Originally published at Project-Syndicate | Dec 1st, 2023
Once again, larger deficits and higher debt-to-GDP ratios in rich countries have become fodder for fiscal hawks and bond vigilantes to warn of a looming crisis that will demand a return to austerity. But the case for such pessimism has no logical or historical basis.
AUSTIN – In a recent commentary for the Financial Times, Martin Wolf trots out the specter of a “public-debt disaster,” that recurrent staple of bond-market chatter. The essence of his argument is that since debt-to-GDP ratios are high, and eminent authorities are alarmed, “fiscal crises” in the form of debt defaults or inflation “loom.” And that means something must be done.
While Wolf does not say explicitly what that something is, “painful fiscal choices seem to lie ahead.” Cue the chorus calling for cuts to Social Security and Medicare in the United States, and to the National Health Service in the United Kingdom.
To bolster his argument, Wolf revisits an equation relating real (inflation-adjusted) interest rates, real growth rates, the “primary” budget deficit or surplus (net of interest payments on public debt), and the debt-to-GDP ratio. It is a familiar device, first offered up in a 1980s working paper by Olivier Blanchard, then at MIT. I analyzed it in depth for the Levy Economics Institute in 2011, and Blanchard recently revisited it for his blog, with this conclusion: “If markets are right about long real rates, public debt ratios will increase for some time. We must make sure that they do not explode.”
Since nobody likes explosions, let us agree with Wolf that “the most important point is that the debt must not grow explosively,” and also that “a particular debt ratio cannot be defined as unsustainable.” The second point is a nod at Carmen M. Reinhart and Kenneth Rogoff, both of Harvard, whose once-famous 90% debt-to-GDP threshold has long been exceeded in many countries without blowing anything up.
The problems begin with Wolf’s claim that “the higher the initial [debt-to-GDP] ratio and the faster it is likely to grow, the less sustainable the debt is likely to be.” While the second conditional clause is circular (the more explosive, the more explosive), the first is incorrect. Under normal conditions, the higher the initial ratio of debt to GDP, the more sustainable it is likely to be.
In the large, rich countries that Wolf is writing about, it is normal for the average real interest rate on government debt – the safest asset – to be below the rate of real economic growth. More precisely, it is normal for the nominal interest rate to be lower than the nominal GDP growth rate (real growth plus inflation). Given the normal relationship of interest to growth, the debt-to-GDP ratio declines more if the initial debt stock is larger. Thus, under normal conditions, the primary deficit (not surplus) compatible with a stable debt-to-GDP ratio is larger with a larger debt-to-GDP ratio. The suggestion that a high initial debt-to-GDP ratio is necessarily more explosive than a lower one may seem intuitively correct, but it is false.
American history and recent experience bear this out. US debt peaked at about 119% of GDP in 1946, then fell for 35 years, despite major wars in Korea and Vietnam, the Kennedy-Johnson tax cuts, and the broader Keynesian Revolution. After reaching a low of about 30% of GDP around 1981, US debt grew rapidly on the back of a recession, tax cuts, and higher military spending – though with no debt disaster. It peaked again at 127% during the COVID-19 pandemic. Three years later, it is down to 119%, despite very large deficits. If Wolf were right about the bad consequences of a high starting point, this would not have happened.
Deficits and high debt-to-GDP ratios are not the problem. What matters is the difference between the interest rate and the growth rate. For many years, the US Congressional Budget Office has regularly projected that high interest rates and low growth rates would lead to a debt explosion. But those projections were always wrong – until the US Federal Reserve started jacking up interest rates last year. But now, both Wolf and Blanchard are warning that we could be facing high interest rates for a long time.
Why is that? On interest rates, Wolf is correct that, “Higher long-term inflation expectations cannot be a large part of the reason for the jump in nominal yields.” This conclusion reflects the now-vindicated view that recent price increases were transitory. But Wolf follows up with a sentence that manages to be both logical and full of nonsense: “This leaves an upward shift in equilibrium real rates or tighter monetary policy as the explanations.” Actually, monetary tightening is the only explanation. Wolf could just as correctly have written, “This leaves Napoleon’s defeat at Waterloo or tighter monetary policy as the explanations.”
What – or rather, who – is keeping the interest rate high? Wolf knows very well: Fed Chair Jerome Powell and his counterparts in Europe. Since Wolf knows that central bankers can cut interest rates whenever they like, he hedges, correctly, on the “likelihood…that interest rates will rise with debt levels.” To explain Italy, where the primary deficit was low, he throws in a quasi-Victorian line about that country getting “punishment for earlier profligacy.” He notes that Japan, with its majestic debt-to-GDP ratio, is “the exception” to high interest rates, though he surely knows that a law with such exceptions is no law at all.
If, as Wolf fears, “real interest rates might be permanently higher than they used to be,” the culprit is monetary policy, and the real risk is not rich-country public-debt defaults or inflation. It is recession, bankruptcies, and unemployment, along with inflation and debt defaults in poorer countries whose debt-to-GDP ratios are usually much lower.
Wolf surely knows that the proper remedy is for rich-country central banks to bring interest rates back down. Yet he doesn’t want to say it. He seems to be caught up, possibly against his better judgment, in bond vigilantes’ evergreen campaign against the remnants of the welfare state.
James K. Galbraith: Professor of Government and Chair in Government/Business Relations at the University of Texas at Austin, is a former staff economist for the House Banking Committee and a former executive director of the Joint Economic Committee of Congress. From 1993-97, he served as chief technical adviser for macroeconomic reform to China’s State Planning Commission. He is the author of Inequality: What Everyone Needs to Know (Oxford University Press, 2016), Welcome to the Poisoned Chalice: The Destruction of Greece and the Future of Europe (Yale University Press, 2016), and the forthcoming Entropy Economics: The Biophysical Basis of Value and Production (University of Chicago Press).