Apr 29th 2013

When Is Government Debt Risky?

by J. Bradford DeLong

J. Bradford DeLong, a former Assistant US Treasury Secretary in the Clinton administration, is Professor of Economics at the University of California at Berkeley.

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.

Copyright: Project Syndicate, 2013.
www.project-syndicate.org

 


This article is brought to you by Project Syndicate that is a not for profit organization.

Project Syndicate brings original, engaging, and thought-provoking commentaries by esteemed leaders and thinkers from around the world to readers everywhere. By offering incisive perspectives on our changing world from those who are shaping its economics, politics, science, and culture, Project Syndicate has created an unrivalled venue for informed public debate. Please see: www.project-syndicate.org.

Should you want to support Project Syndicate you can do it by using the PayPal icon below. Your donation is paid to Project Syndicate in full after PayPal has deducted its transaction fee. Facts & Arts neither receives information about your donation nor a commission.

 

 

Browse articles by author

More Current Affairs

May 27th 2020
EXTRACT: "Obamagate is the latest conspiracy theory to be pushed by US president, Donald Trump. It started on the morning of May 10, when Trump retweeted the word “OBAMAGATE!” By the next day, the Obamagate hashtag had accrued over two million tweets and another four million by the end of the week. Trump has repeatedly reused the slogan on his Twitter feed since and it has been promoted by right-wing influencers including Glenn Beck, Sean Hannity and many others....You are not alone if you’re confused by what Obamagate actually is or why Trump is tweeting about it."
May 23rd 2020
EXTRACT: "Not all aspects of our near and medium-term future can be foreseen at this juncture of the Covid-19 pandemic, but we now know enough to make some hypotheses about what is likely to change, based on what has already changed. The future is sure to look very different than it did before this decade began, regardless of whether a vaccine is found. If a vaccine is found, it is unlikely to be tested, approved, manufactured, and efficiently distributed to the world’s population of nearly 8 billion people for years. Bearing in mind that there is no vaccine for any coronavirus, what is likelier is that the world will be living with Covid-19 as a part of our ecosystem for many years to come – possibly permanently. That means that our new normal is probably already here."
May 21st 2020
EXTRACT: "LONDON – The new Franco-German proposal for a €500 billion ($547 billion) European recovery fund could turn out to be the most important historic consequence of the coronavirus. It is even conceivable that the deal struck between German Chancellor Angela Merkel and French President Emmanuel Macron might one day be remembered as the European Union’s “Hamiltonian moment,” comparable to the 1790 agreement between Alexander Hamilton and Thomas Jefferson on public borrowing, which helped to turn the United States, a confederation with little central government, into a genuine political federation."
May 19th 2020
EXTRACT: "In April 2011, Donald Trump, then considering a run for the presidency the following year, said that he had sent investigators to Hawaii to check out rumors that President Barack Obama wasn’t born there, but in Kenya, which would disqualify him for the presidency. His investigators, Trump declared, “cannot believe what they’re finding.” I can find no record of Trump being challenged on this outlandish claim at the time. In the fall of 2016, Trump, now the Republican presidential nominee, was convinced by his staff that he had to abandon this “birther” nonsense. He did so reluctantly, charging – also with no evidence – that such rumors had actually been initiated by his opponent, Hillary Clinton. There, in a nutshell, is Trump’s modus operandi: he’s not just a liar but a fabulist, seemingly unconcerned with whether his fictions will be exposed. If they are, the world simply moves on as he invents fresh distractions."
May 19th 2020
EXTRACT: "Li, a doctor, was purportedly silenced and chastised by Chinese officials for warning on December 30, 2019, about a new virus in the Wuhan hospital where he worked. When it became evident that he was on to something serious – so serious, in fact, that it ultimately killed him – the Chinese government changed its tune and celebrated Li’s bravery. If only that had happened sooner, the argument goes, the world would have avoided this horrific pandemic.................... But that’s not what happened."
May 9th 2020
EXTRACT: "Jana Winter and Hunter Walker at Yahoo News broke the story that 11 Secret Service agents have tested positive for the coronavirus. Likely some of them served in the West Wing. This week it was revealed at that a US military valet who brought Trump food came down with the virus, sending Trump into a “lava level” rage. Two aides to Vice President Mike Pence have tested positive. Some observers are afraid that the virus is circulating in the West Wing itself."
May 6th 2020
EXTRACT: "There has been much debate around the world about the source of the COVID-19 pandemic, ranging from a laboratory to Wuhan’s seafood market to some other form of animal-to-human transmission. While there is no proof (yet) that the virus may have been inadvertently released from one of the two biological research laboratories located at Wuhan, there is evidence that viral release has occurred in the past, and a host of additional data that point to a laboratory connection. "
May 4th 2020
EXTRACT: "A better bet is that nothing will be the same. Wealth will be destroyed on a catastrophic scale, and policymakers will need to find a way to ensure that, at least in some cases, creditors take part of the hit, a process that will play out over years of negotiation and litigation. For bankruptcy lawyers and lobbyists, it will be a bonanza, part of which will come from pressing taxpayers to honor bailout guarantees. Such a scenario would be an unholy mess."
Apr 29th 2020
EXTRACT: "We need the twenty-first century’s two superpowers, America and China, to set the example, by burying their rivalry and uniting all of humankind around a collective response to the current crisis, and to those that await us. As COVID-19 has taught us, the old international system can no longer guarantee humankind’s safety and security. We cannot afford to be taught that lesson twice."
Apr 29th 2020
EXTRACT: "It should come as no surprise that Trump has abused his power in orchestrating the federal response to the pandemic. For example, he made sure that Colorado received 100 much-needed ventilators, and made sure that Colorado voters knew it, in order to help re-elect troubled incumbent Republican senator Cory Gardner.  More alarming, Trump effectively threatened to wage germ warfare against US Postal Service workers by denying them congressionally approved virus-mitigation aid unless the USPS quadrupled rates on packages. Trump’s actual target was Jeff Bezos, the CEO of Amazon and owner of The Washington Post."
Apr 28th 2020
EXTRACT: "These ten risks, already looming large before COVID-19 struck, now threaten to fuel a perfect storm that sweeps the entire global economy into a decade of despair. By the 2030s, technology and more competent political leadership may be able to reduce, resolve, or minimize many of these problems, giving rise to a more inclusive, cooperative, and stable international order. But any happy ending assumes that we find a way to survive the coming Greater Depression."
Apr 26th 2020
EXTRACT: "In response to the COVID-19 pandemic, the US Federal Reserve will buy unlimited quantities of Treasury bonds, the Bank of England will purchase £200 billion ($250 billion) of gilts, and the European Central Bank up to €750 billion ($815 billion) of eurozone bonds. Almost certainly, central banks will end up providing monetary finance to fund fiscal deficits. The only question is whether they should make that explicit."
Apr 25th 2020
EXTRACT: "Even if you’re not enamoured with creepy crawlies, their gradual disappearance from the places they were once numerous is an ongoing crisis for the natural world. Insects and small invertebrates occupy the bottom rungs of most terrestrial ecosystems. As ecologist E.O. Wilson once observed, if you take away the “little things that run the world” then most of the creatures occupying niches further up the food chain will disappear too, and that includes humans. That’s why a 2017 study in Germany rang so many alarm bells – it reported a 75% decline over 27 years in the local biomass of all kinds of flying insects."
Apr 24th 2020
EXTRACT: "By 2000, China had already established near monopoly status on the manufacture of a whole range of products that the world rapidly consumes. Just a decade ago, 91% of all personal computers, 80% of all air conditioners, 74% of global solar cells, 71% of cell phones, and 60% of all cement were being manufactured in China. The world was hooked on Chinese-made products and the Chinese government had its way with foreign companies choosing to manufacture goods there, enforcing many draconian operating requirements in an environment that most companies would never have agreed to endure anywhere else."
Apr 20th 2020
Extracts: "Long before people and goods were traversing the globe non-stop, pandemics were already an inescapable feature of human civilization.........Nearly two millennia before London’s Great Plague, during the epidemic that killed at least one-third of Athenians near the end of the Peloponnesian War.............Epidemics not only ravage economies, but also throw societal inequalities into sharp relief, deepening deepen mistrust in the status quo........... Machiavelli, who witnessed – and probably died in – the plague in Florence in 1527, viewed the outbreak as the direct result of misrule. Criticisms of China, Trump, British Prime Minister Boris Johnson, and others have echoed this sentiment....Others view epidemics through the lens of conspiracy theories. Marcus Aurelius blamed the Christians for the Antonine Plague. In Christian Europe, the fourteenth-century Black Death was blamed on the Jews......Despite these similarities, the COVID-19 pandemic is likely to stand out in a crucial way: it is unlikely to upend the established order. The Antonine and Justinian Plagues encouraged the spread of Christianity throughout Europe. The Black Death drove people toward a less religious, more humanistic view of the world – a shift that would lead to the Renaissance. The Spanish flu prompted uprisings, massive labor strikes, and anti-imperialist protests; in India, where millions died, it helped to galvanize the independence movement."
Apr 17th 2020
EXTRACT: "From peddling disinformation about the virus to disbanding the National Security Council directorate overseeing pandemic threats, Trump has squandered multiple opportunities to get ahead of the COVID-19 crisis. The health and economic consequences that we are now experiencing have long been predicted. US intelligence analysts were warning about precisely this scenario for at least 12 years. But even they could not foresee that America would end up with a president willing to sacrifice so many lives on the altar of his ego."
Apr 9th 2020
EXTRACTS: ".........[1] The average bankruptcy takes 260 days to work out. During that period, businesses will have a hard time rebuilding.......[2]...consider the complexity of the global supply chain. More than 90% of Fortune 1,000 companies have at least one tier-2 (secondary) supplier in Hubei, the Chinese province around Wuhan.........[3]...disturbingly, 40% of all US corporate debt was rated BBB, just above junk, going into the crisis, while only 30% of the world’s outstanding stock of non-financial corporate bonds were rated A or above..........[4] Despite central bank interest-rate cuts, borrowing costs for companies are now rising dramatically. With further downgrades from credit ratings agencies all but guaranteed, especially with many big earnings announcements due after Easter, some companies will lose access to credit altogether. Moody’s estimates that the default rate for junk-rated companies could hit an astounding 10%, compared to a historical average of 4%......[5]...flu vaccines are relatively ineffective. They reduce your risk of becoming ill by 40% to 60%, compared to 97% for measles vaccines and 88% for mumps........[6] Lockdowns might end, while other measures like social distancing, limits on gatherings and travel restrictions continue – perhaps on a seasonal basis......[7] South Korea could be a glimpse into the future. It has so far avoided an Italian-style health crisis without a lockdown, but has still imposed various restrictions on the economy."
Apr 8th 2020
EXTRACT: "A recent study, published in the British Medical Journal, suggested that 78% of people with COVID-19 have no symptoms. The findings are in line with research from an Italian village at the epicentre of the outbreak showing that 50%-75% were asymptomatic, but represented “a formidable source” of contagion. A recent Icelandic study also showed that around 50% of those who tested positive to COVID-19 in a large-scale testing exercise were asymptomatic. Meanwhile, a WHO report found that “80% of infections are mild or asymptomatic, 15% are severe infections and 5% are critical infections................The new BMJ study is seemingly different to the findings of studies from earlier in the pandemic, which suggested that the completely asymptomatic proportion of COVID-19 is small: 17.9% on the Diamond Princess Cruise Ship and 33.3% in Japanese people who were evacuated from Wuhan.”
Apr 8th 2020
EXTRACT: "Spooked by COVID-19, Americans not only stripped supermarket shelves of toilet paper and pasta, but also drove gun sales higher than ever. Apparently, many of these recent gun buyers never purchased a firearm before. Lobbyists for the US gun industry want gun stores to be counted as “essential” businesses, like food shops and pharmacies. A number of states have readily complied, as has the Department of Homeland Security. Jay Pritzker, Governor of Illinois, declared that “firearm and ammunition suppliers and retailers, for purposes of safety and security” should indeed be allowed to continue supplying these alleged necessities."
Apr 8th 2020
EXTRACT: "........until the health crisis is resolved, the economic situation will look exceedingly grim. And even after an economic restart, the damage to businesses and debt markets will have lingering effects, especially considering that global debt was already at record-breaking levels before the crisis began..............Given that the 2008 financial crisis produced deep political paralysis and nurtured a crop of anti-technocratic populist leaders, we can expect the COVID-19 crisis to lead to even more extreme disruptions. ............it is possible that stock-market losses so far have been less than those of 2008 only because everyone remembers how values shot back up during the recovery. But if that crisis does turn out to have been a mere dry run for this one, investors shouldn’t expect a quick rebound."