Sunday, January 20, 2019

Public Debt In A Time of Growth (And Low Interest Rates)

If you attended the annual ASSA meetings this year, you may have watched or read Olivier Blanchard's American Economic Association presidential address entitled "Public Debt and Low Interest Rates".

Blanchard observes that for most of the post-war period, real GDP growth (g) has been higher than real interest rates (r). He further makes the point that if real growth is higher than real interest rates (r-g < 0), we can grow our way out of an existing debt stock with relative ease. Blanchard argues this is reason for us to be "less worried" about public debt and that debt is "less bad" than we think. There’s also some nice modelling using a Diamond OLG framework if you have the time to read all the way through.

It is true that there are only three ways to reduce public debt (other than default): 1) lowering fiscal deficits (G-T),  2) higher economic growth (g), and 3) seignorage (the latter of which we can and should ignore for inflationary reasons). While we often talk about #1 in fiscal policy/public debt discussions while #2 is either ignored or poorly quantified. Blanchard finally gives #2 the proper attention that it deserves.

Paul Krugman over at the NYT correctly observes and makes the related point that we didn't pay back the debt accumulated from WW2 (when debt-to-GDP was close to levels today around 100%) through taxes or spending cuts. Instead, the U.S. grew its way out through g, something that we we’re able to do in part because r-g < 0 for most of the 20th century (I’ll add while debt-to-GDP levels remained below 100% with a clear path to paying our way out.

We can certainly grow our way out of the existing stock of debt no problem as Blanchard observes, but what if deficits (G-T) persistently grow at rates higher than r-g? In other words, is r-g scalable at higher levels of debt-to-GDP? r-g aren't exogenous and r and g both depend a lot on the growth rate of G-T.

Here is what the r-g differential looks like for the G7 countries at higher levels of debt-to-GDP:

It appears the "Blanchard effect" (where r < g and grow out debt) ends somewhere between 50 to 100% of GDP (depending on the country). The US, which has the world's reserve currency, appears to be something of an exception which might be at the higher end of that range. 

What is causing the Blanchard effect to diminish as debt-to-GDP gets closer to 100%? More or less, it's the same story of Reinhart-Rogoff's "Growth In A Time of Debt" observation that growth begins declines non-linearly with GDP hitting a flashpoint somewhere around 100%:

The real interest rate however is largely invariant to Debt-to-GDP (historically real interest rates haven't changed much over the past 700 years):

Of course, if some event suddenly shifts expectations negatively toward an increased likelihood toward non-repayment of public debt, this sends r skyrocketing (the G7 examples exclude default cases like Greece and Argentina of the world, which hit default at very different levels of Debt-to-GDP).

Absent any shocks to default expectations, the “Blanchard effect” predicated on r-g seems like a real phenomenon to be taken seriously in lower. There could be other reasons behind the historical post-war r-g < 0 phenomenon such as the high productivity of the 20th century which may not continue into the 21st century indefinitely per Bob Gordon’s arguments.

That's not to say, that higher levels of debt-to-GDP couldn't be sustainable (or that there wouldn't be good reasons like increased investments in public education), just that this offsetting "Blanchard" effect which is a feature of the "specialness" of government debt that disappears at a certain point (between 50 and 100% of GDP) and shouldn't be a point of justification for additional debt increases.

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