MIT economist Olivier Blanchard caused a stir in fiscal circles last month with an academic paper suggesting that current levels of public debt may be less worrisome than many experts think (see our analysis here and here). Now Blanchard has written a new policy brief to summarize his analysis and respond to criticism he has received. Here’s a summary of Blanchard’s brief, which you can read in full here:
High public debt is seen as destructive for two reasons:
- It imposes fiscal costs involving higher taxes in the future; and
- It imposes welfare costs by crowding out investment capital and reducing future output.
Blanchard examined the validity of these claims in the current context of low interest rates, concluding that:
- High public debt may incur “no fiscal costs,” because the debt can be rolled over safely as long as the economy’s growth rate remains higher than nominal interest rates; and
- “The welfare costs are probably small,” because the risk-adjusted rate of return to capital is actually pretty low, reducing the crowding out effect.
To put it in less wonky terms, the warnings about the dangers of high debt may be overblown in some cases. Given the modest negative effects produced by high public debt in a low-interest environment, Blanchard says that “while public debt is probably bad, it is not catastrophic. It can be used but it should be used right.”
Interest rates are bound to rise: Higher interest rates would impose much higher fiscal and welfare costs, critics charge, and there’s no guarantee that the current low-rate environment will persist. Blanchard argues that the odds are low that rates will rise any time soon, citing three factors:
- Low interest rates are the historical norm: “In the United States, for example, the one-year T-bill rate has been lower on average than the growth rate for the last 150 years. And over the last 50 years, the inequality has held in every decade except the 1980s, when the Volcker disinflation led to very high interest rates and low growth rates.”
- Secular stagnation, a theory that is looking more likely every year, puts downward pressure on rates;
- Even if rates rise, the U.S. can lock in low rates with long-maturity bonds.
Debt rollover may fail: Critics cite the risk of a failure to roll over the debt, but Blanchard points out that governments take risks all the time and the cost of such a failure would be relatively low.
Debt is already too high: Blanchard acknowledges the current high levels of debt, already roughly equal to GDP, but says critics are looking at the wrong number: “The debt-to-GDP ratio is the ratio of a stock to a flow, and as such of no particular significance without information about the interest on debt. A better concept is the ratio of real debt service to GDP, which is not particularly high (it is now, for example, half its 1995 level).” Additionally, the debt-to-GDP ratio has been shown to provide no clear threshold for the turning point at which debt becomes catastrophic.
Ratings agencies may balk: Critics worry that Moody’s or Fitch may downgrade U.S. debt, potentially raising its cost. But Blanchard argues that the agencies and investors can be “educated” about the lower level of risk, and that the real danger lies with the possibility of “strategic default” done for political reasons.
‘Infinite Amounts of Debt’?
Having moved through his argument and responded to critics, Blanchard asks: “So, do all these arguments add up to a license to issue infinite amounts of debt?” The answer, he says, is “an emphatic no.” For one thing, there is reason to believe that, as economic theory indicates, more debt puts upward pressure on interest rates – even though “long-run effects of higher debt on safe rates are hard to detect.” For another, debt does impose a welfare cost, “even if it is small.”
So When Is Debt Justified?
Blanchard says there are two cases in which it makes sense for the government to finance spending with debt:
- When “private demand is weak, output is below potential, and monetary policy is sharply limited by the zero lower bound.” In this environment, debt-financed spending can have a significant effect on economic output, usually at a relatively low cost. “If it turns out that, as seems to be the case in Japan, domestic demand appears structurally low, and the shadow neutral rate remains consistently close to zero or negative, then permanent primary deficits, and thus the accumulation of debt, might be needed to sustain output and may have no fiscal or welfare cost.”
- To finance public infrastructure “whose risk-adjusted social rate of return exceeds the safe rate at which the government can issue debt.”
On the basis of those general rules, Blanchard concludes that the deficits under President Obama, which occurred in a powerful recession, were justified. The deficits occurring under President Trump “obviously are not.”