In the previous three posts in this series, I have argued that large fiscal deficits are a more or less inevitable concomitant of post-financial crisis deleveraging by the private sector. Moreover, I have argued, substituting a solvent debtor (the government or taxpayers, in general) for insolvent (or illiquid) private ones is feasible and desirable in an economy going through a balance-sheet recession. It is therefore quite possible to get out of debt by going into it, because they are not the same debtors. And the distribution of the debt, not its level, is what matters.
Needless to say, arguments can be made against this point of view and alternative policies considered. But, before considering those arguments and alternatives, it is crucial to stress one point: no pain-free escapes from the consequences of a huge credit boom and consequent private sector debt overhang exist. We are trading off bad alternatives.
The simple argument for taking the fiscal deficit route is that in countries in balance-sheet recessions that are lucky enough to have their own currency, rates of interest on long-term debt can be very low. This is because the depression condition is, rightly, expected to be long-lasting. An economy in such a liquidity trap has excess ex ante savings and so ought to have very low interest rates as Paul Krugman has argued in the New York Times.
If interest rates are very low, the cost of running fiscal deficits is also very low. Indeed, with real rates of interest in the US and UK close to zero, government borrowing is now free, in real terms. (See the extraordinary charts below, in which bond yields collapse as the fiscal deficits soar.) So why not borrow?
So what is the objection to running such deficits? The most potent comes from Carmen Reinhart, Vincent Reinhart and Kenneth Rogoff, in “Debt Overhangs: Past and Present”, April 2012. This is from the abstract of their paper:
“We find that public debt overhang episodes [when ratios of public debt to gross domestic product exceed 90 per cent] are associated with growth over one per cent lower than during other periods. Perhaps the most striking new finding here is the duration of the average debt overhang episode. Among the 26 episodes we identify, 20 lasted more than a decade. Five of the six shorter episodes were immediately after World Wars I and II. Across all 26 cases, the average duration in years is about 23 years. The long duration belies the view that the correlation is caused mainly by debt build-ups during business cycle recessions. The long duration also implies that cumulative shortfall in output from debt overhang is potentially massive. We find that growth effects are significant even in the many episodes where debtor countries were able to secure continual access to capital markets at relatively low real interest rates. That is, growth reducing effects of high public debt are apparently not transmitted exclusively through high real interest rates.”
I have great respect for these authors who have made enormous contributions to our understanding of debt crises. But what conclusion should one draw from their analysis?
The conclusion one cannot draw is that public debt must be kept below 90 per cent of GDP, whatever the cost. Struggling to keep debt below 90 per cent of GDP might be far more costly than letting debt rise above that threshold. As in almost everything in economics, it is all about choosing the best (or, in this case, least unpleasant) alternative.
Whether the least costly option is accelerated fiscal austerity depends on the following points.
First, it depends on why the public debt is accumulated. In many cases, the reason for the debt was the need to fight wars. The authors probably do not wish to argue that the UK should not have fought World War II because it led to excessive public debt (peaking at close to 250 per cent of GDP). Again, if the government’s borrowing was aimed at reducing the economic impact of private sector deleveraging, the economic costs of keeping debt below 90 per cent, instead, could well exceed the costs of allowing debt to rise above it. The authors do not analyse such counterfactuals.
Second, it depends on the direction of the causality: does high debt lower growth or low growth raise debt? The authors themselves note that:
“Another line of reasoning for dismissing concerns about public debt and growth is the view the causality mostly runs from growth to debt. The multi-decade long duration of past public debt overhang episodes suggests that at very least, the association is not due to recessions at business cycle frequencies.”
That may well be true. But huge debt crises that follow credit booms are not normal business cycle events: in advanced countries, they are once- or twice-in-a-century events.
Again, we need to analyse what is going on in particular contexts. In the case of Japan, for example, it seems quite plausible that a collapse in growth opportunities after 1990 also lowered investment opportunities. This then generated long-lasting financial surpluses in the corporate sector, whose counterparts were high fiscal deficits. The causality would then indeed go from poor growth opportunities to high public debt, rather than the other way around.
Third, as the authors again note:
“[S]ome dismiss concerns about high debt, citing the immediate period after World War II for the United States and United Kingdom, and pointing to the fact that the United Kingdom had extremely high debt after the Napoleonic Wars. Our analysis, based on these cases and the twenty three others we identify, suggests that the long term risks of high debt are real.”
Among those “some”, are, I suspect, me. Again, let us accept that very high public debt ratios may create problems. None the less, the period after the Napoleonic War was when the UK began its industrial revolution and the post-war period was one of good economic performance, in both the US and UK. The conclusion is that high debt can be perfectly manageable in countries that know how to manage it.
Finally, as the authors also note:
“this paper should not be interpreted as a manifesto for rapid public debt deleveraging in an environment of extremely weak growth and high unemployment. “
In other words, they agree that the context does matter. Yes, very high public debt may cause problems. But it may still be the least bad alternative: it may make no sense to suffer a huge slump now in order to avoid a putative slowdown in growth later on.
It is all about timing. While the private sector is deleveraging and so running large financial surpluses, large fiscal deficits are necessary, provided they can be sustained, as they certainly can be in the US. Once the deleveraging is finished and the economy recovers, the fiscal deficit will need to be closed. The key is to introduce policy commitments on taxes and spending that make a closure of the deficits credible.
Nevertheless, it must also make sense to consider alternatives to large and continuous fiscal deficits as ways of managing the macroeconomic impact of post-crisis deleveraging. I do that in the next and final post in this series.