Jon Hilsenrath: Tame Inflation to Keep Fed on Course
Risks of Debt?: Extended Version

Risks of Debt?

And we are live at Project Syndicate:

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The piece:

A country that spends and spends and spends and does not tax sufficiently will eventually run into 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 corporations they run for fear of high future taxes on business. Real interest rates will rise because of policy uncertainty, and make many investments that are truly socially productive unprofitable. When inflation takes hold, the web of the division of labor will shrink from a global web he'd together by thin monetary ties to a very small web solidified by social bonds of trust and obligation--and a small division of labor means low productivity.

All of this is bound to happen.


If a government spends and spends and spends but does not tax sufficiently.

But can this happen as long as interest rates remain low? As long as stock prices remain buoyant? As long as inflation remains subdued?

My faction of economists--including Larry Summers, Laura Tyson, Paul Krugman, and many many others--believe that it will not. 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 governments are issuing is highly-prized as a store of value, helps savers sleep more easily at night, and provides a boost to the economy as it assists deleveraging and raises the velocity of spending.

Economists, you see, don't watch just quantities--the amount of debt a government has issued--but prices. And the prices of government debt are the rate of inflation, the nominal interest rate, and the level of the stock market as people trade bonds for commodities, bonds for cash, and bonds for stocks. And all three of these prices are flashing green: saying that markets would prefer and it would be better for the economy if government debt were growing at a faster pace than under current forecasts.

When Carmen Reinhart and Vince Kenneth Rogoff wrote their Growth in a Time of Debt, they asked the question:

Outsized deficits and epic bank bailouts may be useful in fighting a downturn, but what is the long run macroeconomic impact or higher levels of government debt, especially against the backdrop of graying populations and rising social insurance costs?

They saw "a threshold of 90 percent of [annual] GDP. Above 90 percent… growth rates fall… in [both] advanced and emerging economies…."

The principal mistake Reinhart and Rogoff committed in their paper and its analysis--indeed, the only significant mistake in the paper--was their use of the word "threshold".

It and the graph led very many astray. The usually-unreliable Washington Post editorial board condemned the "new school of thought about the deficit…. 'Don’t worry, be happy'" on the grounds that there is a "90 percent mark that economists regard as a threat to sustainable economic growth." (Admittedly, experience since the start of the millennium tells us that the Washington Post needs no empirical backup from anybody to lie and mislead.)

It misled European Commissioner Olli Rehn and many others to claim that "when [government] debt reaches 80-90% of GDP, it starts to crowd out activity." Both believe that Reinhart and Rogoff showed that if debt-to-annual-GDP is less than 90% an economy is safe, and that only if it is above 90% is the economy's growth in danger.

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% the bottom of the top bin. There is, instead, a gradual and smooth decline in growth rates as debt-to-annual-GDP increases. 80% looks only trivially different 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. Some times it is: a good deal of the relationship comes from countries where interest rates are higher and the stock market is lower where government debt is higher, and where higher debt does mean lower growth. Still more from countries where inflation rates are higher when government debt is higher. But some comes from countries where growth was already slow, and high government debt relative to GDP is, as Larry Summers constantly says, a result not of the numerator but of the denominator.

How much of this is left for a country with low interest rates, low inflation rates, buoyant stock prices, and healthy prior growth?

Not much, if any. Until interest and inflation rates begin to rise above normal levels or the stock market tanks, there is little risk to accumulating more government debt here in the United States. And there are large potential benefits from solving our real low employment and slack capacity problems right now.

Extended version: