&l;p&g;Government debt is finite, or so we have been told. There is an absolute limit to the amount of debt that a government can issue. If it exceeds that limit, the government will default. Debt is the accumulated deficits of all past years, so persistently running deficits means that at some point the dreaded default trigger will be reached and the government will default. Therefore, governments must observe fiscal discipline and avoid deficits like the plague.
&l;a href=&q;https://www.forbes.com/sites/francescoppola/2016/05/23/imf-predicts-unemployment-in-greece-will-fall-to-12-percent-by-2040/#342ac26173d9&q;&g;Horror stories like Greece&l;/a&g; merely reinforce the belief that high government debt inevitably results in disaster. &a;ldquo;We could end up like Greece!&a;rdquo; cry the austerity hawks. And the terrified population votes for them.
Even if default is avoided, the cost of servicing debt will be &l;a href=&q;https://www.seattletimes.com/opinion/for-the-sake-of-future-generations-its-time-to-tackle-the-federal-deficit/&q; target=&q;_blank&q;&g;unaffordable for future generations&l;/a&g;, we are told. The moral imperative is to close deficits and cut debt, even at the expense of much needed investment, because otherwise young people will bear an unacceptable burden. Young people themselves might think investment that helps to restore economic growth would be worthwhile, especially if they face years of unemployment because the economy is in a slump. &a;nbsp;But who cares what they think. Their elders know what is good for them and will make sure they get it, even if it hurts.
Because high public debt is believed to be so dangerous, politicians &a;ndash; especially in Europe – have given a higher priority to closing public deficits than restoring economies badly damaged by the worst financial crisis in living memory. The result has been a decade-long slump. Some countries in Europe still have unemployment in double digits. An entire generation has been thrown on the scrap heap in the name of &a;ldquo;balancing the books&a;rdquo;. Unsurprisingly, public unrest is rising across Europe, and populist parties on both the far left and the far right are coming to power. Austerity that aimed to reduce the danger of debt default has rendered politics dangerous instead.
&l;img class=&q;dam-image getty size-large wp-image-901183516&q; src=&q;https://specials-images.forbesimg.com/dam/imageserve/901183516/960×0.jpg?fit=scale&q; data-height=&q;639&q; data-width=&q;960&q;&g; MASCHIO ANGIOINO, NAPLES, ITALY – 2017/12/18: Militants of the unemployed left social classes movement called &s;November 7&s; protesting against fascists. (Photo by Fabio Sasso/Pacific Press/LightRocket via Getty Images)
Now, a &l;a href=&q;http://www.imf.org/en/Publications/WP/Issues/2018/04/11/Interest-Growth-Differentials-and-Debt-Limits-in-Advanced-Economies-45794&q; target=&q;_blank&q;&g;new working paper from the IMF&l;/a&g; casts serious doubt on the entire basis for the austerity mantra. Far from default being inevitable if debt rises too high, it may never happen at all. For advanced economies in good standing, the government&a;rsquo;s debt capacity appears to be infinite.
The key to this is the affordability of debt. Government debt is often quoted as debt to GDP, and sustainable debt models usually presume that the government will run a primary surplus (the excess of government income over spending before interest costs) sufficient to pay back all the debt over a defined time horizon. But governments in good standing generally don&a;rsquo;t repay debt, they refinance it. So what really matters is the debt service cost. To be sustainable, debt interest must be comfortably payable from current income. For a country, therefore, public debt is sustainable indefinitely if the interest rate is equal to or less than the growth rate of nominal gross domestic product (NDGP).
Hitherto, it has always been assumed that the interest rate on public debt is greater than the NDGP growth rate. This would make public debt unsustainable over the longer-term unless the government ran a primary surplus sufficient to repay the debt.
But the IMF&a;rsquo;s researcher, Philip Barrett, finds that for several advanced economies, the average nominal interest rate on government debt over the very long run is less than the average NDGP growth rate:
&l;/p&g;&l;blockquote&g;Since 1880, the average annual interest-growth differential in six advanced economies has been -1.7% and -0.8% since 1960.&l;/blockquote&g;
Admittedly, there is quite a bit of variation over shorter time periods:
&l;blockquote&g;For example, during the era of relative peace following 1960, decadal average interest-growth differentials have varied from around minus five percentage points per year in the 1960s and 70s, to nearly two percentage points in the 1980s and 90s, before dropping back below zero more recently. Third, the short-term volatility of interest-growth differentials in these countries is very high, frequently changing by several percentage points per year&a;hellip;&l;/blockquote&g;
But Barrett says this is less significant than the long-run difference:
&l;blockquote&g;While all three of these properties have important implications for sustainable debt levels, the first (the long-run differential) is paramount.&l;/blockquote&g;
And he concludes &l;em&g;(my emphasis)&l;/em&g;:
&l;blockquote&g;Point estimates of the long run average interest-growth differential in advanced economies are frequently negative. If true, the consequences are rather unpalatable: &l;strong&g;unless governments can commit to infinitely large deficits, they can issue as much debt as they like without becoming insolvent&l;/strong&g;.&l;/blockquote&g;
I am struggling to see why this is &a;ldquo;unpalatable.&a;rdquo; Of course, it might be hard for politicians and IMF economists to accept that the received wisdom that has resulted in a decade of widespread and damaging fiscal austerity could be wrong. But it has been said before, many times. The trouble is that &l;a href=&q;http://neweconomicperspectives.org/2013/01/functional-finance-and-the-debt-ratio-part-iii.html&q; target=&q;_blank&q;&g;those who have been saying it&l;/a&g; have been routinely dismissed as cranks. Their elevation to the ranks of Very Sensible People might be hard for some to swallow.
Understandably, given the controversial nature of these findings, Barrett sets out to test whether they are right. He submits them to two different statistical tests. And he concludes:
&l;blockquote&g;Point estimates of the long-run interest-growth differential are negative. This is robust across countries, periods, and estimation methods.&l;/blockquote&g;
The findings are indeed right. He can&a;rsquo;t quite bring himself to admit it, though:
&l;blockquote&g;This represents a very serious challenge to models of debt sustainability; if true it means that debt limits are not finite.&l;/blockquote&g;
Advanced country governments can borrow as much as they like. We have all been tightening our belts for no reason whatsoever. This is going to go down well, politically.
&l;blockquote&g;However, upper bounds of confidence sets for this average are positive.&l;/blockquote&g;
Phew. There is a small chance that the findings are wrong. Politicians can breathe again.
&l;blockquote&g;For countries with long, unbroken datasets and few extreme events (UK, USA, France) we can be more precise: &l;strong&g;both VAR-based and spectral estimates agree that the largest plausible value for the interest-growth differential over the long run is somewhere between 0 and 2 percent per year&l;/strong&g;.&l;/blockquote&g;
So, even if the interest rate is higher than the NDGP growth rate, it won&a;rsquo;t exceed it by more than a couple of percentage points. It is of course prudent to manage public debt on a worst-case scenario, so as there is an outside chance that the interest-growth differential could be positive, governments might still want to run small primary surpluses.
But the real issue here is the widespread belief that high debt/GDP levels are unsustainable. Clearly, if the government&a;rsquo;s debt capacity is unbounded, the sort of debt and deficit limits imposed by &a;ndash; say &a;ndash; the EU&a;rsquo;s &l;a href=&q;http://www.europarl.europa.eu/RegData/etudes/note/join/2014/528745/IPOL-ECON_NT(2014)528745_EN.pdf&q; target=&q;_blank&q;&g;Maastricht Treaty&l;/a&g; are ridiculously restrictive. And even it is not unbounded, the small interest-growth differential suggests that debt/GDP could be far higher than present levels without debt distress. Barrett observes that this was in fact the case in the U.K. for much of the 20&l;sup&g;th&l;/sup&g; century.
Barrett finds that the term structure of government debt matters considerably. Governments that have large amounts of short-term debt have greater financing needs, and this reduces their debt capacity. It also increases their default risk, since there is always a small risk that debt cannot be refinanced at rollover, and they roll debt over more frequently than countries with higher amounts of long-dated debt. The U.K., which is the principal test country in this paper, has a median debt maturity since 1960 of 8-10 years, which is long by advanced country standards. Using this as a parameter, Barrett estimates a safe debt/GDP level for the U.K. of 140%.
Barrett concludes that in practice, governments probably do have limits on debt issuance, but those limits are unlikely to stem from affordability constraints. They are more likely to arise from rollover risk. This implies that governments would be wise to lengthen the maturity profiles of their debt portfolios.
Of course, this paper only looks at six advanced countries with long and stable histories. It can&a;rsquo;t be assumed that the same findings would apply to countries with a recent history of instability and debt default (sorry, Argentina), nor to small countries that are using a currency that they do not issue (sorry, Ireland). But for the large sovereign countries examined in this paper, there is no reason to impose any more austerity on your populations. Throw off your hair shirts and invest in your economies.