assume r > g from now on even though g > r in the past. However what economists call secular stagnation suggests that the average interest rate required to keep inflation constant has actually been steadily falling, so Blanchard’s findings become relevant again. There is plenty of scope here for more research and debate.

So if normally g > r, does this mean we do not need to worry about debt? Not quite. What it means is that one of the standard objections to raising debt, which is that taxes will have to rise to pay the interest, no longer holds if g > r. If g > r the government can borrow to pay the interest, and yet the debt to GDP ratio will still gradually decline, because the economy is growing faster than debt. The objection to raising debt that taxes will have to rise in the future to pay for it disappears. Indeed the whole ‘burden on future generations’ objection to raising debt falls away, because the debt to GDP ratio declines by itself: there is no future burden.

An important proviso, however, is that we are talking about one-off increases in debt. Such one off increases would include, for example, increases in debt to build new public infrastructure or increases in debt caused by fiscal expansions to fight a recession. g>r does not mean we do not need to worry about persistent primary deficits (by which I mean spending permanently higher than taxes). A persistent primary deficit will add to the growth in debt, so the debt to GDP ratio will rise despite g > r.

This is just the starting point for Blanchard’s lecture, and if you are an economist I recommend watching it as it is very easy to follow. In policy terms I think it is the last nail in the coffin of what Paul Krugman calls the deficit scolds. Those who argued for austerity because of the burden on future generation, although on weak ground even if r > g, find their argument collapses if g > r. [1]

[1] Blanchard shows this remains true even if there are periodic shocks where r > g, as long as on average g > r.


  1. Deficit-spending, public debt, and macroeconomic profit/loss
    Comment on Simon Wren-Lewis on ‘Should we worry about temporarily raising government debt?’

    The curious thing about Simon Wren-Lewis’s argument is that it does not contain the word profit. It goes without saying that this omission makes the whole argument worthless.

    Simon Wren-Lewis’s argument is based on the underlying standard model. This model is provably false and therefore has to be rectified first.#1

    As the correct analytical starting point, the elementary production-consumption economy is defined with this set of macroeconomic axioms: (A0) The economy consists of the household and the business sector which in turn consists initially of one giant fully integrated firm. (A1) Yw=WL wage income Yw is equal to wage rate W times working hours. L, (A2) O=RL output O is equal to productivity R times working hours L, (A3) C=PX consumption expenditure C is equal to price P times quantity bought/sold X.

    Under the conditions of market clearing X=O and budget balancing C=Yw, the price is given by P=W/R, i.e. the market clearing price is equal to unit wage costs. This translates into W/P=R, i.e. the real wage is equal to the productivity.

    Profit for the economy as a whole is defined as Q≡C−Yw and saving as S≡Yw−C. It always holds Q+S=0 or Q=−S, i.e. the business sector’s profit is equal to the household sector’s dissaving, or, the business sector’s loss is equal to the household sector’s saving.

    (i) Now, if the government runs a deficit in period 1, total expenditures are C+G, the market clearing prices rises, and the business sector makes a profit Q=G. The output O is redistributed between the household and the government sector. This amounts to taxation in real terms which is effected by the price increase.

    (ii) Only the central bank exists. Profit takes the form of deposits at the CB. The business sector’s deposits are equal to the government’s overdrafts. For a start, there is no interest on deposits/overdrafts.

    There is no longer deficit spending. The price returns to its original level.

    This intermediary time lasts from period 2 to t−1 and the government’s debt is simply rolled over. If employment and/or productivity increases, the economy grows.

    (iii) In period t, the debt is redeemed. The government taxes the household sector, total expenditures reduce to C−T with T=G, the market clearing price falls, and the business sector makes a loss of −G. After the government’s repayment, both overdrafts and deposits at the CB are again zero.

    As a result, the grandchildren are hit by taxes T but get the whole output O. The business sector’s loss in period t is equal to its profit in t=1. The real taxation happened in t=1, but nominal taxation is deferred to period t.

    If the interest rate on overdrafts is, for simplicity, equal to the interest rate on deposits, the government sector taxes the household sector and the interest payments go to the business sector respectively the firms’ owners a.k.a one-percenters.

    The taxation/redistribution over the indefinite intermediary time and the final taxation and redemption in period t could be avoided by immediate nominal taxation in period t=1. Immediate taxation settles ALL issues of intertemporal redistribution and is, from the perspective of the ninety-nine-percenters, preferable to deficit spending and deferred taxation.

    From the government’s perspective, stealth taxation through deficit spending is preferable because nominal taxation vanishes behind the time horizon. From the business sector’s perspective, profits now and losses behind the time horizon are also preferable.

    So, let the next administration worry about permanently growing debt.#2

    Egmont Kakarot-Handtke

    #1 On the saying “We owe the debt to ourselves”

    #2 Keynes, Lerner, MMT, Trump and exploding profit

  2. Typos?
    "But does a slow explosion in debt matter if the economy is also growing. A government (like a firm of individual)"
    Should it be ?
    "But does a slow explosion in debt matter if the economy is also growing? A government (like a firm or individual)"
    In the last paragraph: "burden on future generation" should be "generations"?
    BTW, about the ‘burden on future generations’ argument, sometimes people write things like: "a baby is born already owning x thousand". The counter argument is that that baby is born in an hospital, there are roads in which his parents drove to and from the hospital and all the other infrastructure which the baby starts to use from his first day.

  3. Nice summary, Simon. One question concerning your claim "A persistent primary deficit will add to the growth in debt, so the debt to GDP ratio will rise despite g > r." Yes, would cause debt to grow, but why would this necessarily entail increase in D/Y?

    1. Well spotted, David.

      I think that the answer is that SWL is uncomfortable with the notion that increased ublic investment is a structural issue, rather than confined to the need to use public investment as a surrogate macro-economic regulator, when interest rates at their effective lower bound.

      The need to raise and maintain public investment at a higher steady state level (combined with institutional reform to ensure much greater efficiency in its selection, planning, and execution) fits less neatly with the new Keynesian framework he is wedded to.

      That's the whinge, but his post was otherwise was very clear and informative, so thanks for that.

      We are all after the benefit of his expertise and experience, god knows many times per week, free of charge

      So much for the assumed base of the motivation of rational economic individual!

    2. For the record, asocialdemocraticfuture, I am not uncomfortable with that at all. Indeed I'm sure I have made exactly this point many times in past posts. The public capital stock in the countries I know is almost certainly way below optimal levels.

  4. Re: "A persistent primary deficit will add to the growth in debt, so the debt to GDP ratio will rise despite g > r."

    That is incomplete (as you know) and I think mis-worded. The basic law of motion of the debt ratio, B, is Delta B = D + (r - g)B where D is the primary deficit and Delta is the difference operator. So the debt ratio can rise but then it stabilizes at D/(r-g) with a given D.

    Does this mean there is no intertemporal budget constraint? Looking forward to more posts on this.

  5. with falling/stagnat population + low growth in productivity, future 'g' will decrease; current 'r' may have been low in anticipation of these factors, so that, in the future, 'r' might be > 'g'. I'm no economist

  6. Does Piketty also collapse if g>r ?

  7. Temorarily increasing debt to build infrastructure is not actually increasing liabilities if taxes are increased to pay all interest on that debt and to pay off the debt atleast as fast as the assets depreciate.

    This is means debt/liability increase is equal to or less than asset increases.

    And increased asset depreciation plus increased interest is less than or equal to increased revenue from user fees and taxes.

    A growing economy will require increased infrastructure assets. Whether roads, education, of production equipment, production can not be increased efficiently (economic) without paying workers to build more or better productive assets. The production cost curve is U shaped because as assets are pushed to produce more than optimum, costs go up, whether its in increased machine maintence being done during production instead of off shift, or highways congested with more accidents or simply slower speeds inncreasing production costs in the movement of assets, whether skilled employees, raw materials, or finished goods.

    Government deficits were once much the same as business cash flow deficits to economists and policy makers. "Tax and spend" were tightly linked. The differences politically were basically liberals setting spending levels first, then setting taxes and fees to pay for the spending, while conservatives set tax rates and then forced spending to be less than tax revenue.

    But that changed with Reagan, triggering HW Bush to call it voodoo economics. When HW rejected voodoo economics, and agreed to hike taxes to spend for increased spending on assets, eg gas tax hikes, while cutting spending which killed lots of jobs related to the military, he and any GOP supporters were purged. Later when Clinton and only Democrats alone did the same, they were purged in places where voodoo economics, more accurately called free lunch economics were most popular.

    Free lunch economics says paying workers costs too much and kills jobs. Only by cutting pay and benefits and killing jobs and then loaning money to fund buying good and services that are mostly consumed can jobs be created to grow GdP. Since 1970, debt has increased in government, individual, and business sectors faster than GDP growth, and actual productive capital has lagged behind debt. The debt is increasing unsecured, like in Venezuela where the government has been created debt aka money secured by assets aka oil production, and debt that is unsecured aka money used to pay workers, buy goods and services, resulting in high inflation.

    US debt aka money is secured by "full faith and credit" over the past 80 years since FDR eliminated gold as the basis of money. Of course, the value of gold was and still is based on the long term labor cost of mining the marginal ounce. Gold in the ground is effectively unlimited, and technology has kept mining labor costs stable for thousands of years, once it was not used unproductively to define the value of money, ie, requiring increasing investment, labor cost, mining gold to create money. A dollar or few in money for every dollar paid to workers mining and refining gold that would be buried in an underground vault.

    Money is debt backed by assets, like gold produced by labor, or simply by the promise of future labor.


    Printing money with no promise it will pay for labor to deliver goods and serices will lead to the money becoming worthless.

  8. Simon Wren-Lewis

    You sum up: “In policy terms I think it is the last nail in the coffin of what Paul Krugman calls the deficit scolds. Those who argued for austerity because of the burden on future generation, although on weak ground even if r > g, find their argument collapses if g > r.”

    Paul Krugman (i) confuses some issues and (ii) lets some negative facts simply disappear by dividing them through infinity.

    If the present government deficit-spends 100 on current output on behalf of the present generation then in some future period t the debt of 100 has to be redeemed. Now Paul Krugman argues if GDP is currently x and in period t has grown to 1000x then the burden in terms of Debt-to-GDP is greatly reduced and in the course of time approaches zero. This is undoubtedly true but misses the point. The debt burden is not reduced by one penny but only optically by putting it in relation to an arbitrary denominator. If the economy shrinks instead, the relative debt burden increases. And this collapses the argument of Paul Krugman.

    Because nobody can say whether the economy is bigger or smaller in a future period t the whole argument degenerates to an exercise in pointless speculation.

    The real problem with government deficit-spending is the distributional effect. In crude terms: because of Public Deficit = Private Profit the Oligarchy gets a free lunch from the government. This, in turn, generates interest income for an indefinite time, i.e. the government taxes WeThePeople and hands the interest over to the Oligarchy. Finally, in some period t, it is NOT the future “generation” who redeems the debt. Instead, the government taxes the future WeThePeople and hands the money over to the future Oligarchy which has inherited the financial assets = public liabilities.

    In sum: compared to immediate taxation, deficit-spending is a bad deal for WeThePeople and a good deal for the Oligarchy.

    The, intentionally or unintentionally overlooked, distributional effect of public deficit spending is the last nail in the coffin of the soapbox economist Paul Krugman.

    Egmont Kakarot-Handtke

  9. "The real problem with government deficit-spending is the distributional effect. "


    should be obvious to people with phd's etc

    it's s shame society is so concerned with the flow (money) instead of the asset (permanancy)...but then again without the politics what would we have to live for?


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