April 21, 2015, 11:23 AM ET
Is Government Debt Too Low?
By Greg Ip
- The U.S. Treasury building in Washington, DC.
- Karen Bleier/Agence France-Presse/Getty Images
Government debt has skyrocketed since the financial crisis, and now tops 100% of GDP on average in rich countries. Is that too high? Oddly, it may not be high enough.
That’s the provocative suggestion Brad DeLong, from the University of California at Berkeley made at the International Monetary Fund’s “Rethinking Macro” conference last week.
Mr. DeLong, who also blogs for the Washington Center for Equitable Growth bases his argument on a simple observation.
The interest rate that rich countries with super-safe debt (in the case of the eurozone, that means Germany but not Spain) pay is astonishingly low: lower than the growth rate of nominal gross domestic product (that is, GDP before subtracting inflation). In the U.S., the Treasury yield has gone from roughly equal to growth in nominal GDP in 2005 to 3 percentage points lower today.
By Mr. DeLong’s reckoning, this means those countries are borrowing too little. Bond yields and prices move in opposite directions, so low government bond yields equate to very valuable government bonds. Mr. DeLong asks, “Isn’t the point of the market economy to make things that are valuable?” Since the debt of rich countries is “very cheap to make… shouldn’t we be making more of it?”
How does that work? How much the government should borrow depends on whether the taxes required to pay off that borrowing in the future are greater, or less than, the benefits that borrowing yields, today or in the future. By Mr. DeLong’s reckoning, the huge gap between interest rates and nominal growth is a signal that the government could borrow a lot more today and make society better off.
What should the government do with the money it borrows? Mr. DeLong’s frequent co-author Larry Summers has repeatedly urged governments to invest more in infrastructure. After all, whatever the return is on highways, airports, water treatment plants or education, it has to be higher than today’s rock-bottom governments bond yields.
But the money could also be used to cut taxes. The government could borrow $100 today, and hand it over to taxpayers. As long as interest rates stay at 2% and the government is happy to keep the debt constant as a share of GDP, and nominal GDP keeps growing at, say, 4%, it could then borrow $104 tomorrow, use $102 to pay off the first $100 with interest, and hand the $2 over to taxpayers as a tax cut.
Mr. DeLong would go further and borrow even more than the additional $4 tomorrow, in fact, he’d keep borrowing until the interest rate on government bonds is driven up to equal the growth rate.
(That, incidentally, is a point that Japan, with a debt equal to 246% of GDP, has already reached: its bond yields and nominal growth rate are both around 0.5%.)
Mr. DeLong’s proposal met with a fair bit of skepticism. “I have a lot of trouble with saying there is not enough government debt,” observed Jaime Caruana, head of the Bank for International Settlements. “If anything, there is too much of it.”
First, some asked, what if interest rates shoot up? Bond markets are notoriously fickle. Mr. DeLong says his read of history (and as an economic historian, his is a pretty good read) is that people don’t often lose their appetite all of a sudden for the debt issued by western European or North American governments absent some terrible bit of news.
Second, what if growth is slower in the future? Paulo Mauro, formerly of the IMF and now at the Peterson Institute for International Economics, raised this issue in a blog post critiquing Mr. Summers’ proposal for more government spending as a cure for “secular stagnation,” which is a persistent scarcity of demand.
In practice, Mr. Mauro notes, it’s hard to tell if slow growth is due to inadequate demand, or inadequate supply, i.e. problems related to technology, demographics, or excessive regulation.
“As years go by, these distinctions become blurred… what matters is whether economic growth in the next decade or two is going to be lower than policymakers assumed.”
For example, suppose the government projects debt will remain at 100% of GDP for the next decade or two. If growth turns out 1 percentage point lower than expected, the debt ratio would soar to 200% after 20 years. A study of many countries over the past century that Mr. Mauro co-authored while still at the IMF found that governments regularly fail to improve their budget enough when long-run economic growth slips.
Third, perhaps countries should reduce their debt to GDP ratios because they never know when they’re going to need the extra capacity to borrow. Harvard University economist Kenneth Rogoff argues government bond yields are low because private investors are fearful of some sort of catastrophe – a financial crisis, a war, or a pandemic – and bonds do much better than stocks in such scenarios.
If those fears are unfounded, Mr. Rogoff agrees it makes sense for governments to take advantage of these low interest rates and to borrow more. But if the fears are rational, then the government has to be ready for the day that catastrophe occurs, at which point it will have to borrow a lot. That means it needs a lower debt today.
Mr. DeLong’s response: surely the dismal state of global economic output today qualifies as that catastrophe.
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