Saturday, August 6, 2011

We Are All Austerians Now

Mark Thoma:

we must cut spending and raise taxes to get the debt under control

I'm sorry, but This. Is. Not. True.

If you look at future debt-GDP ratios and think they are too high, how can you reduce them?

1. You can improve the primary balance by raising taxes and/or reducing spending.

2. You can raise the growth rate.

3. You can lower the real interest rate on government debt.

4. You can raise inflation. (This may also help with 3, depending what we think of Fisher's law.)

EDIT: 5. You can default. (Thanks, Bruce Wilder.)

One is not the only choice. We can, of course, debate which of these choices offers the best tradeoff between feasibility and desirability. But it is not true that reducing the long-run debt-GDP ratio necessarily involves reducing spending or raising taxes. And anyone who want a rational discussion of fiscal issues, needs to stop lying to people that it is.

How bad things are, can be seen by the fact that someone as smart as Barkely Rosser has been convinced that a reluctance to raise taxes is the problem for aggregate demand. When the debate comes down or whether we should raise taxes or cut spending, the real question has been answered, and answered wrong. At that point it's just a question of what flavor of austerity we want. Thank god at least there's still Daniel Davis.

If we wanted to move this debate forward, the next step would be to look at periods when the long term debt-GDP ratio was reduced in rich countries. How much was due to the primary balance that Thoma takes for granted is the only solution, how much was due to faster growth, how much to lower interst rates and how much to higher inflation?


  1. yeah.

    When you say, "the next step would be to look at periods when the long term debt-GDP ratio was reduced" -- you are talking about Federal debt, yes? If so, you are overlooking the problem as surely as Thoma. Reduction of Non-Federal debt is the key. Deleveraging. It is happening anyway, slowly and painfully. Can policy not do a better job?

  2. Hi Arthurian,

    As it happens, I was just emailing about this very issue with a friend. My hypothesis, so far untested, is that reductions in the ratio of public debt to GDP that are achieved through favorable shifts in growth, interest and/or inflation will usually be accompanied by reductions in private debt also, while reductions in public debt that come through tax and/or spending changes will be accompanied by increases in private debt. it seems logical, right? But we'll see if the data bears it out.

  3. Hi, JW. An improvement in growth should show an *increase* in private debt relative to GDP, because we use credit for growth. The postwar golden age, 1947-73 or so, will show a vast increase in private debt and a relative decrease of public. Also, 1995-2000. (But I don't usually include GDP in my debt ratios.)

    Your evaluation seems to see debt as a result of other factors; I see it as a driving force. I think the ratio between Federal and Non-Federal debt is far more significant than has been recognized, as far as its effect on growth.

    Thanks, JW. And I look forward to seeing your data.

    ps. I like the writing style that does not fear to abuse punctuation with purpose: "This. Is. Not. True."

  4. If the list is meant to be comprehensive, then you should consider adding:
    5. Default

    Logically, default is a category of options, too. And, there are circumstances, especially when 1.) and 2.) get entangled in a dynamic of downward spiral for the economy, when it might be a necessary option.

  5. Bruce-

    True, I should have included default/repudiation on the list. In my defense, the question I'm mainly interested in right now is how rich countries have reduced debt-GDP ratios historically, and one has to expand the bounds of history and/or rich countries considerably before default enters the picture.

    I should add, I realize now that if nominal interest rates fully incorporate inflation, even if it's with a long lag, then only permanent increases in inflation reduce the debt-GDP ratio. Arguments that countries have successfully inflated away debt with temporary periods of inflation assume, implicitly or explicitly, that nominal interest rates are *not* set as a fundamentally-determined real interest rate plus (lagged) inflation, i.e. that Fisher's Law does not hold. I think this is probably reasonable in a wide range of contexts, but it's definitely an unorthodox assumption.

  6. It seems the IMF staff have answered the question, how much debt reduction comes from r<g and how much from primary surplus. See

    It appears in the Golden Age, a lot from r<g, but before and after that, mostly from primary surplus.

    This debate is also raging on the internet between Krugman and MMT crowd. As I read it, it really boils down to do you believe the state has the power to make r<g as a policy setting? If so, then "deficits don't matter" (the MMT position, as articulated by Galbraith, e.g. in his TNR and Levy writings); if not, then deficits do imply the need for a primary surplus some time in the future.

    I lean toward the latter position. I think that the long run is 'marxian' and the state has real constraints, even if the short run looks more keynesian. But this is what the left needs to thrash out, so thanks for your excellent posts!!

  7. Thanks Tom!

    Looks very much like what I was thinking of trying to do. Of course this is much more comprehensive than anything I could have attempted. Do you know if the underlying data is available?

    I have to admit, I'm a little disappointed, I thought this would be an interesting project. But I'm sure there's more to be said.

    I agree with you about what's at stake in the MMT debates. Not so sure I agree on the answer. It's not obvious that whatever factors held real interest rates down in 1940-1980 conditions couldn't do so in the future. If inflation is passed through to nominal interest rates less than one for one, that's a reliable way to raise g relative to r. And in the short run, part of changes in the primary balance have to be attributed to changes in output. It's not clear if the IMF folks made any correction for that, but it doesn't look like it.

    I'll try to clarify my thoughts on this in another post soon.

  8. I definitely do agree with the implicit criticism of MMT that the lack of a financial constraint on fiscal policy can't simply be deduced from the fact that the state borrows in its own currency.

  9. "How much was due to the primary balance that Thoma takes for granted is the only solution, how much was due to faster growth, how much to lower interst rates and how much to higher inflation?"

    This FRED graph (GDPC1 / GDPDEF) shows the tussle between faster growth and higher inflation.

    I have not thought how to stick the other factors in there yet :)