The priority for now is reviving economies enough to push interest rates above zero
Robin Harding
© James Ferguson/FT
The national debt has inspired a million boring speeches and exactly one witty remark. “If something cannot go on forever, it will stop,” says Stein’s Law. Coined by the economist Herbert Stein, an adviser to US president Richard Nixon, it was originally about the balance of payments but he used the precise phrase in 1986 to warn Congress that the federal debt cannot rise without limit.
In response to the Covid-19 crisis, the world’s governments seem intent on putting Stein’s Law to the test. This year’s increase in public debt has little precedent outside wartime. According to the IMF, massive borrowing, along with economic contraction, will push the US debt up by more than 30 percentage points to 140 per cent of gross domestic product.
Long-term debt projections in many countries are dire. The IMF says global public debt will hit its highest level in recorded history, greater even than the peak after the second world war.
This seems to portend disaster and require corrective action. But while higher public debt has costs — most significantly if it closes off the ability to respond to a future crisis — there is little cause for immediate alarm. The “safe”, or sustainable, level of national debt is ambiguous and is likely to have risen because of slumping global interest rates.
Given the urgency of responding to Covid-19, and the risk of a plunge into mass unemployment if governments stand aside, they are correct to leave worries about public debt for another day.
Calculating a safe level of public debt is hard because sustainability depends on both interest rates and the pace of economic growth. If interest rates are 2 per cent and the economy is growing at 3 per cent, for example, then all a country has to do is sit back and wait.
As long as it does not borrow more, then debt will gradually dwindle to nothing compared with the size of the economy. If interest rates rise above economic growth, by contrast, then even small debts can get out of hand.
Attempts to estimate debt limits therefore turn into guesses about whether interest rates will rise. This is hard. One IMF effort to calculate debt limits in 2015 found that Japan and Italy had zero space to borrow any more. Both countries have nevertheless done so on a massive scale this year.
In an influential 2019 paper suggesting the costs of public debt are smaller than previously thought, former IMF chief economist Olivier Blanchard argues that interest rates have generally been below growth rates, and therefore that “higher debt may not imply a higher fiscal cost”.
At present, nominal economic growth in the US is forecast at about 4 per cent over the long run. That compares with 10-year Treasury yields of 0.65 per cent, with futures markets suggesting rates will stay low.
This implies that there is room before debt becomes a problem. If interest rates did start to rise, the US would probably have some time to adjust its fiscal policy in response.
Since debt limits are so hard to estimate, economists often look to history instead. Kenneth Rogoff and Carmen Reinhart famously found that growth rates fall when debt reaches 90 per cent of gross domestic product. A graduate student found errors in their work, but they have generated similar results in other studies.
A bigger doubt is whether past episodes of high debt after wars or in small economies are relevant to today. Given how many countries have just burst through the 90 per cent limit, that number is about to get a thorough test.
Another question, particularly for Japan and the eurozone, is whether ultra-low interest rates have fundamentally changed the calculus of public debt. One of the most paradoxical lessons of Japan’s experience over the past 30 years is that attempts to cut its budget deficit often made debt worse, not better.
Several times during the 1990s and 2000s, Japan cut spending or raised taxes. Demand then weakened and, with rates already at zero, the Bank of Japan was unable to respond. To avoid unemployment, the government had to spend more. In recent years, Prime Minister Shinzo Abe managed to stabilise Japan’s debt ratio, before Covid-19 put paid to that achievement.
A different way to look at it is that if Japan never manages to raise inflation and thus interest rates, then the Bank of Japan will never need to sell the government bonds it holds on its balance sheet. The Japanese government will effectively owe such debt to itself.
Such stagnation is not a desirable outcome, to be sure, but it would make public debt worth about 100 per cent of GDP irrelevant. If global interest rates keep declining, other central banks could wind up in a similar position.
Governments should therefore postpone any concern about public debt until they revive their economies sufficiently to get interest rates above zero. Once that is achieved then, given the costs, it may make sense to try to reduce public debt somewhat.
Stein’s Law is often taken as a warning to act against the unsustainable. But that is not how the author intended it. It was, he wrote, “a response to those who think that if something cannot go on forever, steps must be taken to stop it — even to stop it at once”.
If public debt is indeed becoming unsustainable, the warning signals will arrive soon enough.
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