Friday, April 5, 2013

Borrowing ≠ Debt

There's a common shorthand that makes "debt" and "borrowing" interchangeable. The question of why an economic unit had rising debt over some period, is treated as equivalent to the question of why it was borrowing more over that period, or why its expenditure was higher relative to its income. This is a natural way of talking, but it isn't really correct.

The point of Arjun's and my paper on debt dynamics was to show that for household debt, borrowing and changes in debt don't line up well at all. While some periods of rising household leverage -- like the housing bubble of the 2000s -- were also periods of high household borrowing, only a small part of longer-term changes in household debt can be explained this way. This is because interest, income growth and inflation rates also affect debt-income ratios, and movements in these other variables often swamp any change in household borrowing.

As far as I know, we were the first people to make this argument in a systematic way for household debt. For government debt, it's a bit better known -- but only a bit. People like Willem Buiter or Jamie Galbraith do point out that the fall in US debt after World War II had much more to do with growth and inflation than with large primary surpluses. You can find the argument more fully developed for the US in papers by Hall and Sargent  or Aizenman and Marion, and for a large sample of countries by Abbas et al., which I've discussed here before. But while many of the people making it are hardly marginal, the point that government borrowing and government debt are not equivalent, or even always closely linked, hasn't really made it into the larger conversation. It's still common to find even very smart people saying things like this:
We didn’t have anything you could call a deficit problem until 1980. We then saw rising debt under Reagan-Bush; falling debt under Clinton; rising under Bush II; and a sharp rise in the aftermath of the financial crisis. This is not a bipartisan problem of runaway deficits! 
Note how the terms "deficits" and "rising debt" are used interchangeably; and though the text mostly says deficits, the chart next to this passage shows the ratio of debt to GDP.

What we have here is a kind of morality tale where responsible policy -- keeping government spending in line with revenues -- is rewarded with falling debt; while irresponsible policy -- deficits! -- gets its just desserts in the form of rising debt ratios. It's a seductive story, in part because it does have an element of truth. But it's mostly false, and misleading. More precisely, it's about one quarter true and three quarters false.

Here's the same graph of federal debt since World War II, showing the annual change in debt ratio (red bars) and the primary deficit (black bars), both measured as a fraction of GDP. (The primary deficit is the difference between spending other than interest payments and revenue; it's the standard measure of the difference between current expenditure and current revenue.) So what do we see?

It is true that the federal government mostly ran primary surpluses from the end of the war until 1980, and more generally, that periods of surpluses were mostly periods of rising debt, and conversely. So it might seem that using "deficits" and "rising debt" interchangeably, while not strictly correct, doesn't distort the picture in any major way. But it does! Look more carefully at the 1970s and 1980s -- the black bars look very similar, don't they? In fact, deficits under Reagan were hardy larger than under Ford and Carter --  a cumulative 6.2 percent of GDP over 1982-1986, compared with 5.6 percent of GDP over 1975-1978. Yet the debt-GDP ratio rose by just a single point (from 24 to 25) in the first episode, but by 8 points (from 32 to 40) in the second. Why did debt increase in the 1980s but not in the 1970s? Because in the 1980s the interest rate on federal debt was well above the economy's growth rate, while in the 1970s, it was well below it. In that precise sense, if debt is a problem it very much is a bipartisan one; Volcker was the appointee of both Carter and Reagan.

Here's the same data by decades, and for the pre- and post-1980 periods and some politically salient subperiods.  The third column shows the part of debt changes not explained by the primary balance. This corresponds to what Arjun and I call "Fisher dynamics" -- the contribution of growth, inflation and interest rates to changes in leverage. [*] The units are percent of GDP.

Totals by Decade

Primary Deficit Change in Debt Residual Debt Change

1950s -8.6 -29.6 -20.9

1960s -7.3 -17.7 -10.4

1970s 2.8 -1.7 -4.6

1980s 3.3 16.0 12.7

1990s -15.9 -7.3 8.6

2000s 23.7 27.9 4.2

Annual averages

Primary Deficit Change in Debt Residual Debt Change

1947-1980 -0.7 -2.0 -1.2

1981-2011 0.1 1.3 1.2

   1981-1992 0.3 1.8 1.5

   1993-2000 -2.7 -1.6 1.1

   2001-2008 -0.1 0.8 0.9

   2009-2011 7.3 8.9 1.6

Here again, we see that while the growth of debt looks very different between the 1970s and 1980s, the behavior of deficits does not. Despite Reagan's tax cuts and military buildup, the overall relationship between government revenues and expenditures was essentially the same in the two decades. Practically all of the acceleration in debt growth in the 1980s compared with the 1970s is due to higher interest rates and lower inflation.

Over the longer run, it is true that there is a shift from primary surpluses before 1980 to primary deficits afterward. (This is different from our finding for households, where borrowing actually fell after 1980.) But the change in fiscal balances is less than 25 percent the change in debt growth. In other words, the shift toward deficit spending, while real, only accounts for a quarter of the change in the trajectory of the federal debt. This is why I said above that the morality-tale version of the rising debt story is a quarter right and three quarters wrong.

By the way, this is strikingly consistent with the results of the big IMF study on the evolution of government debt ratios around the world. Looking at 60 episodes of large increases in debt-GDP ratios over the 20th century, they find that only about a third of the average increase is accounted for by primary deficits. [2] For episodes of falling debt, the role of primary surpluses is somewhat larger, especially in Europe, but if we focus on the postwar decades specifically then, again, primary surpluses accounted for only a about a third of the average fall. So while the link between government debt and deficits has been a bit weaker in the US than elsewhere, it's quite weak in general.

So. Why should we care?

Most obviously, you should care if you're worried about government debt. Now maybe you shouldn't worry. But if you do think debt is a problem, then you are looking in the wrong place if you think holding down government borrowing is the solution. What matters is holding down i - (g + π) -- that is, keeping interest rates low relative to growth and inflation. And while higher growth may not be within reach of policy, higher inflation and lower interest rates certainly are.

Even if you insist on worrying not just about government debt but about government borrowing, it's important to note that the cumulative deficits of 2009-2011, at 22 percent of GDP, were exactly equal to the cumulative surpluses over the Clinton years, and only slightly smaller than the cumulative primary surpluses over the whole period 1947-1979. So if for whatever reason you want to keep borrowing down, policies to avoid deep recessions are more important than policies to control spending and raise revenue.

More broadly, I keep harping on this because I think the assumption that the path of government debt is the result of government borrowing choices, is symptomatic of a larger failure to think clearly about this stuff. Most practically, the idea that the long-run "sustainability" of the  debt requires efforts to control government borrowing -- an idea which goes unquestioned even at the far liberal-Keynesian end of the policy spectrum --  is a serious fetter on proposals for more stimulus in the short run, and is a convenient justification for all sorts of appalling ideas. And in general, I just reject the whole idea of responsibility. It's ideology in the strict sense -- treating the conditions of existence of the dominant class as if they were natural law. Keynes was right to see this tendency to view of all of life through a financial lens -- to see saving and accumulating as the highest goals in life, to think we should forego real goods to improve our financial position -- as "one of those semicriminal, semi-pathological propensities which one hands over with a shudder to the specialists in mental disease."

On a methodological level, I see reframing the question of the evolution of debt in terms of the independent contributions of primary deficits, growth, inflation and interest rates as part of a larger effort to think about the economy in historical, dynamic terms, rather than in terms of equilibrium. But we'll save that thought for another time.

The important point is that, historically, changes in government borrowing have not been the main factor in the evolution of debt-GDP ratios. Acknowledging that fact should be the price of admission to any serious discussion of fiscal policy.

[1] Strictly speaking, debt ratios can change for reasons other than either the primary balance or Fisher dynamics, such as defaults or the effects of exchange rate movements on foreign-currency-denominated debt. But none of these apply to the postwar US.

[2] The picture is a bit different from the US, since adverse exchange-rate movements are quite important in many of these episodes. But it remains true that high deficits are the main factor in only a minority of large increases in debt-GDP ratios.


  1. Just so I follow you here, what's driving this is that old debts are continually refinanced at new rates?

    1. Right. Government debt isn't like a mortgage, it's being continuously rolled over. So a change in interest rates is going to lead to a higher or lower government debt, independently of current spending and revenues.

  2. Great post. I do have a naive question though, since one aspect of debt is its inter-generational nature, what role does inheritance tax play in influencing the dynamics? If debt is just money we owe to our selves and what we need to worry about is the redistributive effects of government borrowing, then this area of tax policy would seem really critical.

  3. Naive question 2(and 3). I remember a lecture by Robin Hahnel about the class nature of the struggle over inflation policy. One thing I remember though is that the effect on eroding private debt is over-stated because interest rates on long term lending are set with expected inflation rates in mind (which works as long inflation is constant). Does this not happen with public debt?
    And even with private debt, controlling inflation is so a big part of the "establishment" world view, this seems to argue against the idea that lenders can easily handle inflation, i.e., if they can adjust what is the real motivating factor for the inflation "obsession"?

  4. You forget that inflation and interest rates are not independent of debt. Inflation requires an increasing money supply, and the monetary base is backed mainly by government debt. Low interest rates remove incentives for government to reduce debt.

    In addition a high government debt can in and of itself cause the government sector to lose control of interest rates.

    1. Inflation and the money supply are not related and as a monetarily sovereign nation we set the interest rates to wherever we want.

  5. Actually this is all much better known than you realize, but historically states have run into bigger problems when central banks are tools of government that attempt to hold the government's interest rates below the rate of inflation. The goal is not merely to reduce debt, it is to increase well-being, and the '70s policies failed to do that. Hence (semi) independent central banks and eventually inflation targeting became the norm in the developed world.

    That's being rolled back in different ways across the developed world. So far developed-world central banks despite their efforts haven't succeeded in creating much inflation, except to some extent in import prices, by sending capital to and driving inflation in emerging market countries. Public debts continue to climb.

    Japan has taken the step that I guess the author of this article thinks the US should take next: to roughly double monetary financing of the deficit. So those of you who support that will get to see just how effective CB policy is in generating inflation against a deflationary tide. I think you'll be very disappointed, and in five years you won't want to be reminded of articles like these.

  6. Hey Anon,

    Well, I don't claim the point is original, and I cite various papers making it, and could have cited more. So I'm not sure i don't realize how well known all this is. That said, it seems to me that it is definitely not part of the usual discourse around public debt, which usually clearly assumes that the primary deficit is the only margin available. So I think it's worth reminding people that interest rates and inflation are just as important - more important, historically - for the trajectory of public debt.

    Now, whether a central bank can reliably generate inflation is a different question. I am with you, that the powers of central banks have been exaggerated. The apotheosis of central banking "maestros" is a central (and somewhat weird) feature of this political moment. But to say that central banks don't have as much scope for setting the level of demand as often supposed, is not the same as saying there is no scope for demand management at all. I agree with you that saying the central bank can just create inflation (or set the level of nominal GDP) is naive. But to find a situation of growth plus inflation greater than the interest rate on government debt, you only have to go back to 2005 or so. I'm fairly confident that at some point in the next ten years, if not the next five, there will be significant inflation and significant pressure on the fed to raise rates to control it. So what I'm saying is, liberals who want to be "responsible" now about debt a decade from now, should be trying to do something about that, instead of about future spending decisions.

    Also, could you use a handle of some kind?

  7. If you go back through the historical records of 1948-1960 you see that for both Truman and Eisenhower deficit reduction was an absolute priority and that the inflation-adjusted cuts were by no means easy or popular.

  8. "If you go back through the historical records of 1948-1960.."

    OK, let's review the record:

    Federal outlays per capita in constant 1948 dollars:
    1948: Defense: 137, Social Welfare: 81, total 304
    1960: Defense: 262, Social Welfare: 133, total: 521

    Federal Outlays as a percentage of GNP:
    1948: 13.8
    1960: 19.3

    (Source: "The Growth of American Government: Governance from the Cleveland era to the present" by Ballard Campbell)

    No "painful cuts" occurred, rather a huge increase in expenditure occurred during this time period for both defense and non-defense spending. While an individual program may have been cut, and the justification for doing so may have been "the deficit", other programs more than took its place. The expansion in outlays was much greater from 1948-1960 than the increase in expenditure that occurred during great society spending under Johnson.

    Rather, what you have is some public handwringing about the deficit, primarily to justify the introduction of higher corporate and individual tax rates as the government outlays continued to increase.

    "After [Coolidge] departed the White House, Federal spending exceeded revenues in nearly every year. Yet each modern president echoed his predecessors in expressing an abhorrence of budget deficits" (p.198)

    1. Thanks, rsj. This is all seems right to me.

      Now, to be fair, while it's wrong to talk about "painful cuts" in the immediate postwar years, it is true that the federal government did have substantial surpluses for most of that period. Those surpluses just don't explain most of the fall in the debt-GDP ratio.

    2. Yes, I agree with your point! But I was responding to the (commonly held) notion that belt tightening or some kind of consumption pain must follow deficit spending when the debt is "repaid". Particularly if the deficit spending stimulates the economy. This was the point maid by Anon.

      For the private sector as a whole, transfers of real resources to the government occur when the government purchases consumption that the private sector would otherwise purchase for itself. That is the only time when belt-tightening is required.

      It makes no difference if the government prints bonds to buy this year's apple harvest, or prints money to do so, or raises taxes, or just confiscates the apples. In all cases the *required* pain is the quantity of apples purchased by the government that the private sector would have purchased for itself.

      Everything else is a question of good or bad tax/transfer policies. There may well be secondary pains, but these are unnecessary self-inflicted wounds.

      In the case of world war 2, the pain of deficit spending occurred as a result of rationing -- the government purchased consumption that the private sector would have purchased on its own. That war itself was the period of belt-tighetning. It was not followed by a second belt-tightening to "repay" the war debts, it was followed by a consumption boom.

      Bond holders got more in interest payments but paid it back and then some with higher tax rates. It was a null op and so there was no second round of belt tightening. It is *never* necessary to have a second round of belt-tightening to "repay" government debt held by the domestic private sector.

  9. Today Krugman has a piece on "missing deflation", that said that because of downward wage rigidity actual deflation is really rare.
    But the idea of deflation is that a fall in nominal prices causes an increase of debt in real terms.
    We also generally think that economic actors react to expected inflation .
    Which makes me wonder: isn't the current scenario of falling inflation and rising debts a form of "hidden deflation"?

    1. This anonymous here is me. It seems I have some problem with the commenting technology.

  10. RL-

    I thought that Krugman piece was fine. What I would add is that it's not just that wages are sticky downward at zero, there are a lot of zeros built into the price system. But he is certainly right on the big point, which is that the tendency of inflation to converge to zero rather than fall below it is a result of the way the economy works, not a sign of successful inflation targeting.

    The important addition -- which you suggest here -- is that nominal interest rates are also quite sticky, even at inflation rates well above zero. So a fall in inflation translates into a rise in real interest rates, and rising debt burdens. Rising real interest rates due to disinflation is sometimes called the Fisher effect, and it means that the economic effects of falling inflation can be quite similar to outright deflation. So yes, I think talking about "hidden deflation" is right.

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