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.
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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