Sustainable Government Debt – An Old Idea Refreshed

Sustainable government debt – an old idea refreshed

  • New research from the Peterson Institute suggests bond yields may fall once more
  • Demographic forces and unfunded state liabilities point to an inevitable reckoning
  • The next financial crisis may be assuaged with a mix of fiscal expansion plus QQE
  • Pension fund return expectations for bonds and stocks need to be revised lower

The Peterson Institute has long been one of my favorite sources of original research in the field of economics. They generally support free-market ideas, although they are less than classically liberal in their approach. I was, nonetheless, surprised by the Presidential Lecture was given at the annual gathering of the American Economic Association (AEA) by Olivier Blanchard, ex-IMF Chief Economist, now at the Peterson Institute – Public Debt and Low-Interest Rates. The title is quite anodyne, the content may come to be regarded as incendiary. Here is part of his introduction: –

Since 1980, interest rates on U.S. government bonds have steadily decreased. They are now lower than the nominal growth rate, and according to current forecasts, this is expected to remain the case for the foreseeable future. 10-year U.S. nominal rates hover around 3%, while forecasts of nominal growth are around 4% (2% real growth, 2% inflation). The inequality holds even more strongly in the other major advanced economies: The 10-year UK nominal rate is 1.3%, compared to forecasts of 10-year nominal growth around 3.6% (1.6% real, 2% inflation). The 10-year Euro nominal rate is 1.2%, compared to forecasts of 10-year nominal growth around 3.2% (1.5% real, 2% inflation). The 10-year Japanese nominal rate is 0.1%, compared to forecasts of 10-year nominal growth around 1.4% (1.0% real, 0.4% inflation).

The question this paper asks is what the implications of such low rates should be for government debt policy. It is an important question for at least two reasons. From a policy viewpoint, whether or not countries should reduce their debt, and by how much, is a central policy issue. From a theory viewpoint, one of pillars of macroeconomics is the assumption that people, firms, and governments are subject to intertemporal budget constraints. If the interest rate paid by the government is less the growth rate, then the intertemporal budget constraint facing the government no longer binds. What the government can and should do in this case is definitely worth exploring.

The paper reaches strong, and, I expect, surprising, conclusions. Put (too) simply, the signal sent by low rates is that not only debt may not have a substantial fiscal cost, but also that it may have limited welfare costs.

Blanchard’s conclusions may appear radical, yet, in my title, I refer to this as an old idea, allow me to explain. In business it makes sense, all else equal, to borrow if the rate of interest paid on your loan is lower than the return from your project. At the national level, if the government can borrow at below the rate of GDP growth it should be sustainable, since, over time (assuming, of course, that it is not added to) the ratio of debt to GDP will naturally diminish.

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