Saturday, November 29, 2014

When Is Government Debt Risky?

BERKELEY – A government that does not tax sufficiently to cover its spending will eventually run into all manner of debt-generated trouble. Its nominal interest rates will rise as bondholders fear inflation. Its business leaders will hunker down and try to move their wealth out of the companies they run for fear of high future corporate taxes.

Moreover, real interest rates will rise, owing to policy uncertainty, rendering many investments that are truly socially productive unprofitable. And, when inflation takes hold, the division of labor will shrink. What once was a large web held together by thin monetary ties will fragment into very small networks solidified by thick bonds of personal trust and social obligation. And a small division of labor means low productivity.

All of this is bound to happen – eventually – if a government does not tax sufficiently to cover its spending. But can it happen as long as interest rates remain low, stock prices remain buoyant, and inflation remains subdued? I and other economists – including Larry Summers, Laura Tyson, Paul Krugman, and many more – believe that it cannot.

As long as stock prices are buoyant, business leaders are not scared of future taxes or of policy uncertainty. As long as interest rates remain low, there is no downward pressure on public investment. And as long as inflation remains low, the extra debt that a government issues is highly prized as a store of value, helps savers sleep more easily at night, and provides a boost to the economy, because it assists deleveraging and raises the velocity of spending.

Economists, in short, do not watch only quantities – the amount of debt that a government has issued – but prices as well. And, because people trade bonds for commodities, cash, and stocks, the prices of government debt are the rate of inflation, the nominal interest rate, and the level of the stock market. And all three of these prices are flashing green, signaling that markets would prefer government debt to grow at a faster pace than current forecasts indicate.

When Carmen Reinhart and Ken Rogoff wrote their influential study “Growth in a Time of Debt,” they asked the following question: “Outsized deficits and epic bank bailouts may be useful in fighting a downturn, but what is the long-run macroeconomic impact of higher levels of government debt, especially against the backdrop of graying populations and rising social insurance costs?” Reinhart and Rogoff saw a public-debt “threshold of 90% of [annual] GDP,” beyond which “growth rates fall…. in [both] advanced and emerging economies.”

The principal mistake that Reinhart and Rogoff made in their analysis – indeed, the only significant mistake – was their use of the word “threshold.” That semantic choice, together with the graph that they included, has led many astray. The Washington Post editorial board, for example, recently condemned what it called the “Don’t worry, be happy” approach to the US budget deficit and government debt, on the grounds that there is a “90% mark that economists regard as a threat to sustainable economic growth.”

To be sure, The Washington Post editorial board has shown since the start of the millennium that it requires little empirical support for its claims. But the phrasing in “Growth in a Time of Debt” also misled European Commissioner Olli Rehn and many others to argue that “when [government] debt reaches 80-90% of GDP, it starts to crowd out activity.” Reinhart and Rogoff, it is widely believed, showed that if the debt/GDP ratio is below 90%, an economy is safe, and that only if the debt burden is above 90% is growth placed in jeopardy.

Yet the threshold is not there. It is an artifact of Reinhart and Rogoff’s non-parametric method: throw the data into four bins, with 90% serving as the bottom of the top bin. In fact, there is a gradual and smooth decline in growth rates as debt/GDP ratios increase – 80% looks only trivially better than 100%.

And, as Reinhart and Rogoff say, a correlation between high debt and low growth is a sign that one should investigate whether debt is a risk. Sometimes it is: a good deal of the relationship comes from countries where interest rates are higher and the stock market is lower, and where a higher debt/GDP ratio does indeed mean slower growth.

Still more of the relationship comes from countries where inflation rates are higher when government debt is higher. But some of it comes from countries where growth was already slow, and thus where high debt/GDP ratios, as Larry Summers constantly says, result from the denominator, not the numerator.

So, how much room is left in the relationship between debt and economic performance for a country with low interest rates, low inflation, buoyant stock prices, and healthy prior growth?

Not much, if any. In the United States, at least, we have learned that there is little risk to accumulating more government debt until interest and inflation rates begin to rise above normal levels, or the stock market tanks. And there are large potential benefits to be gained from solving America’s real problems – low employment and slack capacity – right now.

Read an extended version of this argument in J. Bradford DeLong’s blog post, “Risks of Debt: The Real Flaw in Reinhart-Rogoff?”

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    1. CommentedGary Foxwell

      More useless economic dribble. what's happening in the US and world economies has most of the experts befuddled. Also the fact that most of the economist that get any press work for the major banks or investment houses makes most of what they say suspect at best. I would like them to explain to me how you can cut cost to prosperity.

    2. CommentedDave Thomas

      I wonder if the Spanish Hapsburgs knew how much government debt was bad before it went bankrupt?

      Mr. DeLong inferring that he or anyone else knows when government debt is risky through analysis when the collected body of economists didn't know when the housing market was risky leaves me with little confidence in his or their abilities to foretell the future.

      The truth of the matter is we won't know if the stove is hot until we touch it. I'm sorry Mr. DeLong, but I'll take the side of caution and since the stove isn't hot right now, we don't have too much debt already hopefully, I won't keep reaching my hand out for it.

      I'll also trust the economic reasoning of Dr. Robert Mundell whose fiscal and monetary policy mix that called for a strong dollar and deficits created through tax cuts for the private sector worked much better in my lifetime that Obama's use of LBJ's failed Big Government Liberalism to promote economic growth.

      All government debt is not the same and this seems to escape Mr. Delong.

      Might I suggest he read "Econoclasts" and get some economic history instead of relying on just theoretical economics.

        CommentedJose araujo

        Yes, yes, Mundell the father of the Euro, and the situation we are living...

        And the Bush policy did work much better, didn't it?

    3. CommentedMarc Sargen

      All of these people argue that a nation is different than an individual or a corporation about debt because they can tax. I see no real difference.
      Debt is avoided in extremes because it increases risk in the real world. If you have a company with the same income & operating cost you can juice returns by borrowing but you also juice losses.
      When Krugman or Tyson advocate supporting stimulus with debt at high levels they are making a bet that nothing else will go wrong. If you are fully loaded with debt & then a black swan event happens, you find that there are no resources to respond & all of the options (including draconian tax increase) are horrible.

        CommentedPeter P


        Notice 2 things in my example (which is very real, this is how colonial countries were monetized and how kings financed their wars: they imposed taxes on local population payable in something which only THEY possessed: gold, gold was stamped with higher nominal value than metallic (otherwise it would be melted and they would never see it again) and gave it to the guy who ran the war: he could now provision himself paying with the money).

        2 things to notice:

        * Taxes in your own autographs that you collect do NOT finance your spending: you issue autographs out of thin air. Taxes ensure your autographs have value.

        * For the population to be able to pay taxes and save a bit for a rainy day you HAVE TO issue a bit more than you tax (run a deficit), so deficits are completely normal for a money issuer and mathematically necessary if the population is to have any money savings.

        CommentedPeter P

        Imagine a currency of your autographs. You issue autographs and only promise to... exchange them to other autographs. Can you default on that promise? Only if you choose to. The problem of course it the autographs are worthless so you can't buy anything with them. But what if you have policy and force the people of your town to pay you 10 autographs each on Apr 15th each year? All of a sudden they will try to get hold of at least 10 autographs each, possibly more for a rainy day. They will show up to work for your autographs to stay out of prison. You now promise to exchange autographs for other identical autographs and to accept them for payment of taxes. You CANNOT default. You can choose to pay interest on them (which on a balance sheet looks like borrowing but is clearly not, because you are the issuer of the money: you choose to pay interest on your money, you could choose zero). So the only worry is to issue enough currency so that everybody has a job (you don't want to issue only 9 autographs per person - they need 10 just to pay taxes, otherwise there will be unemployment and you will have to put some of them in jail, which would be stupid) but not too much so that coupons are too easy to come by and lose value (inflation).‎

    4. CommentedTR Barnes

      You write that debt cannot become a problem as long as interest rates remain low, stock prices remain buoyant and inflation remains subdued. But aren't these present circumstances due to ZIRP and QE and globalization? ZIRP and QE are widely considered to be boosting the stock and bond markets and globalization it is said suppresses inflation in the US and wage inflation in particular. If this is the case, then behind these false masks mightn't there be a real boogeyman as frightful as he is fatal? And to the same point, the flashing green light might not at all be indicating that more debt should be piled on but rather that some prankster turned the sign and on the other side of it is a precipice and the bottomless abyss of black perdition.

    5. CommentedEdward Ponderer

      I fear a dangerous flaw in the analysis here in that it doesn't account for the completely new effects of full globalization, natural resource limits, and the nature of empowered human greed.

      These effects include a vast complex of ever-tightening interdependence, the drying up of "new" markets and the overburdening of this planet's ability to provide the raw resources and waste management.

      This means a strong cross-coupling between human economics, and the natural world -- chemically, biologically, and climatically.

      This also provides an international legal and economic complex that can be manipulated to some extent to limit wealth into very few hands by the production of vaporware money pumped around numerous time with interest gaining on it, and that interest used to purchase actual material wealth which is taken out of the system. The cost of such dealings used to be the risk taken, but now the "too big to fail" conglomerate of wealth extorts the entire populous to share the burden of evermore irresponsible high-risk taking.

      The consequences of all this are very clear:

      1 - We are reaching, perhaps have reached, an effectively closed system, and per force, are acting as if we believed in perpetual motion machines.

      2 - The implicit entropy in the system comes not as just a simple heat death, but is multiplied by the vast interdependence into deterministic chaos -- read Murphy's law. Because of the cross-coupling with the natural world, this will not merely lead to far more complex economic realities than classic black-box method can handle, but do so as well in our relationship with Nature -- from disappearing clean water and the growth of environmental mutagen toxins, to the growth of antibiotic-immune bacteria and inter-species disease transmission of disease, to clear percentage annual growth in the rate and severity of natural catastrophes.

      3 - The analysis tools and actions we do regarding all this, corresponds to trying to use a hammer and chisel to address systemic illness in a human body. And in this analogy lies the key.

      For in fact, we need to recognize on a grand scale, the transitional crisis that is taking place as we go from a flat planet with vast open territory and independent elements to a very round world and nonlinear interdependence. The nature of all this, fractal really, call to two directions -- complete chaotic decay, or a healthy evolution in homeostasis -- in this case not of a human body, but of the Body Humanity and its natural environment.

      In short, it is only the butterfly that can fly out alive from the cocoon -- the caterpillar is gone. Or more classically: All the kings' growth plans, austerities, and taxes, won't be able to put Humpty together again -- as its time for a new baby chick to arise out of the yolk.

    6. CommentedFrank O'Callaghan

      The German 1923 case is a special one. It cannot be used as an example. They were in the middle of reparations and trying to recover from defeat in WW1. Their economy was still adjusting from the war and their their country had been dismembered. Not to mention the dislocation of their previous 'economic sphere of influence'.

      Inflation is still low for a number of reasons, one of which is that demand is suppressed by the impoverishment of the lower middle and working classes in the developed world. The widening inequality between the rich and the rest is a core threat to the stability and future of the system.

    7. CommentedG. A. Pakela

      How can you say that there is this large private demand for public debt when the Federal Reserve is spending $85 billion per month purchasing what is essentially the entire budget deficit? And how do low interest rates, distorted by (nearly) world-wide central bank intervention , raise the velocity of spending? Does that mean individuals and households are being discouraged from saving and are encouraged to ignore their long-term needs and spend like there is no tomorrow? Or does it mean that retirees are forced to liquidate their savings in order to live because the interest returns are too low? And exactly what are those potential gains from directing even more resources away from the private sector to government spending when the amount of fiscal stimulus has already been the highest ever, excepting WWII? Ultimately, your Keynesian theories rely on private sector spending and investment to replace the temporary increase in government deficit spending, but how is that to take place when there is this public policy hostility directed towards investors and businesses through increased taxes and regulatory burden? If your political party could actually make critical choices in spending, we could probably afford an extra couple of hundred billion on providing health care insurance.

    8. CommentedPeter P

      Brad DeLong is saying we are a stock market crash away from the complete doom. But "economists watch prices". Very reassuring. He is still lost.

      Please read up on MMT: in monetarily sovereign countries not the bond market, not the stock market but the central bank controls rates. Since there is no default risk long term rates are expected short rates, no default premium and that is that. The CB could also target long rates directly as it did during WW2 or Operation Twist. As Krugman showed, what adjusts then is the exchange rate. Krugman now understands the MMT insight that sovereign countries never face high rates, he even claims he understood it in the 1990s (obvious lie, he worries about Italy as recently as 2011, and about US in 2003 - he admitted he had been wrong)

        CommentedPeter P

        Thank you for responding, but you angered me :)

        Germany in 1923 was sovereign? You are not serious, right? It was an occupied country (French in the Rheinland) saddled with reparations it could never possibly repay - so it had to scour its economy for anything that could be exported and buy raw materials with nothing to offer in return but a printed paper.

        Why do you think you can lower rates only when unemployment is high? I see it as follows: no default risk ever, so long rates are expected short rates, plus the CB could peg long rates as easily as short rates (WW2, operation twist). What mechanism do you see for a sovereign country to lose control of interest rates?

        Portrait of J. Bradford DeLong

        CommentedJ. Bradford DeLong

        As I recall, interest rates in Germany in 1923 were pretty high--and Germany then was certainly sovereign. The claim to make is not that sovereign countries never have to face high rates, but that sovereign countries never have to face high rates when unemployment is high. And whether that claim is true or not is an empirical matter--Lerner (1943) makes theoretical arguments for that claim, but there are lots of wrong theoretical claims in the literature...

    9. CommentedClint Ballinger

      Spending and taxation are not related except (mostly) through inflation. A sovereign state can spend as much as it wants; taxation only serves social goals and to help constrain inflation when necessary.

      Inflation is not a danger now, while unemployment is not a danger but a reality.

      Thus taxes should be lowered and/or spending increased until unemployment improves and/or inflation becomes an issue.

      Increased spending = increased private financial assets; this is not “risky” but good. The title of the post itself is misleading and illogical.

      DeLong surely knows this.

        CommentedClint Ballinger

        Brad- on your first point -
        A sovereign currency issuer also sets the interest rates.
        You know that too.

        On your second point "for when it will be necessary to constrain inflation is the key issue" - Err, when it gets to be over about 2%; not a big deal (relative to the VERY big deal that is unemployment).

        Portrait of J. Bradford DeLong

        CommentedJ. Bradford DeLong

        A sovereign state can spend as much as it wants as long as it possesses the exorbitant privilege of having sufficiently low interest rates. When it does not, spending has to be balanced by taxes in the long run--including the tax on cash holdings that is inflation. If you want to advance the discussion, think about under what circumstances economies possess this exorbitant privilege and how it is lost--"A sovereign state can spend as much as it wants; taxation only serves social goals and to help constrain inflation when necessary" does not advance the discussion, for when it will be necessary to constrain inflation is the key issue.

    10. CommentedProcyon Mukherjee

      Some simple facts suggest that the Government Debt has risen from 65% of GDP in 2008 to 101%in 2013 and the the debt in absolute terms have reached $15 Trillion , out of which $5 Trillion is held by foreigners, which has itself grown by $1 Trillion in this period. The point to be noted is that in this entire period the government had not really been such a great spender though. If the debt is entirely held domestically, it may not be such a big deal, but the complexion of the debt matters. On the other hand government debt to revenue ratios have jumped to 5.25:1, which may be one of the worst among the developed nations.

      So in sum, debt may be fine, but what are the avenues of spending that would create jobs?

    11. CommentedRalph Musgrave

      BradDeLong is 95% right. Mind he’s only saying what others (like me) have been saying for years.

      My only quibble is that he seems to claim that if the bond vigilantes demand a higher rate of interest for holding government debt, then that puts a constraint on the deficit. Actually it doesn’t because government can simply stop borrowing and print money instead (as Keynes and Milton Friedman pointed out).

      What DOES PUT A CONSTRAINT on the deficit is inflation. That is, if the latter money printing is inflationary, then that’s a constraint. But we’ve printed money like there’s no tomorrow in the guise of QE recently and excess inflation is nowhere to be seen.

        CommentedKen Presting

        Well, private corporations (incl cities, etc) are issuing bonds too. Lending increases money supply whether the debt is a security or just a promissory note

        The difference between plain old "printing money" vs. Federal borrowing is that the debt creates offsetting entries in balance sheets - the lender gives the borrower some cash, but in return the lender obtain a valuable asset - the promissory note and its cash flow. Same for the borrower who got cash, but also has to book a liability and make payments. So it is clear to each party (and their auditors!) that no wealth was created and nobody is pretending there was.

        Printing money, on the other hand, is an attempt to create wealth without acknowledging that a corresponding debt has been incurred. It is no different from a counterfeiting operation, if you look at it in bookkeeping terms. The Wikipedia article on "Quantitative Easing" is helpful here.

        The finances of a modern state are more and more like any other corporation, and that pattern is probably all for the better. Of course, it is a monopoly, which can only be allowed in a free market system when it is well and carefully regulated.

        There are many examples of successful, well-regulated monopolies of many sizes. The problem is, how to get our Govt. to become one.

        CommentedClint Ballinger

        PS There is some good relevant discussion here

        CommentedClint Ballinger

        Thanks Ken for clarifying. Would you still say it has to do with the states role as bond issuer?

        CommentedKen Presting

        Replying to Clint -It's not the ability to issue currency which gives the central bank influence over interest rates. All lending adds to the money supply, whether the borrower is private or public.

        Rather, it is arbitrage relationships between the overnight rates, discount, etc and the rest of the debt market which makes gives the central bank its 'leverage.'

        CommentedClint Ballinger

        Reply to Brad's reply to Ralph:
        Brad still does not get that the state as currency issuer can determine interest rates as well - "In short, there is no 'equilibrium' short-term rate besides the rate targeted by the Fed; instead, it is the Fed’s target that serves as the anchor
        for these other rates." (p. 23 )

        Portrait of J. Bradford DeLong

        CommentedJ. Bradford DeLong

        When interest rates are high, money-printing is highly likely to be inflationary, no? When interest rates is high the opportunity cost of keeping money in your pocket is large, and so the incentive to spend it is high, no?

    12. CommentedLacey Mower

      I'm curious. This paragraph states that R&R's only significant mistake was their use of the word "threshold," yet recent news coming out of the Political Economy Research Institute (PERI) shows their study had multiple very significant issues. And arguably the most significant issue, is what has now been referred to as, "the excel error heard round the world." R&R made an error in their spreadsheet which changed the fundamental results. This error was discovered by UMass Amherst doctoral student, Thomas Herndon, and in the last couple of weeks has gained international acclaim. It seems the "recently condemned" article mentioned here is NOT so recent of a condemnation compared to the criticisms that have erupted over the past two weeks. There is no mention in this article of Herndon's discovery or the associated critiques about correlation/causation pointed out by Arindrajit Dube already.

        CommentedPeter P

        Mr DeLong,

        R-R refused data to many people, Herndon prob. got it because he was a student, thought harmless.

        Portrait of J. Bradford DeLong

        CommentedJ. Bradford DeLong

        Herndon did very good work. And I am kicking myself for not asking R&R for the details of their calculations two years ago, because my people and I were not able to replicate the details (although there is a negative correlation between growth and debt).

        But the significant error isn't the data-processing one. It's taking seriously an artifact of their statistical procedure to say that there is a cliff at 90%...

    13. CommentedZsolt Hermann

      Discussing debt in isolation is like discussing the high temperature of a sick patient without looking at the disease causing the temperature rise.
      As economics is the external representation of basic human relationships, the model by we deal with each other, the increasing debt reflects our distorted view of reality, human relationships in general.
      Initially business dealing relied on simple exchange of products of need.
      Then to make such exchange easier an intermediary tool was invented so instead of the direct exchange of products people could buy and sell necessities in an easier fashion, according to their available means.
      But then humanity started accumulating that intermediary tool, that itself become the object of desire and as at the same time we also started promoting, producing and consuming products that are not necessary but artificial with inflated values, the new credit based economy was born which gradually lost all of its ties with the initial necessity based "simple exchange" economy.
      This is nobody's fault, as our evolution is based on the evolution of the increasing ego, this unnatural path, separating ourselves from the initial natural based system was inevitable.
      But today we are so far removed from the natural system that our present system has absolutely no natural foundations.
      Humanity is floating in an artificial bubble, and instead of daring to look down, we try to escape forward, and when bubbles start to burst we build new ones around them, when we have credit problems we take more credit or print more money although there is no asset or commodity behind it.
      Most of today's wealth is expressed in virtual stock market portfolios, bonds, and so on, wealth can build up in minutes and be lost in minutes. As if people played a giant, virtual Monopoly game.
      This system is dying, no artificial, unnatural structure can survive within a natural system.
      Sooner or later we have to look down from the bursting bubble, we have to open our eyes and see the monster we created and how now this monster is consuming us.
      We have to return to the natural, necessity and resource based economy and lifestyle as only such lifestyle has right to exist.

    14. CommentedRahil Devgan

      A succinct and straightforward analysis. R&R didn't make any effort to publicly claim that their research was being misinterpreted and politicised. The excel error was of no importance but the selection and weighting is pretty significant. As a whole, the research is far too simplistic and the sample is just not worthy enough for consideration (reminds me of the Mishkin/Hamilton etc. paper presented at the Monetary Policy forum not too long ago). As you correctly state, what about interest rates, asset prices, output gaps etc.? What's wrong with a focus on increased growth instead of reducing debt? Causation is easier said than done, the easy way out is to correlate and conveniently conclude.