Blanchard calls for rethink on costs of debt

Fiscal cost of public debt may be zero, macroeconomist argues, but that does not make debt costless
Olivier Blanchard

Economist Olivier Blanchard highlighted the flaws in the dominant debates over the level of government debt in a speech on January 4, arguing in favour of a more nuanced approach.

The MIT professor said his paper reached “strong, and, I expect, surprising, conclusions”. He said in many cases the fiscal costs of governments taking on more debt might be zero or close to zero, and the welfare costs might also be “limited”. But the argument was subject to important caveats.

“My purpose in the lecture is not to argue for more public debt, especially in the current political environment. It is to have a richer discussion of the costs of debt and of fiscal policy than is currently the case,” Blanchard told the annual gathering of the American Economic Association.

Blanchard started from the position that risk-free rates have diminished to levels lower than the nominal growth rate, which implies that governments can issue at least some debt without having to later increase taxes – the bill will be covered by higher tax revenues from future growth.

In the US at least, he argued risk-free rates being lower than nominal growth was “more the historical norm than the exception”.

While this meant the US government could theoretically keep issuing more debt without the debt-to-GDP ratio rising, such an outcome was still not necessarily desirable, Blanchard said. Because higher public debt impacts private capital, it therefore affects welfare, even if the fiscal cost is zero.

The welfare effect divides into two: an impact via capital accumulation; and an impact through the “induced change” to the returns on labour and capital.

Based on a simple model that represents debt as an intergenerational transfer, Blanchard noted the welfare impact of higher debt was positive via the capital accumulation channel when the risk-free rate is below the growth rate.

Meanwhile, the returns on labour and capital depend on the “risky” rate given by the marginal product of capital. When this rate is above the growth rate, the welfare impact of higher public debt is negative.

Thus, in the current situation in the US, one channel of the welfare effect is positive and the other negative. Overall, the effect of higher debt is ambiguous.

In an effort to resolve this ambiguity, Blanchard turned to numerical simulations. Under certain assumptions, if the risk-free rate is far enough below the growth rate and the marginal product of capital not too high, then higher public debt can be beneficial to welfare, he said.

This was particularly true when one accounted for the stimulative effect of higher fiscal spending, Blanchard said. His simpler models assumed the economy was at full employment, and even in such a case fiscal expansion could be beneficial. If the economy was running below potential, then the argument became even stronger, he said.

But there were also objections, he noted. For one, it was possible the risk premium was distorted by forms of financial repression, he suggested, in which case rates might not give a reliable guide to the welfare benefits of higher debt. Though the US no longer forced banks to hold Treasuries, financial regulations such as minimum liquidity requirements could have a similar effect, he said.

Second, the future may turn out differently to the past. If the risk-free rate rises above the growth rate, the government will find it harder to roll over its debts.

Thirdly, there may be “multiple equilibria”, in the sense that investors could trigger a spiral if they doubt the government will repay its debt. By demanding a higher interest rate, they make a default more likely, pushing rates higher still.

This third argument “is relevant and correct as far as it goes”, said Blanchard, “but it is not clear what it implies for the level of public debt: multiple equilibria typically hold for a large range of debt, and a realistic reduction in debt while debt remains in the range, does not rule out the bad equilibrium.”

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