Free exchange

What are the limits to government borrowing?

New research explores governments’ “Goldilocks” zone


The scale of Joe Biden’s plans is hard to exaggerate. 

Where the American president’s former boss, Barack Obama, pivoted quickly to deficit-cutting after the trials of the global financial crisis, Mr Biden’s first budget, which he unveiled on May 28th, will borrow unapologetically. 

The plans assume that annual fiscal deficits will exceed 4% of gdp through to the end of the decade; net public debt will rise to 117% of gdp in 2030 from 110% today. 

The largesse raises two big questions. 

One is whether, coming on top of past stimulus packages, it will contribute to an overheating of America’s economy in the short term. 

The other important question is whether in the longer term America can prudently afford to loosen the purse-strings for a sustained period. 

As crisis has hit and interest rates have fallen, politicians have felt more able to run up debts than in the past. 

But the issue of whether and when limits to borrowing might apply still remains. 

Recent research casts light on these constraints.

In a new working paper, Atif Mian of Princeton University, Ludwig Straub of Harvard University and Amir Sufi of the University of Chicago attempt to gauge governments’ room to run. 

Their analysis (which does not incorporate the effects of the pandemic) builds on recent work that estimates how the “convenience yield” on government bonds—or the amount by which a bond’s yield is reduced because of the safety and liquidity benefits it offers investors—varies with the size of the debt burden. 

Other things equal, the greater the volume of outstanding bonds, the higher the return investors demand. 

Work by Arvind Krishnamurthy of Stanford and Annette Vissing-Jorgensen of the University of California, Berkeley, suggests, for example, that a 10% increase in the ratio of debt to gdp pushes government-bond yields up by 0.13-0.17 percentage points. 

(In practice, of course, other things are not always equal: the long-run effect of increased bond supply on safety and liquidity premia may be offset by other factors, such as a short-run surge in demand for safe assets prompted by financial instability, leading to falling bond yields amid rising debt loads.)

Because the supply of bonds matters, Mr Mian and co-authors write, a level of government debt that is too low can result in an interest rate that slinks towards zero. 

But rates cannot fall much further below zero; the result is narrower scope for central banks to stimulate activity, and therefore lower economic growth and higher unemployment. 

The problems of debt sustainability are often associated with high debt levels, which push the interest rate above the economic-growth rate. 

When that condition is met, the debt burden grows steadily even in the absence of new borrowing. 

But the authors raise the theoretical possibility of another source of fiscal-sustainability problems: when too low a level of debt leads to serious deflation, dragging the growth rate into negative territory and below the interest rate.

In between those two extremes, the researchers argue, lies a “Goldilocks zone” in which a fiscal free lunch is possible. 

They flesh out a point highlighted in 2019 by Olivier Blanchard of the Peterson Institute for International Economics: that when the interest rate on public debt is below the economy’s growth rate, existing debt burdens have essentially no fiscal cost. 

In such cases, existing debt will decline as a share of output even if no new taxes are levied—though a government that continues to run deficits may nonetheless add to its debt pile. 

Assuming a balanced budget and based on estimates of the convenience yield on Treasuries, the authors reckon that America’s Goldilocks zone—the maximum level of debt you could reach and then stabilise without raising taxes—could extend up to about 260% of gdp. 

(The uncertainty around their estimates means the limit could lie between 230% and 300% of gdp.)

There is also a range of indebtedness across which governments may run deficits in perpetuity without increasing the debt burden. 

America, they estimate, could run a deficit of 2.1% of gdp for ever so long as its debt is below 130% of gdp (after which threshold the largest deficit that could be run in sustained fashion without raising the debt burden drops steadily towards zero).

This logic suggests that though supersized deficits may be appropriate now, America cannot run them for ever. 

Doing so would cause debt to rise, potentially out of the Goldilocks zone and into riskier territory. 

And the longer America waits to shrink its deficit to the maximum sustainable level, the closer to surplus (or the further into surplus) that level will be. 

Mr Biden may take some comfort from the fact that his borrowing is manageable for now. 

Even so, it could eventually limit America’s fiscal freedom.

Bonds away

Importantly, a Goldilocks window is not fixed. 

Slower economic growth could shrink the safe zone by narrowing the gap between growth and interest rates—unless, that is, an economic slowdown also causes a sharp drop in interest rates, pushing them closer to zero and necessitating fiscal stimulus. 

Rising inequality may lead to calls for redistribution, but because the rich tend to buy government bonds in disproportionate numbers, levelling the income distribution may reduce the scope for a fiscal free lunch. 

That also means, the authors note, that efforts to address wide deficits through progressive taxes may not bear much fruit: taxes on high earners will hoover up money that might be used to buy bonds.

Analyses such as these are trying to understand circumstances outside of historical experience, and necessarily come with large uncertainties and assumptions attached. 

Budget-setting politicians too have uncertainties to navigate, and must do so carefully. 

Government borrowing plays a starring role in today’s macroeconomic zeitgeist. 

A balance of sorts is still required, between making good use of the government’s capacity to borrow, and acknowledging that limits to public borrowing are not so distant that they can be ignored altogether.

Michael Pento: The Fed’s Tools Are Broken

BY JOHN RUBINO 


The U.S. central bank has metastasized from an institution that was originally designed to assist distressed banks, to one that believes its purview now includes perpetuating asset bubbles, fighting global warming and reconciling racial inequities. 

Another distortion of the original purpose of the Fed is that its mandate has changed from providing stable prices and full employment, to creating an inflation rate above 2% for a period of time equivalent to the duration it was below that level.

But the members of the FOMC claim there is nothing to fear if inflation were to ever grow too hot because it has the tools to bring it under control. 

In other words, when necessary, the FOMC can not only stop QE but it can raise rates aggressively enough to vanquish inflation without destroying the markets and economy along the way. 

Let’s see just how true this contention really is.

But before we get to how “successful” the fed will be to tame inflation, a funny thing happened on the way to achieve its 2% goal. 

Our central bank focuses on the incredibly distorted core rate of inflation found in the Personal Consumption Expenditures Price Index. 

But meanwhile, prices are surging in the real world. 

For instance, headline PCE inflation increased by 3.65% year over year in April. 

And even in the fed’s preferred metric, prices jumped by 3.1% y/y. 

Not only this, but a slightly less massaged reading of inflation, which can be found in the headline CPI metric, had prices rising by 4.2% y/y.

If you want an even more accurate view of the current rate of inflation just look at home prices, which are up 21% y/y, according to Redfin data. 

Also, the 19 commodities in the CRB Index have soared by over 60% in the past 12 months. 

Safe to say, the actual rate of inflation is already far above the Fed’s inane 2% target.

These absurd inflation rates were brought about by paying citizens $6 trillion between 3/20-3/21 to lay fallow at home and not produce goods and services. 

Hence, creating supply shortages; and a huge void to absorb the massive liquidity wave. 

Therefore, the rate of inflation has already climbed to a point that is dramatically destabilizing to the economy. 

This is the conundrum for our Treasury and Fed: keep printing money and cause inflation to run intractable, which will destroy the stock market and the economy. 

Or, stop monetizing debt and let the gravitational forces of deflation implode the gargantuan asset bubbles. 

Given the history of the Fed, it is clear Mr. Powell will soon try to once again convince investors that the U.S. economy has healed and it’s time to normalize monetary policy.

Most in government and on Wall Street claim that the Treasury can slowly and innocuously reduce its spending while the Fed gradually stops printing money. 

However, this is virtually impossible because of the massive amount of debt taken on since the start of the global pandemic and the mind-boggling level of asset prices–which are predicated on free and continuous money printing.

Twenty percent of the largest U.S. corporations are in the zombie category (meaning they don’t earn enough money to even pay interest on outstanding debt). 

Those big businesses are carrying some $2.6 trillion in debt, according to Barron’s. 

Once the free-money spigot is turned off, massive bankruptcies will emerge. 

The asset bubbles in junk bonds, real estate and equities have been built on top of that risk-free-rate of zero percent. 

Take it away and the game ends in catastrophe.

History is clear regarding this dynamic. 

In the year 2000—the peak of the NASDAQ bubble–the Fed Funds Rate (FFR) was 6.5%. 

It was reduced to 1% by June 2003, in order to help ease the pain of the imploding stock market. 

But by June 2006, the Fed promised the crisis was over and had the FFR back to a lower high of 5.25%.

However, Mr. Bernanke had it all wrong. 

Bringing interest rates close to the average rate caused the housing market to crash. 

In the wake of the Great Financial Crisis, the FFR was taken to zero percent by December 2008—it was the first time in history that money became almost free.

Of course, the members of the FOMC are very slow learners. 

The Fed was once again assuring a weary consumer that the once in a hundred-year storm had passed, and the current Fed-Head Jerome Powell finished the job started by Janet Yellen when he took rates to another lower high of just 2.5% in 2018.

Nevertheless, a crash in the equity market in the fall of 2018, plus a REPO market crisis in the summer of 2019 caused the Fed to cut rates three times, to 1.75% by October of that same year. 

Unsurprisingly, the global Pandemic eventually put the FFR back to zero percent, but it was already on its way there before the advent of COVID-19.

Money printing, debt accumulation and asset bubbles have become the fragile foundation for which this current economy is built. 

Therefore, the notion that the Fed can end its $120 billion per month QE program and gradually raise interest rates back anywhere close to the normal level of 5-6% is ridiculous. 

Indeed, it would be shocking if it could get rates close to the previous high of 2.5%–the new lower high on the FFR is probably below one percent given the massive increase in the number of insolvent companies and unsustainable level of equity valuations.

Forget about 2% core PCE inflation. 

Intractable inflation is acutely manifest in asset prices right now! 

However, the government and many businesses can only pretend to be solvent while borrowing costs are close to zero. 

Take the free money away and the whole system goes belly-up.

For proof, just think about the following three key data points. 

For proof, just look at the following three key charts.


If the Fed couldn’t normalize rates before, how could it possibly come close to doing so now?

The truth is any real effort to tighten monetary policy back to the previous old high of 2.5% will cause the credit markets to freeze once again, which should cause a more intense market crash than the other previous attempts to normalize borrowing costs. 

Nevertheless, Mr. Powell will soon lead the average investor down this predictably perilous path toward perdition. 

The question is, what happens when consumers and investors reach the epiphany that the Fed’s tools for the purpose of taming inflation have now become broken?


Michael Pento is the President and Founder of Pento Portfolio Strategies, produces the weekly podcast called, “The Mid-week Reality Check” and Author of the book “The Coming Bond Market Collapse.”

The Return of the Finance Threat?

Given recent history, policymakers would be unwise merely to hope for a best-case scenario in which a strong and quick economic recovery redeems the enormous run-up in debt, leverage, and asset valuations. Instead, they should now act now to moderate the finance sector’s excessive risk-taking.

Mohamed A. El-Erian



CAMBRIDGE – After the 2008 global financial crisis, governments and central banks in advanced economies vowed that they would never again let the banking system hold policy hostage, let alone threaten economic and social well-being. 

Thirteen years later, they have only partly fulfilled this pledge. 

Another part of finance now risks spoiling what could be – in fact, must be – a durable, inclusive, and sustainable recovery from the horrid COVID-19 shock.

The story of the 2008 crisis has been told many times. 

Dazzled by how financial innovations, including securitization, enabled the slicing and dicing of risk, the public sector stepped back to give finance more room to work its magic. 

Some countries went even further than adopting a “light-touch” approach to bank regulation and supervision, and competed hard to become bigger global banking centers, irrespective of the size of their real economies.

Unnoticed in all this was that finance was in the grip of a dangerous overshoot dynamic previously evident with other major innovations such as the steam engine and fiber optics. 

In each case, easy and cheap access to activities that previously had been largely off-limits fueled an exuberant first round of overproduction and overconsumption.

Sure enough, Wall Street’s credit and leverage factories went into overdrive, flooding the housing market and other sectors with new financial products that had few safeguards. 

To ensure quick uptake, lenders first relaxed their standards – including by offering so-called NINJA (no income, no job, no assets) mortgages that required no documentation of creditworthiness from the borrower – and then engaged in outsize trading among themselves.

By the time governments and central banks realized what was going on, it was too late. 

To use the American economist Herbert Stein’s phrase, what was unsustainable proved unsustainable. 

The financial implosion that followed risked causing a global depression and forced policymakers to rescue those whose reckless behavior had created the problem.

To be sure, policymakers also introduced measures to “de-risk” banks. 

They increased capital buffers, enhanced on-site supervision, and banned certain activities. 

But although governments and central banks succeeded in reducing the systemic risks emanating from the banking system, they failed to understand and monitor closely enough what then happened to this risk.

In the event, the resulting vacuum was soon filled by the still lightly supervised and regulated non-banking sector. 

The financial sector thus continued to grow markedly, both in absolute terms and relative to national economies. 

Central banks stumbled into an unhealthy codependency with markets, losing policy flexibility and risking the longer-term credibility that is critical to their effectiveness. 

In the process, assets under management and margin debt rose to record levels, as did indebtedness and the US Federal Reserve’s balance sheet.

Given the magnitudes involved, it is not surprising that central banks in particular are treading very carefully these days, fearful of disrupting financial markets in a manner that would undermine the post-pandemic economic recovery. 

On a financial-sector highway where too many participants are driving too fast – some recklessly so – we have already had three near-accidents this year involving the government debt market, retail investors pinning hedge funds in a corner, and an over-levered family office that inflicted a reported $10 billion of losses on a handful of banks. 

Thanks to some good fortune, rather than official crisis prevention measures, each of these events did not cause a major pileup in the financial system as a whole.

Central banks’ long-evolving codependent relationship with the financial sector seems to have led policymakers to believe that they had no choice but to insulate the sector from the pandemic’s harsh reality. 

That resulted in an even more stunning disconnect between Wall Street and Main Street, and gave a further worrisome boost to wealth inequality. 

In the 12 months to April 2021, the combined wealth of the billionaires on Forbes magazine’s annual global list increased by a record $5 trillion, to $13 trillion. 

And the world’s billionaire population grew by nearly 700 from the previous year, reaching an all-time high of more than 2,700.

Policymakers would be unwise merely to hope for the best – namely, a type of financial deus ex machina in which a strong and quick economic recovery redeems the enormous run-up in debt, leverage, and asset valuations. 

Instead, they should act now to moderate the financial sector’s excessive risk-taking. 

This should include containing and reducing margin debt; enforcing stronger suitability criteria on broker dealers; enhancing assessment, supervision, and regulation of non-banking institutions; and reducing the tax advantages of currently favored investment gains.

These steps, both individually and collectively, are not in themselves a panacea for a persistent and growing problem. 

But that is no excuse for further delay. 

The longer that policymakers allow the current dynamics to grow, the greater the threat to economic and social well-being, and the bigger the risk that yet another crisis erupts – unfairly and despite a decade of promises – in the same sector as last time.


Mohamed A. El-Erian, President of Queens’ College, University of Cambridge, is a former chairman of US President Barack Obama’s Global Development Council. He was named one of Foreign Policy’s Top 100 Global Thinkers four years running. He is the author of two New York Times bestsellers, including most recently The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse.