The Interest Rate Time Bomb

The recent policy debate over whether its time for interest rates to start to rise after being at the lowest levels since the Great Depression for nearly five years shows just how much of a policy box governments are in when it comes to fiscal and monetary policy.  Never mind the debate over whether there is a trade-off between monetary stimulus and financial stability. Raising rates to reduce the perverse incentives on long-run economic behavior and activity comes with the risk of destabilizing public finances by raising debt service costs.

On the one hand, the global economy has been stagnating for five years and it can be argued still requires monetary stimulus in the form of low interest rates and fiscal stimulus in the form of deficits and expansionary fiscal policy.  On the other hand, low interest rates are having perverse economic effects in the form of encouraging excessive risk taking and potential asset bubbles as well as reducing the returns to savers.  Moreover, much like the case for home buyers, low interest rates have also been a factor in reducing the burden to governments of acquiring debt.

Here is the policy box. Low interest rates and the size of public sector debts and deficits are not mutually exclusive policy choices.  Any move that raises interest rates will substantially raise debt-servicing costs and actually worsen many countries fiscal positions at least in the short run.  Let’s take the example of Canada.  For the 2011-12 fiscal year, total expenditures for the federal government were 271.423 of which 31 billion dollars was debt service costs with a net debt of 650.1 billion dollars (see Federal Fiscal Reference Tables).   The debt service share of total federal government expenditures is 11.4 percent and the “effective interest rate” on the net debt was 4.8%. If the effective interest rate is simply one percentage point higher – at 5.8% - then debt service costs would have been 37.7 billion dollars or 14 percent of total federal expenditure.  Just one percentage point in the effective interest rate on the entire net debt increases spending by almost seven billion dollars without any stimulus increase on government programs or spending on goods and services.  It is simply a transfer to bondholders.

Take the United States federal budget as a second example.  In 2012, total spending by the US federal government was 3.537 trillion dollars of which 220 billion was net interest for a debt service share of 6.2 percent of federal expenditure (see US federal budget documents).  Net financial debt in 2012 was 10.282 trillion dollars resulting in an “effective interest rate” of only 2.1 percent.  An increase in the effective interest rate by 1 percent to 3.1 percent raises debt service costs to 319 billion dollars thereby raising federal spending by 99 billion dollars and bringing the debt service share of federal spending to 9 percent. 

By historic standards, these are small increases in the effective interest rate on net debt. Larger increases would have even greater impacts on the bottom line.  A return to the rates of even the mid to late 1990s would be nothing short of catastrophic in terms of the havoc they could wreak on public sector budgets.  Now of course, interest rate increases are phased in gradually as debt rolls over but my point remains the same.  Despite the perverse long-term impact of low interest rates on economic incentives when it comes to private saving and investment behaviour as well as government debt accumulation, the short-run impact of raising interests on government budgets will also be harsh and substantial.    Borrowing from Nick Rowe’s recent pole analogy – policy makers are like tightrope walkers with a balancing pole that has interest rates on the one side and government budgets on the other.  If interest rates are raised, the other side will not necessarily move up to counterbalance without deliberate fiscal policy action – it can move down and toss you over.  At the same time, raising interest rates and new austerity on the fiscal side to counteract the effect of high interest rates on government budgets - well, that is the kind of nightmare that must keep central bankers and finance ministers on the edge of their seats. The C.D. Howe piece by Paul Masson on why interest rates should go up outlines and deals with two major objections to raising them - yet the effect on public sector budgets is not one of them.

Comments

[Vladimir]

If interest rates rise -yes that increases the cost of debt service. Interest rates for many governments like Canada where markets are unlikely to question-- in the short run-- the solvency of the sovereign will only rise as the pace of economic activity quickens and resources are more fully employed. This of course will mean a revenue windfall for government--increasing tax revenues-and reduce spending on various social insurance programs. Additionally measures take to stimulate growth will also be wound down. You therefore can't make an apriori assumption that governments face an interest rate risk of any great magnitude without explaining why rates will go up but the economy remain below it's trend growth rate. For those who manage government debt no doubt a key question right now is whether to take advantage of these rates and try to tilt the balance of outstanding debt toward longer term bonds.

[Determinant]

Livio, I don't get your reasoning here.

Raising rates to reduce the perverse incentives on long-run economic behavior and activity comes with the risk of destabilizing public finances by raising debt service costs.

We're in a Liquidity Trap.

On the one hand, the global economy has been stagnating for five years and it can be argued still requires monetary stimulus in the form of low interest rates and fiscal stimulus in the form of deficits and expansionary fiscal policy.

It's been stagnating because we're in a Liquidity Trap. There is an excess of Savings over Investment, which makes the clearing rate of interest negative. Due to ZLB, this cannot be realized easily, leading to the Trap condition. We haven't faced this particular condition in Canada since the 1930's, but it's back, which is why this Recession is the Lesser Depression and it has every appearance of being the Great Depression's kid brother.

If the effective interest rate is simply one percentage point higher – at 5.8% - then debt service costs would have been 37.7 billion dollars or 14 percent of total federal expenditure. Just one percentage point in the effective interest rate on the entire net debt increases spending by almost seven billion dollars without any stimulus increase on government programs or spending on goods and services. It is simply a transfer to bondholders.

Wow, there is a huge unstated assumption there that income is constant. That's untenable, in my opinion. Right now we are in a classic Keynesian Liquidity Trap, with inflation low and falling. Nowhere is there any sign of runaway inflation. Any interest rate increase at this point would be from increased economic activity, which leads to higher tax receipts and higher ability to carry debt. What's the problem, that's exactly what we want!

I'm sorry, without consideration of the income side of the equation I can't see that there's a problem. ISTM that your argument falls on that.

[Max]

I have a cynical view of this debate - some people want higher rates because they produce an immediate profit boost for them. The arguments in favor are just insincere blather.

As an example, Schwab has published multiple editorials in the WSJ calling for higher rates. One of Schwab's major profit streams is interest on customer cash, so near-zero rates directly reduce Schwab's profits. Of course they can't say "gimme more profit!" in their editorials - they need to come up with something more persuasive.

[K]

Livio,

"encouraging excessive risk taking and potential asset bubbles as well as reducing the returns to savers."

Reducing returns to savers is *designed* to get them to take investment risk. The whole point is to encourage risk-taking! If risk-taking was excessive there wouldn't be over 7% unemployment. 

Where's the evidence of a bubble or any sort of trade off whatsoever?

"A return to the rates of even the mid to late 1990s would be nothing short of catastrophic in terms of the havoc they could wreak on public sector budgets."

Except, of course, that NGDP growth was correspondingly higher back then. In fact, if you look back over the past 50 years of North American economic history, apart from one or two years in the early eighties, there is not a single period where the policy rate exceeded NGDP growth. There is just no theoretical *or* empirical justification for postulating interest service being a significant contributor to the debt/GDP ratio. 

[Donte]

lol, if rates returned to late 90's levels, there would be no public debt to service. You simply aren't getting that.

Matter fact fact, those nominal rates were in fact nominal.

[rsj]

I don't understand the need for such incendiary language -- "time bomb". The whole article relies on a lot of non-sensical claims that serve no purpose other than move the scare story forward:

1) The CB is lying when it says it will keep rates low even once the recovery starts in order to try to generate excess future inflation
2) That government revenues are independent of changes to NGDP, so we can play a game of pretend in which an increase in interest payments necessarily must cause an increase in the revenue share of interest payments.
3) That the CB will, inexplicably, raise interest rates above the NGDP growth rate in an environment of depressed demand
4) That household savings demands will suddenly and rapidly decrease

I have to think that given the irrelevance of huge deficits run by nations with their own currency, the deficit-scolds are forced to invent their own reality in which ticking time bombs are just around the corner.

[Determinant]

Deficit-Scolds, next it'll be Very Serious People. Paul Krugman's articles are having a worldwide effect in a way he didn't intend, I see. ;)

[rsj]

Ha! You are right!

[Ralph Musgrave]

Vladimir is right: this is one huge non-problem.

[jt]

Assuming a "consolidated and coordinated behaviour" of the US Fed + federal gov I can see this being a non-issue (so others argue). What about Canada, with very large provincial debts? Is it in a more precarious position?

[Frank Restly]

Livio,

"Here is the policy box. Low interest rates and the size of public sector debts and deficits are not mutually exclusive policy choices."

They can be IF:
1. The fiscal authority switches from coupon bonds to accrual (non-coupon) bonds
2. The fiscal authority does not limit the duration of the securities that it sells.

The limiting factor on a the size of the public debt is the annual interest payments that must come from tax revenue.

For coupon securities, the amount of annual interest paid is:

Interest Expense = Total Debt * Annual Interest Rate

For accrual securities, the amount of annual interest paid is:

Interest Expense = ( Total Debt / Average Duration ) * ( 1 + Annual Interest Rate ) ^ Average Duration

For accrual securities the Annual Interest Rate is some Term Premium times the Short Term Interest Rate

Interest Expense = ( Total Debt / Average Duration ) * ( 1 + Term Premium * Short Term Interest Rate ) ^ Average Duration

With accrual securities, extending duration can lower the annual amount of interest paid.

[Tim]

It seems to me that if the effective interest rate is currently 4.8%, while 1 years bonds are yielding 1.05% (30 year 2.53%), then that rate is currently falling as debt rolls over. Further more, even if the Bank of Canada raises its overnight rate by the 1% you use in your analysis (to 2%) those rates would continue to fall.

[J.V. Dubois]

This may be considered a good article in regular business newspaper promoting the "good thing" of not being scared of low interest rate using flawed language that readers are used to. But it is still wrong. Doubly so that it was posted on a blog where reasons why it is wrong are spelled every other day.

If anything one should learn from market monetarist blogs that interest rates are unreliable. One cannot look at solely at nominal interest rate and claim that they are low or high. Interest rates should be always seen in context of the monetary policy stance, which can be observed from thing like inflation and nominal income growth. Are inflation and NGDP growth "low" (lagging behind trend)? Then it is a very bad idea to have CB increasing interest rates. Not because it has this or that impact on fiscal policy. But because it will make already tight monetary policy tighter - which will mean that sometime in the future CB will have to ease it (by lowering interest rates) or accept higher unemployment and depression. And because people do not like unemployment and depressions, it is more likely that we will see the former - look how much good did ECB interest rate hike do in 2011. The economic condition worsened so much that ECB did not only revert the interest rate hike but cut it a little bit more. And looking at NGDP and inflation in Eurozone it is by far not enough. ECB baby steps toward easier monetary policy can be seen as passive tightening if one looks at relevant making macroeconomic indicators like inflation and NGDP. This is why MM sometimes say that low interest rates may be a result of past tight money.

[Livio Di Matteo]

I find it amusing that economists are faulted when they fail to anticipate future economic situations and told they are presenting non-problems when they lay out what future economic issues may arise. I still think that increases in the interest rate on government debt has the potential to become a more important public finance problem for governments given the mass of debt that has been accumulated to date as a result of fiscal stimulus as well as the low cost of acquiring more debt due to low rates. I can recall the early 1980s and the early 1990s when debt service costs soared due to rising interest rates and deficits. The economic and policy conditions of that period that drove the high rates were of course very different then and not being replicated at present. But given the level of debt that has been incurred, if rates rise, debt service costs will rise. In Canada, the combined level of federal and provincial net debt has been estimated at about 1.2 trillion dollars - with GDP at about 1.7 trillion. Federal debt service costs in 2011-12 were 31 billion dollars. Compare that to what the federal government spent on Old Age Security (38 billion), Employment Insurance (17 billion dollars) or the Health and Social Transfer (38 billion). In Ontario, the amount of debt service (10.6 billion dollars) exceeds what it spends on colleges and universities (7.6 billion) or transportation (2.8 billion). If debt service is starting to rival government expenditure categories on programs at "low"interest rates, then we should be concerned about interest rates rising and their impact on government finances.

[J.V. Dubois]

There are two stories one hears a lot nowadays. In the first story governments spend too much on wasteful projects crowding out private spending and investment. In this story easing monetary policy will achieve nothing - besides higher inflation. Many proponents of this theory actually shout loudly that money is already too easy despite low inflation and low NGDP growth. They explaining it either by pretending that this question was never asked, by pretending that low interest rates means easy money or by bad data, or by supporting volume of flawed evidence etc. But this is basically a story of supply-side recession.

Then there is another story where economy experienced a large nominal shock to incomes and is it is now stuck in a bad equilibrium where some sticky prices (especially wages) will not clear leaving us with unemployment and unused production capacity. MM claim that the nominal shock was brought upon us by mismanagement of central banks back in 2007 and continuation of bad monetary policy. The best solution for this is to jump-start demand prefferably by "unorthodox" monetary policies - such as creating the money printing path that is consistent with economy with sufficient demand (yeah how "unorthodox" for central bank to print money, right)?

Then some people - like Scott Sumner - say that we may have both. We may have experienced shifts in both - aggregate demand and aggregate supply. But the first one is way easier and quicker to solve by printing money. Then we may think about the supply side problem.

So where comes your story into this? It comes nowhere. Because you focused on the wrong problem. Because "central bank rising interest rate" is insufficient information. Because there are two ways how CB can "increase interest rates". The first one is that it will tighten the monetary policy which means deflation and unemployment. But sure, crazy enough central bank can certainly do this, especially if noone important seems to understand that it was CB that caused the trouble (like ECB in 2011). Or there is a way where Central Bank may achieve interest rates increase by printing money - enough to bring equilibrium to the labor market. And then at the point where the money velocity picks up, when inflation will threaten to push NGDP growth way too much, then CB can with clear conscience increase interest rate - without even thinking about fiscal policy.

The moral of the story is that it is just wrong to shackle monetary policy with fiscal considerations. It is never good for a nation to have a bad aggregate demand policy. There is no situation where bad aggregate demand policy is a price to pay for some particular thing. Not for supposed fiscal problems. Or for soothing egoes of hedge fund managers who made bets against CB. Or to "protect European savers". Or to prevent runaway lending by banks. Or whatever. The price is just too high and many times you end up with the exact opposite anyways.

[Determinant]

I'm quite open to Aggregate Supply problems, I acknowledge they exist. But they don't exist right now, not on the order of our Aggregate Demand problems.

Respectfully, Livio, your post appears to embody a "Anchoring Effect" in which economic problems are compared to the 1970's/80's in a Stagflation framework. It's a common human bias to make such analyses, but the problem in economics is that the present crisis is not the 1970's, it's the 1930's. There are far more similarities with the Great Depression than there are with Stagflation, which is why Paul Krugman and his traditional Keynesianism has done so well as an theoretical framework.

Starting in 1981 (when we were as far from a Keynesian paradigm as we were ever going to get) we managed to blow ourselves back to 1935 in the space of 30 years.

[Livio Di Matteo]

I suppose we all have our biases and mine have been shaped by coming of age during the recessions of the early 1980s and early 1990s. True, our current situation is not the 1970s but it is also not really the 1930s either. The present situation is quite unique in that it was marked by Depression-like economic forces but many of the worst effects were partly mitigated by successful and quick deployment of monetary policy and fiscal stimulus - unlike the 1930s. As well, interest rates were already low prior to 2008-09 as a result of dealing with the tech crash. Also, international trade has not dried up like the 1930s. Unemployment in North America during the 1930s was over 20%. At present, there are some European countries that are marked by Depression-like conditions (eg. Spain) but others that are not - such as Germany. Canada itself has escaped relatively unscathed. However, one of the side effects of expansionary monetary policy and low interest rates has been low debt servicing costs which have made it easier to acquire more debt. Its not wrong to be concerned that if interest rates rise, debt service costs will squeeze out other government spending. It is also not wrong to assume that monetary policy can influence government fiscal situations and vice versa. Monetary and fiscal forces and policy do not operate in watertight compartments.

[Determinant]

Canada itself has escaped relatively unscathed.

I do not agree. The voluminous lines of young graduates trying to get a job (and the recurring articles this fact generates in newspapers) says that we were, and still are, very much scathed.

True, our current situation is not the 1970s but it is also not really the 1930s either.

Blunting the knife's edge does not diminish the fact that it is still a knife and still caused a wound.

Monetary and fiscal forces and policy do not operate in watertight compartments.

And yet I am mystified that you have not considered the increase in tax receipts that higher inflation,, high employment and higher NGDP would entail. This is exactly the result that Keynesian policies are supposed to deliver via the Fiscal Multiplier. Why are we concerned about our own success?

[Livio Di Matteo]

I graduated high school during a recession and from graduate school into another. Many in my cohort did not find decent work right away and their lifetime earnjngs have suffered so I can sympathize with current young graduates. It is worse now I suppose given that those recessions had relatively sharp recoveries whereas the current downturn has been protracted. Still, unemployment peaked at much higher rates during those recessions.

[Determinant]

Right, the early 1980's recessions were "planned" as Dr. Torben Drewes, a prof at Trent memorably said in a talk he gave that I attended. The Bank of Canada and the Federal Reserve deliberately raised interest rates to eye-watering levels to suppress inflation. It was a deliberate lowering of demand. Once inflation was suppressed, the recovery commenced, as one would expect if demand was artificially, mechanically and deliberately lowered.

But today we have an "unplanned" recession, demand has fallen short of its own accord; it has to be stoked. That was the world Keynes talked about. As Paul Krugman so effectively said, the map is not the territory; the problems, causes and effects of the 1980's recessions don't apply today to a much different world. It's apples and oranges. So we need a different map and coincidentally the map Keynes drew is the map we need.

[rsj]

Livio,

The problem here is that over the last 100 years of interest rate history, you are not going to find a single example of the overnight rate being consistently higher than the NGDP growth rate. Here, I define "consistently" to be for a period of 4 years or more. The call money rate averages significantly below the NGDP growth rate. When it rises above this rate, it is because 1) there is a financial panic in a gold standard environment, or 2) in a gold standard or pegged regime, nations are trying to engineer internal devaluation.

So you really need to make a case as to why you think Canada, which does not have a currency peg, would try to engineer internal devaluation for a prolonged period of time.

It just doesn't make any sense, you have no theoretical model to back up your fear, and the data doesn't support you that interest burdens are something to be afraid of.

Sure, you can find lots of handwringing and *political* fears of interest burdens but there is no real solvency or accounting fear. None.

Nor was there any real excess interest burden in the early 80s-90s (when rates were falling, not rising). The only burden is political and self-imposed.

This blog is scare mongering pure and simple -- and is pretty damn irresponsible.

[Livio Di Matteo]

I think I've laid out the evidence for any concerns I have. I am neither irresponsible nor a scare monger. If and when interest rates rise, they will raise debt service costs - ceteris paribus.

[Determinant]

If and when interest rates rise, they will raise debt service costs - ceteris paribus.

That's a Macro 1000 error, as Nick would say. Or Macro 1A03, in my alma mater's course terminology. Which I have repeatedly pointed out, as have others.

[rsj]

Governments tax a proportion of NGDP, so the interest *burden* does not go up when interest rates go up, provided that interest rates stay in line with NGDP. That is the key issue at stake here, and we have data tracking both the call money rate and NGDP growth rate for many nations. Interest rates rise above NGDP growth rates when nations are trying to create deflation so that they internally devalue. For example in the gold standard era when nations needed to defend a gold peg even at the expense of domestic output.

I think it highly unlikely that we will see a situation like that again. It is not a "ticking time bomb". There is always the possibility that the future may hold fantastically bad policy decisions, but those decisions are not created by current (good) policy decisions, nor made inevitable by the present deficit stance.

[Edward Lambert]

Monetary policy is dead and won't be coming back unless labor share increases. So in the meantime, monetary policy has to "do like the Romans, when in Rome". Monetary has to adjust to the conditions in which it is operating and the conditions have shifted after being stable for decades. If monetary policy continues to operate under past conditions that don't exist now, it is making an error. The new conditions warrant a change in calculation. The central bank interest rate in the US should have been rising slowly over the past 2 years. It is now way behind and will not soon catch up.
Here is the explanation of the model behind the thinking...
http://effectivedemand.typepad.com/ed/2013/05/monetary-policy-of-effective-demand-the-basics.html

[Frank Restly]

RSJ,

"The problem here is that over the last 100 years of interest rate history, you are not going to find a single example of the overnight rate being consistently higher than the NGDP growth rate. Here, I define "consistently" to be for a period of 4 years or more."

The cost of debt service is a function of the nominal interest rate AND the total amount of debt outstanding. Governments typically do not borrow at the overnight rate, but instead across a spectrum of maturities. Look instead at growth rate of debt + average interest rate and compare it to the nominal GDP growth rate.

[Ciceron]

A few points:
1) The Paul Masson piece does mention the effects on public sector budgets. But he portrays it as an advantage (or rather as a disadvantage of low interests). In his view, low interest rates are an incentive for fiscal irresponsibility. Increasing short term rates, would force the provinces to make hard choices (which he seems to favor).

2) Obviously, this would mean that the economy would feel both fiscal and monetary contraction if rates increase (c.f. Ireland, or perhaps Spain). It could get very ugly.

3) If we suppose that rates (both short and long-term) increase only once nominal GDP (and thus nominal government receipts) growth has reached a fast pace, then this extra revenue will help cover the higher interest expenditures. (Say government sees revenue growth at 5% instead of 3%, this would cover almost a full percentage point increase in the "effective interest rate" prof. Di Matteo gave in example. By the way, this means that half our present debt should be rolled over at 6.8%. That is quite an interest hike!)

5) In that same scenario where NGDP growth is strong, then we would expect some government expenditures related to social services (e.g. unemployment insurance) and other recession-related spending to be quite lower. By how much? I do not know. This lower mandatory spending combined with higher revenue growth could help keep public sector deficits under control.

6) If NGDP growth is strong, we would expect private sector investments to be strong (which is of course a cause of long-term interest increases). Significant government spending in these circumstances would be expected to crowd out investment and thus be quite counter-productive. In this environment, budget cuts could be economically well justified.

[rsj]

The cost of debt service is a function of the nominal interest rate AND the total amount of debt outstanding.

Yes, but government revenue grows with NGDP, so *independent* of the size of the debt, if the weighted average interest rate is less than the growth rate of GDP, then the Debt/GDP ratio will stabilize without the need to run any primary surpluses. You can run primary deficits every year and have the debt/GDP ratio be bounded because the numerator is growing at a smaller rate than the denominator.

[rsj]

Significant government spending in these circumstances would be expected to crowd out investment and thus be quite counter-productive.

That is a red herring. The reason why we have such large deficits now is because of countercyclical spending which will decrease when aggregate demand is robust. The issue being debated is whether the "overhang" of the present level of countercyclical spending\ will prove to be a burden in future years, and there is simply no evidence for this argument.

[Nick Rowe]

A crude but useful measure of debt-service costs would be DSC = (i-n)(NDEBT/NGDP)

where i is average nominal interest rate on govt debt, n is growth rate of nominal GDP, and NDEBT/NGDP is the nominal debt/GDP ratio.

This measures what fraction of GDP is needed to service the debt to keep the debt/GDP ratio constant over time.

It does not matter *for this question* if n > i (so DSC is negative). You get exactly the same effect if i rises relative to n. A reduction in a benefit is the same as an increase in a cost. Both are bad things.

Currently, for Canada, i *on new debt* is abnormally low relative to n (because world interest rates are abnormally low, and the Canadian economy is (or at least has been) recovering, so n is not that low). But it is plausible to predict that i will rise relative to n in Canada, at least on *new* debt. (That's an important caveat, since a lot of Canadian debt is old debt, issued when interest rates were higher than they are now, which explains that 4.8% number, and so there will be a temporary offsetting effect coming from the vintage effect as old debt gets rolled over at lower rates.)

If i-n is going to increase in future, and it probably will, then Livio is right that we need to take that into account. But I would be more worried about Japan than Canada. First because Japan has a higher debt/GDP ratio. Second, because Japan has been in recession with low interest rates for much longer, so there will be less of a "vintage effect" going the other way in Japan. Lets just hope that Abenomics works, and works quickly.

[rsj]

Nick,

If the NGDP growth rate is greater than the weighted average interest service, then we completely ignore Debt/GDP. We never raise taxes to "pay down" debt, and we never cut any spending that we would have made without debt. We do whatever we would have done with zero debt, just rolling the debt over.

Therefore there is no cost. It does not "require" any portion of GDP to service the debt, since the debt services itself via refinancing operations.

And this is the world that we -- by and large -- live in now and have lived in the past.

I say "by and large" because there can be periods of manias in which we *do* choose to suffer through austerity not because we need to, but because we want this number to be lower more quickly. The pleasure of seeing this ratio fall, or the fear of seeing this number go up, causes a lot of people to believe that austerity is necessary. But these are just scare tactics, and often attempts to reduce this number cause the ratio to go up, as GDP declines.

[rsj]

Here is a graph of the primary budget surplus/deficit since 1947 as a percentage of NGDP (the time we started "repaying" WW2).

http://research.stlouisfed.org/fred2/graph/?g=iBV

You will note that pretty much every year, we ran a primary budget *deficit*, and yet the debt/GDP ratio today is about the same as it was in 1947. We ran an average primary deficit of -1.92% of GDP over that time period.

[Nick Rowe]

rsj: see where I said in my comment: "It does not matter *for this question* if n > i (so DSC is negative). You get exactly the same effect if i rises relative to n. A reduction in a benefit is the same as an increase in a cost. Both are bad things."

(And who is "we" in your last two lines? On this blog, "we" means "Canada" ;-) )

[rsj]

"we" means "Canada"

Heh. Point taken. Well, point me to a good website disseminating free Canadian data, and I will run the numbers for you, too. Btw, I think Livio made an error in the post because I strongly suspect he is using 'interest payments' when he should be using 'net interest payments'. But, I can't prove this as I don't know where you Canadians store your data.

A reduction in a benefit is the same as an increase in a cost.

No, in that case we should run deficits up until the point where i = n. As long as i < n, then we are leaving a free lunch on the table because we are effectively borrowing money that never needs to be paid back.

[rsj]

OK, OECD to the rescue!

http://www.oecd.org/eco/outlook/economicoutlookannextables.htm

For Canada, we have general government net interest payments of 0.4% of GDP in 2012, or about 7.3 Billion (assuming a 2012 GDP of 1.8 Trillion) -- not 31 Billion. You cannot include principle repayment when determining interest expense, as this confuses stocks with flows and in any case will vary with the maturity structure of the debt.

[Mark]

"I am neither irresponsible nor a scare monger."

When you put 'time bomb' in the title of a post, I'd have to disagree.

[K]

Over the past 62 years US nominal GDP increased by a factor of 58. Over the same period, if the US government had merely let the debt compound at the t-bill rate and never paid off any interest, the nominal amount of debt would have increased by a factor of 17. I.e. debt/GDP would have decreased by more than a factor of 3. This chart should also help clarify the picture:

[K]

Nick,

"A reduction in a benefit is the same as an increase in a cost"

I'm with rsj, here (what else is new). If the economy is dynamically inefficient (and there are good theoretical reasons as well as empirical evidence that it is - see above graph), then there's a free lunch to be had in increasing unfunded public expenditure. This is the market's way of telling us that we can increase the intertemporal consumption optimum via increased investment in public goods.

[rsj]

And while we are setting the facts straight, the effective interest rate for canadian government net general debt is 1.26%, not 4.8% (that's another conflation of including principle repayment as an interest expense). Moreover, an increase of 1% in the effective interest rate would cause the interest expense to go up to 13.1 B from 7.3 B, nowhere near 14% of general expenditures, and of course the cited estimates for the U.S. suffer from similar errors.

You just cannot include principle repayment, which is a financing operation on stocks, as a part or fraction of general expenditures, which is a flow.

If you do, you will massively overstate expenditures as well as the debt service share of expenditures.

As a simple example, suppose all debt was financed with a 1 year bond, so principle repayment included the entire debt outstanding each year. Now you've ballooned expenditures and suddenly "debt service" is by far the largest share of expenditures. Good for scare-mongering, bad for estimating debt burdens.

[J.V. Dubois]

Nick: "If i-n is going to increase in future, and it probably will, then Livio is right that we need to take that into account"

What do you mean by "need to take it into account"? Should we take it into account when deciding about premature tightening right now that would lead us to higher unemployment and reduction of utilization of production capacity anyways? Or should we worry about increasing 'i-n' when deciding about monetary easing right now in order to end recession, increase employment and closing output gap?

Is there actually some literature when aggregate demand management is analyzed from welfare point of view that takes into account all these particular things that should be taken into account? Should we for instance take into account profit/loss of central bank on OMO. Or the level of bank lending tied to particular aggregate demand policy? Or impact of monetary policy on savers? Or utility loss caused to goldbugs that would preffer to pay with gold coins?

I personally think that you are just trying to salvage an untenable position. If there is a lesson from monetary history that I am aware of it is that aggregate demand policy should not be subordinate to these particular interests, because the costs are high and there are always better ways to achieve particular goals anyways. But maybe I am wrong, then please can you point me to a macro-literature that seriously analyzes when fiscal considerations should be taken into account when forming monetary policy, preferably something that has at least remote relation to the condition that are similar to those in today Canada?

[Frank Restly]

RSJ,

"Yes, but government revenue grows with NGDP, so *independent* of the size of the debt, if the weighted average interest rate is less than the growth rate of GDP, then the Debt/GDP ratio will stabilize without the need to run any primary surpluses. You can run primary deficits every year and have the debt/GDP ratio be bounded because the numerator is growing at a smaller rate than the denominator."

TR = Effective Tax Rate (Taxes as percentage of NGDP)
NGDP = Nominal GDP
INT = Weighted average interest rate across all maturities of government debt
D = Total Debt Outstanding
dNDGP/dt = Growth rate of NGDP
dD/dt = Change in growth rate of D

The only condition that the government must satisfy:

TR * NDGP > INT * D

After that the government is borrowing from one person to make the interest payments to another (Ponzi finance)

TR * NGDP = k * INT * D : k is a number larger than one
TR = k * INT * D / NGDP

Assume a constant tax rate and weighted average interest rate:

dNGDP/dt * TR = k * dD/dt * INT + dk/dt * D * INT

For dk/dt = 0 ( constant debt service as a percentage of tax revenue )

dNGDP/dt * TR = k * dD/dt * INT
TR / k = dD/dt * INT / ( dNGDP/dt )

In the U. S. that has not been the case because a lot of the increase in the federal debt has been a debt swap from financial sector to public sector. Federal debt growth rate has been much larger than nominal GDP growth rate because of debt swap. If the nominal GDP growth rate is larger than the product of the debt growth rate and the weighted average interest rate, your percentage of tax revenue dedicated to debt service - the fraction 1/k - will get smaller.

"You can run primary deficits every year and have the debt/GDP ratio be bounded because the numerator is growing at a smaller rate than the denominator."

The debt/GDP ratio is not a binding concern of governments. That is the point I was trying to make. The only binding concern is the amount of tax revenue available to make the interest payments.

[Livio Di Matteo]

I have used total public debt charges (which means I have included principle repayment) because those are obligations that a government must meet and therefore represent a burden on current resources. Governments do include interest on the principle when it comes to paying the bills. Frank is right in stating that ultimately "the only binding concern is the amount of tax revenue available to make interest payments" but it still means if the payments get large enough, spending is moved to debt service and away from other government programs. An example from Canadian fiscal history - in 1971/72, federal program spending as a share of total federal spending was approximately where is is now with debt service at 11 percent of total spending). By 1981/82, the program expenditure share was 82 percent and debt service share was at 18 percent. By 1990/91,the program expenditure share was 71 percent and debt service was taking up 29 percent of the federal budget. The result was a major restraint program in the 1990s that reduced federal transfers to health and education and led to reductions in services. Fortunately, the economic boom after the mid 1990s to 2007 raised tax revenues and reduced the burden of debt and deficits. Rising GDP reduced debt to GDP ratios. Moreover, declining interest rates yielded a fiscal dividend that allowed governments to reduce their debt service payments and put money into both programs and tax reduction. We are now in 2013. Unlike the period after WWII which saw high debt to GDP followed by a robust economic boom and low interest rates or the mid 1990s where high debt to GDP was again followed by a boom period and falling interest rates there does not seem to be a boom on the horizon after five years of low growth, low rates and substantial debt accumulation. If interest rates start to rise, debt service costs will rise and without strong GDP growth those payments will impose additional fiscal burden on government. The large mass of accumulated debt is tinder awaiting the match of higher interest rate. Higher nominal GDP growth is the fire extinguisher. If this is scare mongering, so be it.

[rsj]

Livio,

I have used total public debt charges (which means I have included principle repayment) because those are obligations that a government must meet and therefore represent a burden on current resources.

No, rolling over of principle is not a burden on current resources (a flow). It is a refinancing operation.

You cannot subtract principle payment from current income anymore than you can add borrowing to income.

Moreover you cannot say count principle repayment as "transfer to bondholders" -- only the interest income is a transfer to bondholder.

Also, you cannot divide total debt by the principle repayment to get an "effective interest rate" -- your interest rate is 3 times too high!

Finally. you cannot assume that a 1% increase in rates will cause both the interest and principle payments to rise -- that is double counting!

Yes, governments typically use cash-flow based accounting, but that is a classification that you need to understand and not confuse with more standard accounting terms used by the private sector.

[Bob Smith]

RSJ,

IF you're going to cite the OECD net debt interest figures for Canada - which are facially ridiculous as measure of Canada's government interest obligations - to refute Livio's point, you might want to read the accompanying notes a bit more closely. From the accompanying OECD notes:

"Net property income is used as a proxy for net interest payments, which are not separately available. For Canada this includes significant levels of royalties from the exploitation on natural resources, which may bias corresponding measures of primary balances compared with other countries."

I don't know about you, but that to my mind that renders the OECD numbers (at least for Canada - given the not insignificant role that royalty revenues play in provincial finances) more or less useless in this discussion.

And if you want to check Livio's numbers, you might try looking at our public accounts (at least for the federal government). The $31 billion public debt charge comes from that. http://www.tpsgc-pwgsc.gc.ca/recgen/cpc-pac/index-eng.html

[Bob Smith]

RSJ: The $31 billion does NOT include capital repayment, it's a pure interest calculation. In addition to the $31 billion in interest charges the federal governm also had to finance $41 billion in maturing debt in 2011-12.

Also, using the treasury bill rate to measure government debt cost is seriously misleading, seeing as the bulk of the government's marketable securities is made up of longer term debt which is significantly more expensive than the T-bills.

[rsj]

Bob,

I was using table 31, "General government net debt interest payments". As you know, this page has 62 tables, with many footnotes. The footnote you cite is not for this table and has nothing to do with the calculation of net interest payments. You need to make a better case than this

The reason why you cannot site a "public debt charge" as interest expense is that it includes principle repayment and so is manifestly not an interest expense. Because it is not an interest expense, it cannot be used to calculate the effective interest rate, or the amount transferred to bondholders, which is the point of Livio's post. It has meaning -- just not for this discussion.

Seriously, it makes a big difference if the government's interest burden is 1.26% or 4.8%, no? For example, the former is less than inflation, therefore in one case the government gets to borrow at negative rates, and in the other case the government does not. When deciding whether or not to borrow, this makes a difference no? The amount "transferred to bondholders" in one case is positive and another negative in real terms. That makes a difference.

[rsj]

Bob,

From Statscan:

"H29. Public debt charges are gross interest and carrying charges on public debt."

http://www.statcan.gc.ca/pub/11-516-x/sectionh/4057752-eng.htm

[K]

Bob,

Even if you understand the difference between accounting interest and principal, accrual accounting numbers are completely irrelevant to understanding the economics of the debt burden. If a government locks in all its borrowing in 30 year bonds at 1%, and inflation and the 30 year rate then rise to 10%+, then the debt, as structured, will be easy to carry. If on the other hand, they lock in 30yr debt at 10% and rates then drop to 3% (see the Great Moderation), then carry costs will appear high. These are just examples of good or bad trading and the effect of carrying liabilities at book, rather than market value. In both cases, what is really happening is a huge change in the market value of debt, which is then carried forward at the spot short rate.

If governments keep the average duration of their liabilities relatively short (e.g. less than 5 years), then the carrying costs over the period of a business cycle will tend to average around the short rate plus a bit of term premium. Looking at accounting numbers which reflect some random weighted average of coupon rates incurred over the past 30 years is completely pointless.

If you want to understand the *expected* economic carry costs of additional debt, you need to understand the relationship between nominal growth and the equilibrium short rate. The empirical evidence (see my graph above) is very strong here and gives no support at all to the existence of any burden whatsoever. The future reality may be different (hey, maybe this time *is* different) and it's worth thinking about. But you are not going to establish anything by comparing accounting cash flows that were baked in over the last 30 years with current economic size and growth numbers.

[Bob Smith]

RSJ: "I was using table 31, "General government net debt interest payments". As you know, this page has 62 tables, with many footnotes. The footnote you cite is not for this table and has nothing to do with the calculation of net interest payments. You need to make a better case than this."

Naughty, naughty, RSJ. You really should have read the "Notes to the Economic Outlook Annex Tables", specifically, the notes to Table 31, and more specifically, the country specific notes under that section from which that excerpt is drawn (http://www.oecd.org/eco/outlook/notestotheeconomicoutlookannextables.htm). Is it too much to expect you to have looked at the notes to the table you were referring to?

RSJ: "H29. Public debt charges are gross interest and carrying charges on public debt."

Sorry, in what universe does "gross interest and carrying charges" include principal repayment? I don't know what you think carrying charges mean, but in the rest of the world, they are a cost of financing, not principal repayment. In any event, the suggestion that "public debt charges" includes principal repayment, apart from being absurd, is refuted by the Public Accounts numbers for 2011-12, in which "public debt charges" were $31 billion, and $41 billion worth of debt matured (since on your interpretation the former must always be larger than the latter - at least for any non-zero government interest rate).

[rsj]

Bob,

Oops and now I am wrong -- a good definition was on Fred (ha!)

http://research.stlouisfed.org/fred2/series/GGGDTACAA188N

"Gross debt consists of all liabilities that require payment or payments of interest and/or principal by the debtor to the creditor at a date or dates in the future. This includes debt liabilities in the form of Special Drawing Rights (SDRs), currency and deposits, debt securities, loans, insurance, pensions and standardized guarantee schemes, and other accounts payable. Thus, all liabilities in the Government Finance Statistics Manual 2001 (GFSM 2001) system are debt, except for equity and investment fund shares and financial derivatives and employee stock options. "

By this definition, gross debt was 85.641% of GDP, so that debt charges of $31 B is not going to be an effective interest rate of 4.8%, but rather 1.7%. So you are looking at other things -- e.g. pension liabilities, etc., when measuring gross debt. Net debt = gross debt - assets, and net interest = effective interest on net debt.

For good reason, we generally look at net debt rather than gross debt when calculating debt/GDP ratios, but then it is an error to take the gross interest payments, divide by net debt, and get an effective interest rate.

In terms of measuring what is transferred to bondholders, net interest is the more appropriate measure as well.

The measure that Livio was using before is called (on the page you referenced) the "interest ratio", which is debt charges/revenues. It is not the effective interest rate.

I would point out that whether you are looking at gross interest/gross debt, or net interest/net debt, you are still getting interest rates less than the NGDP growth rate.

[Mark]

Livio, you are correct in noting that debt service costs rose markedly between 1971, 1981, 1990.

Average GDP deflator growth was 8.7% between 1970-82, 3.8% between 1983-91 and 1.3% between 1992-99.

Following each regime shift, income growth slowed down as legacy interest costs rose. Debt/GDP rose markedly. It wasn't as if debt burdens just rose because of completely reckless public finances. Something purposely happened to cause it.

For your story to have the umpf to bring it to 'time bomb' territory you would have to lay out the scenario for a major regime shift. I don't think you've made that argument.

The other possibility is major irresponsibility by governments to manage finances. Governments in Canada have been doing OK and very well by international peer comparisons particularly given these are very abnormal times we are in.

I don't disagree with the premise that governments should manage finances responsibly. I do disagree with the characterization that debt is a 'time bomb'. The irony is that the government that has been the least responsible (in my mind) is the province with no debt costs.

[rsj]

Alternately, you could have skipped all of that and, realizing that most governments carry debt at a maturity of around 7 years, just look at 5-10 year yields in Canada, and inferred an interest rate of about 1.6%. Then compare that to an expected GDP growth rate of 4% (2% inflation + 2% real growth) to determine that interest expense not a burden, and that in fact the burden of government would be reduced if Canadians carried substantially higher debt burdens.

Now, yes, we can play "what if" games and assume that the interest rate would go up, but historically this happens when NGDP goes up. The spread is what matters, and the spread between NGDP and interest rates has been negative, not positive, for both Canada and the U.S.

[K]

Mark,

"For your story to have the umpf to bring it to 'time bomb' territory you would have to lay out the scenario for a major regime shift."

The required major regime shift, of course, is a significant downward shift in the interest rate term structure. If, as discussed above, government locks in term borrowing at rates which, ultimately, turn out to be much higher than realized short rates, then that's a bad trade. That bad trade was without a doubt a big part of the debt growth story of the '80s and early '90s. But it obviously can't happen again, to any significant extent.

rsj's last comment is absolutely the bottom line. The present value of government debt must be carried forward at current market rates. When the 30 year bond is yielding 2.5%, there is no universe in which you can claim any economic relevance of a 4.8% "effective interest rate." Apart from confusing net and gross debt (if that's what's going on), we are not going to get anywhere if we confuse old bond coupons with current interest. It's like if I go out and buy an old 10% coupon bond and claim I'm making a 10% return on my investment.

[Bob Smith]

RSJ, where are you getting your inferred interest rate numbers from? At least for the federal government, we know what the average interest rate on its debts were - in 2011-12 it was 2.65%, down from 4.61% in 2008, and from just under 6% a decade ago. For the provinces, those numbers are probably slightly higher (reflecting their slightly higher credit risk) - recall that we've only been talking about the federal government, but the provinces are every bit as indebted as the federal government, and have considerably less fiscal flexibility (since they provide politically sensitive services and have less revenue raising flexibility).

Livio's point, and it's a good one, is to wonder what happens to the government's finances when cost of government debt migrates back to something closer to its long term average. And while Canada is probably in pretty good shape (I wouldn't say the same thing about all our provinces),

[K]

Bob,

rsj gets his numbers from current market yields of Canadian government bonds. It's the only thing that is of any interest and it's what I've been harping on about in the last few comments. If market interest rates suddenly sky rocket, the accounting carry costs of debt will continue to decline for a few years, and we'd look really good compared to current NGDP growth. But it's the wrong measure. If you want to understand the sustainability of your interest carry costs you need to look at forward measures. Ie market yields, not old bond coupons. (For the third time)

[Bob Smith]

Mark,

Although I agree with K that we aren't likely (at least in Canada) to see a repeat of the interest rate regime of the early 80's or 90's again, I think you're right that policy regime change in the real risk. So, for example, in Europe (and Japan) the likely "regime" change is a demographic change. Between higher health care and pension costs and declining population growth (or, in cases like Japan and important chunks of Europe, absolute population declines), the ability of governments to finance their outstanding liabilities are likely to be stressed.

[K]

Bob,

"Livio's point, and it's a good one, is to wonder what happens to the government's finances when cost of government debt migrates back to something closer to its long term average."

Yes, while pretending that NGDP growth doesn't also go back to its long term average. If there's one thing that's strong in the historical data it's that historical nominal growth is strongly correlated with and higher than historical interest rates. So no, it's not a good point.

[K]

Bob,

I don't think I said that we won't see high interest rate regimes again (though I agree that we probably won't). What I'm saying is that over any reasonable period they will be accompanied by even higher NGDP growth, and there will therefore be no debt service burden at a constant debt/GDP ratio.

The real risk is that lower growth and inflation will be accompanied by a lower and likely negative nominal natural rate leading to a permanent liquidity trap. The resulting debt deflation spiral is the only circumstance in which debt service cost is likely to become a problem (negative nominal growth with zero nominal service cost. The only thing that's critical is escaping the liquidity trap.

[rsj]

RSJ, where are you getting your inferred interest rate numbers from?

K is right.

The estimate of 1.6% I made in the comment at 10:54 am was by looking at yields in the maturity range of canadian debt in the 5-10 year range. Because of this, I knew that it could not be the case that Canadian government interest expense was the 4.8% figure cited. Now we know that Livio was citing the "interest ratio" which is a ratio of gross interest expense divided by revenue -- something completely uninteresting and which has no bearing on government interest expense, sustainability of debt, etc.

The other estimate I cited was for net interest expense divided by net general government debt from the OECD, to get a 1.26% figure. Or, you can look at gross interest expense divided by gross debt to get a 1.7% figure.

All of these figures are less than the NGDP growth rate.

Again, if Livio is going to argue that future interest rates will exceed the NGDP growth rate for prolonged periods of time, he needs to have a reason for believing this, rather than saying, "Let's pretend something unprecedented will happen". If I tell you that in the future, the equity risk premium will consistently be 10%, I damn well better have a reason for this before I can get you to worry about it.

Moreover, it *is* scare-mongering to call such a bizarre and historically unprecedented occurrence a "time bomb". One reserves the word "time bomb" for something that we expect to happen in the future, like driving without changing your oil.

No sane person should worry about NGDP growth rates being consistently below risk free rates. Let's first see this virgin birth happen before we worry about it.

[Bob Smith]

K, RSJ,

I had a lenghty comment that got eaten, so I won't repeat it. But the jist of it was that the "debt is sustainable" if I

And, unfortunately, history is littered with these sorts of stochastic elements. We saw a big run up in debt levels in the 1970's, coinciding with a sharp decline in TFP growth. Ok, no worries, our debt levels were low, so we could manage that. Then we saw the high interest rates of the 80's and 90's, well, we managed that (although, at considerable cost in the case of Canada). Next it'll be an aging population (and corresponding pension and health care costs) and declining populations (in countries like German, Italy and Japan). Maybe they can manage those (though I wouldn't bet on it, at least not without radical changes in those societies - does anyone see the Japanese accepting significant immigration?). And after that, there'll be something else - wars, breakups (any bets one what happens to Spain if Catalonia decides it wants out?), global warming, plague, zombies. There's always something.

And note, a lot of those shocks don't show-up in the interest rate or the NGDP growth rate, they show up on either the revenue or expenditure side of the government ledgers.

And I don't disagree with you about the risks of the liquidity trap. But that just illustrates my point, because of a high starting debt level, the Euro-zones countries are caught between trying to get out of the liqudity trap with short-term borrowing, at the risk of pushing the borrowers past a tipping point of unsustainable debt. Nasty choice and one that, with the benefit of hindsight, I bet they wish they had avoided.

[Bob Smith]

Sorry, part of that comment was cut off. The end of the second sentence should read "if we ignore the stochastic eleement in human history".

[Frank Restly]

RSJ,

"Now we know that Livio was citing the interest ratio which is a ratio of gross interest expense divided by revenue -- something completely uninteresting and which has no bearing on government interest expense, sustainability of debt, etc."

Where do you think the interest payments come from if not from tax revenue?

[K]

Bob,

"We saw a big run up in debt levels in the 1970's"

Except, we didn't. The inflation, for the most part, ate the deficits. The Trudeau liberals basically ran balanced primary deficits, and as discussed above, interest payments are more than covered by growth. By 1980 Canadian federal debt was 20% of GDP, about the same as in 1970. The debt runup *began* in the early '80s and continued until 1996 when it hit 70%. For the most part Mulroney did it, but interest coverage did not contribute to the debt ratio in the '80s either. Like I said above, I wouldn't be surprised if there was a significant negative impact from treasury issuing long dated bonds into the Great Moderation (bad trading).

"Next it'll be an aging population..."

What we want to avoid is a situation where interest is sustainably higher than NGDP growth. Barring the virgin birth, there are two ways I see that could happen:

1) Massively higher government debt. No, not 100% or 150% debt/GDP. Something more than Japan or post-war Britain, both of which have proven to sustain extremely low nominal yields. I.e. 300%+. To me, for there to be significant upward pressure on rates, the quantity of government debt has to be ballpark around the same as the quantity of other capital assets. That's still a long way off, and it's not a question of 10 or 20% more or less of debt. It's a question of hundreds of percent.

2) NGDP growth goes negative, and interest rates, of course, stay above zero. In this case zero nominal rates will be well above the natural rate which causes a positive feedback disaster. This scenario is the actual near term likely one, and is exactly where we will go as a result of an exogenous growth slowdown (ageing). The interesting thing about this scenario is that it is actually aggravated by too *little* debt, since it is a *low* natural rate of interest which causes the economy to get trapped. More debt and more inflation puts the liquidity trap further out of reach.

Frank,

"Where do you think the interest payments come from if not from tax revenue?"

More debt, of course. If NGDP grows at 5% then you can finance up to 5% interest by additional borrowing and still keep debt/GDP constant.

[K]

Bob,

One more comment. This made me think:

"the "debt is sustainable" if we ignore the stochastic element in human history"

I think this is actually exactly backwards. If NGDP grew at exactly 5% every year, with 100% certainty, I suspect the nominal short rate would be much higher than if NGDP grew at an average of 5% but with lots of risk around that average. The uncertainty of nominal growth is the source of systemic risk to equity returns, which in turn increases investor demand for the risk-free asset. I.e. the greater the systemic risk, the lower the risk-free rate for any given level of expected NGDP growth, and the greater the quantity of government debt that is sustainable.

[Frank Restly]

K,

"Where do you think the interest payments come from if not from tax revenue?"

"More debt, of course. If NGDP grows at 5% then you can finance up to 5% interest by additional borrowing and still keep debt/GDP constant."

???

If Nominal GDP grows at 5% and the federal government collects no tax revenue, it can finance up to 5% interest by additional borrowing? Is that what you are saying?

[K]

Assuming no primary deficit and a constant debt/GDP ratio, yes, exactly. That's how the math works.

[Frank Restly]

K,

Would you buy the bonds of a company when you know that they are repaying the interest to you with money they borrowed from someone else? Ponzi finance works great on paper - the math works. In real life, not so much.

Why is a constant Debt / Nominal GDP ratio important when it is not a legal constraint on the ability of a government to borrow?

You might argue that it measures the effectiveness of government borrowing, but you could look at just Nominal GDP for that result. You might argue that the markets will signal when government borrowing is effective / ineffective through the interest rate mechanism but if the government is making interest payments with additional debt, then the interest rate is really controlled by the government and not the markets.

[Max]

K, "If the economy is dynamically inefficient (and there are good theoretical reasons as well as empirical evidence that it is - see above graph), then there's a free lunch to be had in increasing unfunded public expenditure."

Hold on, this is not dynamic inefficiency. You're looking only at the risk free rate, not the return on capital. If the economy really were dynamically inefficient, then "crowding out" of investment would *increase* economic growth (turning the argument against deficits completely on its head).

The only free lunch available here is to reduce the cost of taxation.

Except that this free lunch exists only in theory, since we can't predict what will happen.

[rsj]

Hold on, this is not dynamic inefficiency

Yes, this is the point made here: http://finance.wharton.upenn.edu/~rlwctr/papers/8814.PDF

The only free lunch available here is to reduce the cost of taxation.

Well, that's what it means to run deficits. No one is claiming any other kind of free lunch.

The problem is that we are not running enough deficits. If we were, then the interest rate on government debt would average the NGDP growth rate, instead of being substantially below it.

Which begs the question, why don't we take advantage of the free lunch? I think there is deficit bias against running deficits, just because households are scared of the word "debt", and view the government as another household. It doesn't help that irresponsible economists keep pretending that the debt is equal to the present value of primary surpluses, despite all the evidence that governments typically run primary deficits while reducing the debt/income ratio.

Unfortunately the "debt is bad" meme is popular now, and a lot of people are preying on this meme to encourage austerity and fear, primarily because they have a deep philosophical discomfort with the notion that government has such enormous fiscal policy space.

[rsj]

then the interest rate is really controlled by the government and not the markets.

Yes, that's what it means to be a currency issuer. Interest rates are set by governments as soon as governments issue currency. The only mechanism that would cause those rates to go up is inflationary pressure. Note that having a bunch of wealthy bond holders sit around a table and complain that they don't like deficits is not the same as inflationary power. They have to rush out and spend money, and do so to the point that inflation starts to go up.

And I think there is a big difference between "I would prefer a higher rate" and "I am going to spend down my wealth". That space, where on the one hand bondholder preferences are catered to and on the other, people are willing to part with wealth in order to consume on a mass scale, is (IMO) the reason why risk free rates are below the NGDP growth rate. And I think those who like to think of the financial markets calling the shots, rather than ordinary consumers, don't like to have their impotence exposed. They would much prefer to have a euro-style arrangement where rates reflect investor preferences rather than consumer preferences.

[K]

Max,

"The only free lunch available here is to reduce the cost of taxation."

When the risk free rate is asymptotically below the growth rate that is a form of dynamic inefficiency - but I agree that the meaning of that is subtle in a stochastic economy. 

I do agree that I only made the case for a Pareto improving tax cut. I do however also think that the case for growth-raising public investment is excellent, and also pretty easy to make. 

As to the free lunch existing only in theory, that could be true. As far as I'm concerned, though, it's equally likely to be even bigger than expected in practice. 

[Frank Restly]

"Unfortunately the "debt is bad" meme is popular now, and a lot of people are preying on this meme to encourage austerity and fear, primarily because they have a deep philosophical discomfort with the notion that government has such enormous fiscal policy space."

People have a deep discomfort with governments that do stupid shit with money whether its borrowed or not. And that is born out by evidence, not philosophy.

[rsj]

That is a type of libertarian fantasy. In reality, government social benefit programs are wildly popular whereas there is deep ambivalence about handing decisions regarding interest rates over to the financial markets. In order to counteract this popular desire for social spending yarns must be spun about how governments "can't afford" to do things that are welfare enhancing.

[rsj]

But Frank R.'s comment is revealing, because at the end of the day, the deficit scolds are not motivated by any real concern with the budget, because if they reviewed the record, they would know that that risk-free rates are less than the growth rate. The concern is over an activist and powerful government. Government programs, whether they be social health care, or employment insurance, or pensions are wildly popular. So the people need to be convinced that the government --- which is really just them -- is limited somehow and cannot afford to carry these programs out. In the capital markets, each person's say is weighted by their wealth, which means that the top 300,000 people have as much say as the bottom 100 million people. Most people have no say. But with government, they do have a say, which scares the market fanatics as well as the wealthy to know end. It is fear of democratic decision making and social expenditures, in principle, which drives the hand waving about deficits. It has absolutely nothing to do with any real solvency concerns.

[Frank Restly]

RSJ,

You have me mistaken for some other guy.

"In reality, government social benefit programs are wildly popular..."
And all of them have a dedicated source of tax revenue (Social Security, Medicare, Medicaid).

"In order to counteract this popular desire for social spending yarns must be spun about how governments "can't afford" to do things that are welfare enhancing."
Wrong. Just plain wrong. This is not about government's "can't afford". Again you have me confused with a different guy. The only stipulation I have made throughout this argument is that for a government to avoid a Ponzi financing scheme, tax revenue must exceed interest expense. The government bears a cash flow risk but not a solvency risk.

"The concern is over an activist and powerful government."
The writers of the U. S. Constitution had the same concerns.

"..the deficit scolds.."
Again wrong guy. Government debt scold - yes, unproductive activity scold - yes, deficit scold - no.

"It is fear of democratic decision making.."
It is fear of bad decision making. And yes decisions that are reached democratically can still lessen marginal welfare. Governments can and do kill off their own citizenry on occasion.

[Determinant]

"In reality, government social benefit programs are wildly popular..."
And all of them have a dedicated source of tax revenue (Social Security, Medicare, Medicaid).

That is a specific American political choice, and in counterpoint it isn't true in Canada, and this is a Canadian blog, after all.

Up here, the dual role of Social Security as poverty relief and income replacement are done by two different programmes. Old Age Security is paid for by the Federal Government out of the Consolidated Revenue Fund, general revenues. The Canada/Quebec Pension Plan is paid for by CPP/QPP dues and investment returns. OAS handles poverty relief. CPP/QPP does income replacement.

There is no dedicated levy for Canada's health system, that comes out of general provincial revenues or transfers from the Federal Government, which themselves come from general federal tax revenues.

[rsj]

Well, Frank, if you don't like a particular program you have to argue against it on its merits, rather than arguing in bad faith, saying "We cannot afford it".

[Frank Restly]

RSJ,

"Well, Frank, if you don't like a particular program you have to argue against it on its merits, rather than arguing in bad faith, saying we cannot afford it."

Again, you must be reading someone else's writing and attributing it to me. I have already said that a government does not bear solvency risk and so the whole concept of a government being able to "afford" something is meaningless. It is the U. S. government's decision making processes (spending and financing) that I have a problem with.