Sunday, August 20, 2017
Photo of Robert Skidelsky

This argument for fiscal austerity is invalid. A government that can issue debt in its own currency can easily keep interest rates low.

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The Scarecrow of National Debt

CAMBRIDGE – Most people are more worried by government debt than about taxation. “But it’s trillions” a friend of mine recently expostulated about the United Kingdom’s national debt. He exaggerated a bit: it is £1.7 trillion ($2.2 trillion). But one website features a clock showing the debt growing at a rate of £5,170 per second. Although the tax take is far less, the UK government still collected a hefty £750 billion in taxes in the last fiscal year. The tax base grows by the second, too, but no clock shows that.

Many people think that, however depressing heavy taxes are, it is more honest for governments to raise them to pay for their spending than it is to incur debt. Borrowing strikes them as a way of taxing by stealth. “How are they going to pay it back?” my friend asked. “Think of the burden on our children and grandchildren.”

I should say that my friend is extremely old. Horror of debt is particularly marked in the elderly, perhaps out of an ancient feeling that one should not meet one’s maker with a negative balance sheet. I should also add that my friend is extremely well educated, and had, in fact, played a prominent role in public life. But public finance is a mystery to him: he just had the gut feeling that a national debt in the trillions and growing by £5,170 a second was a very bad thing.

One should not attribute this gut feeling to financial illiteracy. It has been receiving strong support from those supposedly well-versed in public finance, particularly since the economic collapse of 2008. Britain’s national debt currently stands at 84% of GDP. This is dangerously near the threshold of 90% identified by Harvard economist Kenneth Rogoff (together with Carmen Reinhart and Vincent Reinhart), beyond which economic growth stalls.

In the face of criticism of the data underlying this threshold Rogoff has held firm, and he now gives a reason for his alarm. With US government debt running at 82% of GDP, the danger is of a “fast upward shift in interest rates.” The “potentially massive” fiscal costs of this could well require “significant tax and spending adjustments” (economist’s code for increasing taxes and reducing public spending), which would increase unemployment.

This is the financial leg of the familiar “crowding out” argument. The higher the national debt, according to this view, the greater the risk of government default – and therefore the higher the cost of fresh government borrowing. This in turn will raise the cost of new private-sector borrowing. (That is why Rogoff wants the US government to “lock in” currently low rates by issuing much longer-term debt to fund public infrastructure). Maintaining low interest rates for private bank loans has been one of the main arguments for reducing budget deficits.

But this argument – or set of arguments (there are different strands) – for fiscal austerity is invalid. A government that can issue debt in its own currency can easily keep interest rates low. The rates are bounded by concerns about inflation, over-expansion of the state sector, and the central bank’s independence; but, with our relatively low levels of debt (Japan’s debt amounts to over 230% of its GDP) and depressed output and inflation, these limits are quite distant in the UK and the US. And as the record bears out, continuous increases in both countries’ national debt since the crash have been accompanied by a fall in the cost of government borrowing to near zero.

The other leg of the argument for reducing the national debt has to do with the “burden on future generations.” US President Dwight Eisenhower expressed this thought succinctly in his State of the Union message in 1960: generating a surplus to pay back debt was a necessary “reduction on our children’s inherited mortgage.” The idea is that future generations would need to reduce their consumption in order to pay the taxes required to retire the outstanding debt: government deficits today “crowd out” the next generation’s consumption.

Although governments have endlessly repeated this argument since the 2008 crash as a justification for fiscal tightening, the economist A. P. Lerner pointed out its fallacy years ago. The burden of reduced consumption to pay for government spending is actually borne by the generation which lends the government the money in the first place. This is crystal clear if the government simply raises the money it needs for its spending through taxes rather than borrowing it.

Furthermore, the idea that additional government spending, whether financed by taxation or borrowing, is bound to reduce private consumption by the same amount assumes that no flow of additional income results from the extra government spending – in other words, that the economy is already at full capacity. This has not been true of most countries since 2008.

But in the face of such weighty, if fallacious, testimony to the contrary, who am I to persuade my elderly friend to ignore his gut when it comes to thinking about the national debt?


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Photo of Carmen Reinhart

I cannot recall an instance of a government that is concerned about having too low a level of debt. Perhaps it is because the debt scarecrow has teeth.

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The Perils of Debt Complacency

CAMBRIDGE – “What a government spends the public pays for. There is no such thing as an uncovered deficit.” So said John Maynard Keynes in A Tract on Monetary Reform.

But Robert Skidelsky, the author of a magisterial three-volume biography of Keynes, disagrees. In a recent commentary entitled “The Scarecrow of National Debt,” Skidelsky offered a rather patronizing narrative, in a tone usually reserved for young children and pets, about his aged, old-fashioned, and financially illiterate friend’s baseless anxiety about the burden placed on future generations by the rising level of government debt.

If Skidelsky’s point had been that some economies, including the United States, would benefit from higher infrastructure spending, even at the cost of more debt, I would agree wholeheartedly. Compelling reasons for boosting US public investment include deteriorating infrastructure, tepid growth, low interest rates, and limited scope for further monetary stimulus. For the US, such an impetus might be especially welcome as the Federal Reserve raises interest rates (albeit gradually) while other countries ease further or hold rates steady and the dollar likely strengthens.

But that was not the route Skidelsky took. Instead, in his critique of a commentary by Kenneth Rogoff, he argued that it is silly and passé for a country that can issue debt in its own currency to fret over medium-term debt levels. Call me old-fashioned, but that argument smacks of complacency and is not supported by evidence. On this score, Skidelsky confuses two different papers on debt and growth, a 2012 paper of mine, in which there were some alleged data concerns, with one that I co-authored with Rogoff and Vincent Reinhart, in which there were none.

Coming from an author who knows Keynes so well, such complacency disappoints. I cannot read How to Pay For the War and conclude that Keynes thought that high war debts were a “scarecrow” for the United Kingdom. In fact, the apparatus of the Bretton Woods arrangements that Keynes subsequently helped to craft were designed to ease a difficult transition out of debt.

The case for near-term fiscal stimulus, even if in the form of increased infrastructure outlays, cannot ignore the medium-term outlook for economies with already large debt obligations, major entitlement burdens, aging populations, and what appears to be a steady downward drift in potential output growth.

As Skidelsky notes, debts have risen significantly in the UK and the US (among others) since 2008, while interest rates have remained low or declined. Should we therefore conclude that high debt is not linked to low growth via high interest rates (which crowd out private spending)?

Reading a little further into my study with Rogoff and Reinhart, one would find that there was ‘‘little to suggest a systematic mapping between the largest increases in average interest rates and the largest (negative) differences in growth during the individual debt overhang episodes.”

Our research considered 26 high-debt episodes between 1800 and 2011, looking both at growth rates and at levels of real (inflation-adjusted) interest rates. In 23 of these high-debt episodes, growth was lower, and in eight growth slowed even as real interest rates remained about the same or edged lower. Japan’s debt overhang (entirely domestic currency debt), which we trace back to 1995, illustrates this pattern.

Why do high debt and slow growth coexist, despite cheap financing?

High debt levels can and do constrain a country’s abilities to cope with adverse events. For example, some of Italy’s largest banks have been diagnosed as approaching insolvency and requiring substantial recapitalization. Not surprisingly, the confidence of Italian households and firms has been shaken, and capital flight has ensued. If Italy’s debt were not already 130% of GDP, might its government have been better positioned to provide the resources to tackle decisively its lingering banking and confidence problems?

Our 2012 study identified three ongoing public-debt overhangs that began in the mid-1990s – Greece, Italy, and Japan. Relative to other advanced economies, these three economies are the worst growth performers (see chart). To be sure, a country’s economic performance depends on many factors. But the view that it is low growth that causes debt to rise, though important when assessing the cyclical feedback effects, can hardly explain the two-decade experience of these three countries.


It is difficult to imagine a sustained revival of Greek growth without another round of haircuts and debt forgiveness from Greece’s official creditors, which now hold most of its debt. Italy depends critically on the continued large-scale purchases of its bonds by the European Central Bank (its Target 2 balances have recently climbed, reflecting capital flight). The Bank of Japan is going to greater and greater lengths to orchestrate an increase in inflation expectations and price growth, which can help erode the value of outstanding debts. (“For inflation is a mighty tax-gatherer,” as Keynes observed.) Other countries, like Portugal, are also struggling with low growth and weak fiscal positions.

Concerns about debt levels (public and private) have now extended beyond the advanced economies to many emerging markets. I cannot recall an instance of a government that is concerned about having too low a level of debt. Perhaps, it is because the debt scarecrow has teeth.

Skidelsky needs no reminder of the historical record, but it bears noting that more than a dozen advanced economies received debt relief in one form or another during the depression of the 1930s. The approach to unwinding current debts is likely to vary considerably across countries, but it is time to place greater emphasis on debt restructuring (which comes with a menu of options) than on accumulating more debt.


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Photo of Kenneth Rogoff

With net US government debt already running at 82% of national income, the potential fiscal costs of a fast upward shift in interest rates could be massive.

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America’s Looming Debt Decision

BOGOTÁ – Should the US government lock in today’s ultra-low borrowing costs by issuing longer-term debt? It’s a tough call, but with overall debt levels already high (not to mention unfunded pension and medical insurance liabilities, which are both likely to rise), perhaps the time has come.

Until now, the US Treasury and the Federal Reserve Board, acting in combination, have worked to keep down long-term government debt, in order to reduce interest rates for the private sector. Indeed, at this point, the average duration of US debt (integrating the Fed’s balance sheet) is now under three years, well below that of most European countries, even taking into account their own central banks’ massive quantitative-easing (QE) programs.

The tilt toward short-term borrowing as a way to try to stimulate the economy has made sense until now. Given that the interest rate on 30-year US debt is roughly 200 basis points higher than on one-year debt, short-term borrowing has saved the government money as well.

But the government should not operate like a bank or a hedge fund, loading up on short-term debt to fund long-term projects. It is too risky. With net US government debt already running at 82% of national income, the potential fiscal costs of a fast upward shift in interest rates could be massive.

No one is saying that such a shift is likely or imminent, but the odds aren’t as trivial as some might like to believe. For starters, interest rates could spike in the event of a war or some other catastrophic event. Less dramatic but more likely is that the Fed will someday find a way to push up inflation expectations, which, as in most advanced economies, have been drifting inexorably downward. If inflation expectations do start rising, this will push up rates.

A rise in borrowing rates could also come from self-inflicted damage. Suppose, for example, that US voters elect as their president an unpredictable and incompetent businessman, who views bankruptcy as just business as usual. Alternatively, it is not difficult to imagine a sequence of highly populist leaders who embrace the quack idea that the level of government debt is basically irrelevant and should never be an obstacle to maximizing public spending.

Unfortunately, if the US ever did face an abrupt normalization of interest rates, it could require significant tax and spending adjustments. And the overall burden, including unemployment, would almost surely fall disproportionately on the poor, a fact that populists who believe that debt is a free lunch conveniently ignore.

Mind you, lengthening borrowing maturities does not have to imply borrowing less. Most economists agree that larger deficits make sense if used to pay for necessary infrastructure and education improvements, not to mention enhancing domestic physical and cyber security. There is a significant backlog of worthy projects, and real (inflation-adjusted) interest rates are low (though, properly measured, real rates may be significantly higher than official measures suggest, mainly because the government’s inability to account properly for the benefits of new goods causes it to overstate inflation). One hopes that the next president will create an infrastructure task force with substantial independence and technocratic expertise to help curate project proposals, as the United Kingdom’s pre-Brexit government did.

With control of the global reserve currency, the US has room to borrow; nonetheless, it should structure its borrowing wisely. Several years ago, it still made sense for the Fed to do cartwheels to bring down long-term borrowing costs. Today, with the economy normalizing, the case for creative policies like QE, which effectively shortens government debt by sucking long-term bonds out of the market, seems much weaker.

That is why the time has come for the US Treasury to consider borrowing at longer horizons than it has in recent years. Today, the longest maturity debt issued by the US government is the 30-year bond. Yet Spain has successfully issued 50-year debt at a very low rate, while Ireland, Belgium, and even Mexico have issued 100-year debt. Sure, there is no guarantee that rates won’t drop even more in the future, but the point is to have a less risky stream of future interest obligations.

Many left-leaning polemicists point to Japan, where net debt is about 140% of GDP, as proof that much higher debt is a great idea, despite the country’s anemic growth record. The implication is that there is little need to worry about debt at all, much less its maturity structure. In fact, Japanese policymakers and economists are plenty worried and do not recommend that other countries emulate their country’s debt position.

Europe is admittedly in a very different place, with much higher unemployment, and a much stronger argument for continuing to pursue stimulus at the risk of higher debt-service costs in the future. But with the US economy now enjoying a solid recovery, the best approach may be to move faster toward normalizing debt policy, and not to assume that foreign lenders will be patient, regardless of the direction of US politics.


The Debt Dilemma

Read Comments (3)
  1. Comment Commented

    I can't not remind Dr. Reinhart that Alan Greenspan did issue a warning about too low debt levels for the US as the Clinton administration presided over massive reductions thereof.

    To recall lyrics from an old song, "Nobody's right when everbody's wrong". Here both sides to the argument are injudicious. The economy is NOT a set of differential equations, not even those of Chaos. It is rather a Complex System which implies that as circumstances change so do the participants' reaction to stimuli. The notion that bright lines exist, here thinking of "90% debt to GDP" is hubris on a scale similar to Agamemnon's. Equally wrong-headed is the assertion that debt doesn't matter, no matter how much or what the circumstances.

    Even Isaac Asimov's Hari Seldon was more circumspect than our debaters today. But I suppose in these sorts of fora heat is valued more than light. Read more

  2. Comment Commented

    It has become clear that the side effects of perpetually low / zero interest rates (increasing wealth inequality, ruinous returns on long-term investments [pension black holes], and perverse incentives across both public and private sectors) need to be addressed.

    What is needed from both thought and political leaders is a roadmap that gets the world’s economies back to state of ‘normality’ and it seems the logical solution staring us in the face is a coordinated approach to:

    -public debt reduction via monetization to improve the debt profiles of the major western economies. This enables further long-term borrowing with higher rates while still incentivising governments to keep total debt as low as practicable.

    -an increase in interest rates and consequent restoration of returns for savers is crucial. The Bank of England has failed to explain how a rate of 0.25% will perceptibly alter the UK’s economic track from a rate of 0.5% - the drugs don’t work anymore they are just building up and storing problems for the future (asset price inflation and pensions deficits).

    -A long-term transition in fiscal policy that:
    1. Ensures the most profitable businesses and people pay tax at similar rates in similar countries and where they are making their profits
    2. Supports the significant technologically driven shifts in employment patterns to ensure stable demand in future decades

    Adolf Hitler gave us a crisis large enough to consummate the deals and ideas (League of Nations, currency convertibility with stabilising mechanisms, global and open trade arrangements) that were discussed and promulgated decades prior to WWII. Re-architecting the whole global monetary, trade, diplomatic and international legal systems with the UN, GATT, Bretton Woods etc took so much destruction and changing of the World order.

    It frightens me a little to think what magnitude of crisis is required in order to bring some coherence and ingenuity to bear on today’s major geo-political problems. Read more