Tag Archives: debt

Earlier today Matt Yglesias borrowed a chart from Thomas Piketty’s new book noting that public assets remain above public debt. This chart actually underestimates the strength of our balance sheet.  A more striking image is the ratio of our gross national product (GNP) to our gross domestic product (GDP).
The left axis here is a pretty narrow range, so the dynamics aren’t as extreme as they first seem, but what you’re seeing is that the GDP-GNP ratio is at it’s highest pint in history and continues to rise. What does that mean? Remember from Econ 101 that the GNP = GDP + American income on foreign assets – foreign income on American assets. In essence, the ratio I’m graphing shows that over the past decade net inflows have grown substantially faster than GDP, despite the skyrocketing debt. (Since GNP/GDP = 1 + (net payments)/GDP In fact, you would expect precisely the opposite phenomenon, more so than ever before as our deficits are increasingly financed by foreign savings (interest payments to domestic pension funds cancel out). As Wikipedia recites basic economic wisdom:
Similarly, if a country becomes increasingly in debt, and spends large amounts of income servicing this debt this will be reflected in a decreased GNI but not a decreased GDP. Similarly, if a country sells off its resources to entities outside their country this will also be reflected over time in decreased GNI, but not decreased GDP. This would make the use of GDP more attractive for politicians in countries with increasing national debt and decreasing assets.,
It’s worthwhile asking yourself what exactly national debt represents – a claim on future income. This graph suggests that our claim on everybody else’s future income is way higher than their claim on our income. You should be scratching your head – why are emerging markets throwing money at us when the domestic return on capital is far more attractive? They are lending us really cheap credit so that we can recycle that to our firms which then invest in foreign equities earning a huge premium. That should sound pretty familiar to you, because it’s basically how Wall Street made all of its money. America, basically, is a huge hedge fund.
But for the Federal Government, this isn’t a problem. We can always roll over our debt since the dollar is sovereign. We can actually make some pretty insightful observations taking the perspective that the government is a big bank. We could theoretically sell our foreign assets to repurchase our own debt (or, since we don’t have a sovereign wealth fund, tax our citizens more, which is the same thing) which is less volatile than emerging market equities (and isn’t subject to any currency risk). But we’d then be short emerging market, which means we would pay the risk premium rather than earn it. 
The in-built short term volatility isn’t actually a big deal, either. In the long-run, equity indices are pretty well correlated with economic growth, and everybody else will grow faster than us on average. That leaves liquidity risk, but because the Federal Reserve exists even that is negligible. The currency implications of this are even more mind bending still. For most countries, a depreciation has a negative wealth effect – that is we can buy less on the international market than before in real terms. But the more our own inflows are denominated in foreign currencies, the less obvious this link becomes. That gives monetary policy more space as higher inflation would be a lot less detrimental for us than any other country.
People are happy to pay a premium for safety. We should be happy to earn that spread. 

Tyler Cowen recently linked to Larry Kotlikoff on the correlation between growth and debt. I want to keep this a short post, without passing judgement on the actual question RR set to answer. Now let’s be clear, Kotlikoff’s post actually had nothing to do with the correlation on growth and debt, but with his decade-long position that “official debt” is a legal anachronism and what we ought to worry about is our fiscal gap. Indeed the article barely discusses the causal levers in the debt-GDP ratio, and primarily rehashes a thesis he has made over and over. (There is nothing wrong with this, but it’s important to understand the context of the conversation).

There may be merit to that claim, but his conclusions are far less empirically-founded than RR or Dube. Take this:

Domestic saving is the main determinate of domestic investment, so it’s no surprise that take as you go has also wiped out most of domestic investment. And less domestic investment has meant slower economic growth. In sum, Reinhart and Rogoff are right. They just aren’t using the right numbers to show they’re right.

You have to wonder on what basis Kotlikoff thinks RR “are right”. Has he compared – for all countries across the rich world – the correlation between growth rates and the discounted future value of all liabilities? What is the regression, I wonder? And on what confidence?

But the bigger point is, even if he had, it would not matter. Kotlikoff explains there’s no “economic theory” behind excluding our Social Security and Medicare liabilities from official debt. Actually there is: and it’s not going to sound pretty for the American taxpayer or pensioner.

If America seems likely to default on its “official debt” (here forward referred to as “debt”), international capital markets will reward us with a punishing increase in bond yields, and depreciation of dollar-denominated debt. Here’s what’s going to happen if America updates its promises to the sick and elderly: nothing.

Bond markets won’t break with adoption of chained CPI and Moody’s won’t downgrade us if we pass the Ryan Budget. In fact, we have multiple times amended our promises to these trusts. Imagine if one day Congress decides that paying creditors face-value isn’t politically savvy? People will never trust us again. And it will be worse than Argentina or whatever, because we do not even face a serious fiscal crisis. Capital markets will see an America that falls to political whims even when debt service is still eminently possible.

That’s the “economic” difference between liabilities to creditors and Social Security. Now, don’t get me wrong: left-wing commenters make the same comparison. When economists cringe at the idea of a debt ceiling crisis, but then suggest a “long run” entitlement reform, they ask “why default on your promises to the elderly”?

The answer is: they are political. On the left, I believe our safety net programs have strong economic value. But I cede that there is a fair argument that they do not, and are simply political artifacts. However, the financial position of American securities is an unimpeachable reality left, center, or right. Conflating the two is a significant mistake.

And why is this important to Kotlikoff’s claim? Well, there’s nothing in stone about the so-scary “$222 trillion”. The idea that CBO can compute our fiscal gap on an infinite horizon based on current law is absurd. Because “current law” has this uncanny habit of changing.

There’s another point as well: our social security and Medicare shortfalls are financed through the sale of government debt. That’s right – the argument that debt doesn’t mean much becomes even weaker when you consider our liabilities to entitlement programs are reflected in official debt figures, which are at least a better gauge of contemporary law.

Folks, I’m not telling you to ignore our fiscal position (though I think there’s a good case for agnosticism). But not all liabilities are created equal, I don’t know which “economic theory” textbook teaches you that. American debt is the most important source of liquidity in international capital markets. “Bonds” held by social security and Medicare pensioners are useless. They can’t even be traded.

That doesn’t mean Kotlikoff is wrong, in fact he’s dead right – just in the wrong debate. His argument makes an incredibly strong case that we must amend our law. That is the definition of a “$222 trillion” fiscal gap. There are no other ways to look at the picture. But the idea that theoretical dynamics behind growth and debt do not discriminate between mode of liability is insane.

The only social security vigilantes are political, backed in full confidence by the AARP.

Brad DeLong sends us to a fantastic paper from University of Massachusetts-Amherst economist Arindrajit Dube. This, in the wake of a powerful essay from Miles Kimball and (undergraduate!) Yichuan Wang, we learn two things:

  • Quartz publishes important empirical findings. (!)
  • There is not “even a shred of evidence […] for a negative effect of government debt on growth”.

We are approaching a new consensus, among serious people and clowns alike. The narrative – whether Keynesian or not – for the past two years has been a reluctant understanding that debt can have a adverse effect on level of GDP. The argument for immediate stimulus derived from the idea of hysteresis and liquidity traps rather than a rejection of long-term consequences from deficits, per se. Indeed, in my most popular blog post, I maintain that “It is of unimpeachable importance that the USA pay down its debt in the long-run.” I’m still wedded to this idea, but I would replace “unimpeachable” with “probable”. I am less confident that debt, even by itself, negatively effects growth. Indeed, in the long-run, we must all be agnostic. From where does this new consensus emerge?

Enter Dube. The central argument submitted by Keynesian critics such as Paul Krugman regarding the Reinhart-Rogoff result was the chance, indeed likelihood, of reverse causality. That is, R-R all but explicitly argued that high levels of debt are causally-linked with lower growth rates. The theoretical provisions included:

  • The idea that as the debt-to-annual-GDP ratio increases, interest payments will eat a greater portion of national output, and hence constrain investment. This is an argument I’ve empirically-questioned before.
  • The idea that as the debt-to-annual-GDP ratio increases, bond markets will perceive a positive feedback loop between further deficits and growing interest rates and will hence be unwilling to lend at any but exorbitant yields. The empirical doubts here are self-evident.

It is curious that no one until now has so thoroughly thrashed this idea, empirically, as Dube has just done. His insight was to delineate the empirical presentation of the two causal levers: (A) higher debt causes lower GDP and (B) lower GDP causes higher debt. The mathematical tautology that RR casually ignore is that, as Brad DeLong and Larry Summers to not tire of noting, ratios must have both a numerator (debt) and denominator (GDP).

Dube suggests, rather convincingly, that if (A) is true, current debt levels will be correlated with future growth rates and that if (B) is true, current debt levels will be correlated with past growth rates. And yet:

ImageWe do not see any  association – let alone threshold! – with regard to the debt-to-annual GDP ratio and the 5-year forward growth rate (light bar). Or take:


The correlation with past growth (i.e. slow growth causes debt) is far tighter than the corollary. It is noted several times in the paper that the very tight association for past, present, and future growth to debt correlations exist only at very low levels of debt. Perhaps it is because the sample for such is far smaller, and hence less diverse across economic structures, when debt is so low, indeed such is the exception not the rule.

Nagging at me, however, is that the empirics in this study look forward and backward only by 5 years. That is, I am curious how the relative correlation between past, present, and future growth with debt changes if the increment were changed to 1 year. To 10. And 50. The statistical and intellectual validity of very high increments are limited by the fact that:

  • The international economic structure can change wildly over long times.
  • There is very little theoretical reason to believe that debt levels in 1900 affect us today.
  • There is even less reason to believe growth rates in 1900 affect debt today.
  • Path dependency and serial correlation of GDP will make this a very noisy set.

In other words, the economic “long run” is not readily defined.

But “5” is still an arbitrary number. The bond vigilante theory would be quick-acting, suggesting we should employ a smaller increment. To put it crudely, the causality may be “diluted” by other complex factors with a large window. Further, low growth today effects the debt-to-annual-GDP ratio most importantly (by tautology) today, and decreases in causal importance – ignoring serial correlation – over a larger window.

Therefore, it might be interesting to see a correlation that defines the window by a weighted average of the association over a set of years, decreasing by some “discount” rate by year.

Here’s why this is important. There may be a certain “discount rate” – for wont of a less confusing term – or simple window period at which the relative correlation between lever (A) and lever (B) are very different. There would be substantial econometric and theoretical value in understanding the parameters for which (A) is most easily defended and, too, rejected.

A note of caution. There is a big obstacle in understanding the mechanism of causation between debt and GDP that is too little discussed. See:


I’m sure you’ve seen this graph a million times. Note how slow-changing it is. Both Kimball-Wang and Dube note this as a forgone conclusion, rather than as a warning sticker on their results. Unlike unemployment or GDP growth rates, which vary as a nice and bumpy business cycle, the above ratio hardly changes, and does so slowly. There are periods of secular decline (1950-1980) and secular ascent (1980-2000). There are no trends.

This means comparisons on different levels of debt take place on very different economic structures. When we talk about the America with 30% debt-to-annual-GDP (the first bin in R-R), we’re talking about an America before modern floating exchange rates, strong unions, extremely high taxes, and declining inequality – each of which adjusts the causal mechanism in question.

Therefore the ultimate lesson from any of the RR-smashers cannot be that debt does not hinder growth. Rather, it reinforces the econometric difficulty of answering such a question. It is often said that macroeconomists are deprived of a scientific lab. However, those studying business cycles and Okun’s Law can may control for factors within the relatively short 15-year time period, wherein the grand structure of the economy is unchanged.

RR, Kimball-Wang, and Dube face the more Sisyphean task of comparing economic structure over the longest of runs. Even the most sophisticated statistical techniques cannot erase the ferment economies undergo.

But I said a new consensus was emerging. No longer can even serious conservative commenters so easily claim to care about “growth” and simultaneously extoll the importance of balanced-budgets. RR, to their silent chagrin, have served, serve, and will continue to serve as the intellectual firepower for causal lever (A). But liberals no longer need to uncomfortably point to hysteresis and the liquidity trap.

It is no longer self-evident based on theoretical whims that debt causes low growth. As a profession, economists will emerge as formally agnostic on this question. And it will be their responsibility to inform politicians of this evolution and hence to propose an economic vision that is not held captive by one little ratio, but perhaps more ambitious goals: to remain the world’s richest and most innovative economy in the face of incredible competition.

In 1991, the United States officially switched from the gross national to the gross domestic product as the standard measure of output. They’ve basically moved together as this graph from FRED shows:


However, this obscures something pretty important. Take a look at this simple graph I made, with the GNP as a percent of GDP (left) and debt (right):


Ok a few very important caveats. The y-axis here is a very narrow range, so the dynamics aren’t nearly as significant as would first seem. But there does seem to be a general trend: that is over the postwar period there was a consistent increase until the ’80s, after which there was a (relatively) sharp decline until 2000, after which GNP/GDP goes up again to its highest point ever.

Note that 2000 was about the year George Bush started to randomly handout tax cuts and weird Medicare provisions. He also decided to invade Iraq. Naturally, our debt load increased. Here’s what Wikipedia says should happen, lest debt be evil:

Similarly, if a country becomes increasingly in debt, and spends large amounts of income servicing this debt this will be reflected in a decreased GNI but not a decreased GDP. Similarly, if a country sells off its resources to entities outside their country this will also be reflected over time in decreased GNI, but not decreased GDP. This would make the use of GDP more attractive for politicians in countries with increasing national debt and decreasing assets.

Or basically what conservatives have been preaching this whole time. After all, a Treasury is a claim on future American growth. James Hamilton frequently claims that interest rates are going to rise bringing rise to this truth.

Remember: GNP = GDP + American income on foreign assets – foreign income on domestic assets

As the increase in the blue line since 2000 tells us, that last component has been going down well before Bernanke started QE. Brad DeLong talks about a shortage of safe-assets. He’s right. Bernanke has talked about a global savings glut. He’s right.

Whatever the case, despite massively increased public debt, our national income has increased faster than domestic product. Contrary to everything the pols tell you, our claim on the expected future returns of everybody else is more than theirs is on ours, and it keeps growing. Here’s another secret: this means we can and should borrow a lot more money to invest. In fact, America could become something like an ultra bank for a while based only on international confidence in the Dollar.

Of course, the public deficit isn’t the only component in the picture. Foreign companies obviously own American stock and corporate bonds. I hear rich Chinese people are buying land in New York City nowadays. But the point is the biggest fears vis-a-vis short term government debt are, for lack of a better term and irony, inflated.

Here are a few titles befitting of this post:

  • China does not own America
  • The Wall Street Journal is wrong
  • It’s the Dollar-standard, stupid!
  • Wait, we run a trade deficit?
  • America is the biggest and baddest hedge fund of them all.

Look, based on that last point, there’s actually a bit of inbuilt short-term volatility here. Theoretically, we could sell our foreign assets and buy our own very safe debt. Our income comes from American capital equity abroad. Trade theory tells us we’re leveraging ourselves and, obviously (see: 2007), this isn’t always a good thing. 

But we have good reason to believe that much of the world is undergoing relatively strong (I mean in India 5% is bad) economic growth. I’m not saying they’re all in the same convergence club, but over the next 50 years global income is going to increase. Lots. And equity markets are pretty well correlated with GDP in the long-run. (They’re not nearly as much in the short-run, which is where the volatility comes from).

This means as globalization progresses, we might see some short term flux in GNP/GDP, but in the long-run it’s a safe bet.

None of this is defending bad spending (see: the American military). None of this is saying long run problems with regard to social security are no big deal. I am saying that if America was a company, I wouldn’t be all too worried about its finances. That it’s a government with sovereignty over the global reserve currency and oil purchases just makes me a million times more confident.

Since today is “here’s a chart to prove why I’m right day” (Brad DeLong and Alex Tabarrok are playing, DeLong is winning), I’m going to make one of my own. I think it’s scary:

ImageThe y-axis is output gap as a percent of potential output. x-axis is months after the start of recovery. Take a serious look at this. If this isn’t frightening, I don’t know what is. There are a few things you should note:

  • After every recession, except this one, the slope of the trend-line (“pace of recovery”) is directly proportional with the y-intercept, which basically tells us how bad the crisis was at its peak. 1982 was a bad time, but we recovered pretty quickly. 
  • By 20 months, all economies (except ours today) are converging to full employment.
  • The 1980s financial crisis was comparable in scope (8% output gap) but recovered in 10 months what we have in 50.

Here’s a funny thing about the other crises – we didn’t engage in senseless austerity prematurely. Also remember, unemployment was worse in 1980. There’s good reason to believe the output gap elasticity of unemployment (“how sensitive is the unemployment rate to changes in output gap”) is higher as recovery deepens. This is because initial recovery seems to have allocated to the top earners. Employment has shifted from manufacturing to skilled positions requiring ownership of human or physical capital. $100,000 in the output gap can be filled by employing either one laid of engineer or five fry cooks.

So the good news is that even as the slow growth continues, unemployment should drop faster. The bad news is, it’s impossible to get employed after two years out of a job. That means the economy is giving up on a lot of people it can save by killing jobs today with austerity. Even if there are long-term consequences to debt, by keeping aggregate demand low, we’re loosing people forever.

This is a huge supply-side problem. We will regret letting the labor-force contract. And it doesn’t have to be this way. No honor in grabbing victory from the jaws of defeat. Europe’s already taken first place.

By the way, at this pace, we have another 166 months of recovery left. By that time we’ll have serious worries about long-run debt (something I actually worry about) and then we’ll have a real pickle on our hands. Because by then the would-be austerians will have an actual argument to make.

Front-loading deficit reduction is a ridiculous idea. There are big, hysteresis costs to not acting right now. Higher deficits will be a good thing. Here’s the secret about low-interest rates: they mean we’re not borrowing enough. And it’s not like the American government doesn’t have a bunch of really good, long-term, projects to fund. Roads, education, basic research, a space program all come to mind.

Paul Krugman likes telling us the American government can save itself by staging a zombie invasion. What if we invade Mars, Mercury, and the Moon instead. We’d get some cool gadgets, more scientists, and a recovery.

People like to caricature PK as some sort of deficit nut. The crazy professor that runs around screaming “Deficits don’t matter, ever“, or “Keep printing that money“. Or, more recently, that he’s a crude Keynesian.

So, I’m not going to do any analysis here, just post a few quotes from the good doc and you tell me if this is “crude” or, as Jeffrey Sachs and Joe Scarborough put it:

Dick Cheney and Paul Krugman have declared from opposite sides of the ideological divide that deficits don’t matter, but they simply have it wrong. Reasonable liberals and conservatives can disagree on what role the federal government should play yet still believe that government should resume paying its way. It has become part of Keynesian lore in recent years that public debt is essentially free, that we needn’t worry about its buildup and that we should devote all of our attention to short-term concerns since, as John Maynard Keynes wrote, “in the long run, we are all dead.” But that crude interpretation of Keynesian economics is deeply misguided; Keynes himself disagreed with it.

Here’s what Paul Krugman has to say:

I wish I could agree with [the view that deficits never matter, as long as you have your own currency] […] But for the record, it’s just not right.

The key thing to remember is that current conditions […] won’t always prevail […] But this too shall pass, and when it does, things will be very different.

So suppose that we eventually go back to a situation in which interest rates are positive, so that monetary base and T-bills are once again imperfect substitutes; also, we’re close enough to full employment that rapid economic expansion will once again lead to inflation […]

Suppose, now, that we were to find ourselves back in that situation with the government still running deficits [and] that for whatever reason, we’re suddenly faced with a strike of bond buyers — nobody is willing to buy U.S. debt except at exorbitant rates. […]

Well, the first month’s financing would increase the monetary base by around 12 percent. [The price level would rise] roughly in proportion to the increase in monetary base. And rising prices would, to a first approximation, raise the deficit in proportion.

So we’re talking about a monetary base that rises […] 400 percent a year. Does this mean 400 percent inflation? No, it means more — because people would find ways to avoid holding green pieces of paper, raising prices still further.

I could go on, but you get the point: once we’re no longer in a liquidity trap, running large deficits without access to bond markets is a recipe for very high inflation, perhaps even hyperinflation. And no amount of talk […] can make that point disappear:if you’re going to finance deficits by creating monetary base, someone has to be persuaded to hold the additional base.

[…] But the idea that deficits can never matter, that our possession of an independent national currency makes the whole issue go away, is something I just don’t understand.

Correct me if I’m wrong, but the professor sounds like a Very Serious Person.

James Hamilton asks Brad Delong:

Finally, let me invite you to answer the questions I posed for Krugman and O’Brien: “Do you maintain that U.S. debt could become an arbitrarily large multiple of GDP with no consequences for yields? If you acknowledge that there is a level of debt at which these effects would start to matter for the United States, what is your estimate of that level, and how did you arrive at it?” We give our answers to these questions in our paper. What’s yours?

I’m going to invite myself into this little debate. This question can be interpreted in many different ways that, I think, is the problem with the fear-mongering behind a particular debt-GDP ratio. What do I mean by this?

The R-R paper infamously notes that after debt exceeds 90% of GDP, yields start rising, because investors no longer have confidence that the country in question can service its debt. Even ignoring the fact that this “limit”, if you will, doesn’t apply to countries that borrow in their own currency, the 90% figure is meaningless.

Presumably, investors worried that countries will have to borrow more to pay interest on its bonds which will lead to a snowball effect of debt accumulation. Therefore, it’s hardly the debt that’s important, but the deficit. So it’s not a particularly worthwhile task to wonder the debt-GDP ratio at which a country “tips over”.

Consider an example. You’re told a country has debt levels at a staggering 500% of national income. You’re also told that its debt has been at this level for the past 500 years, and official estimates predict this ratio well into the next 500 years. The market won’t suddenly demand higher yields, because the country has consistently serviced all its interest in the past, and will do so in the future.

Deficits imply that a country has to borrow to service its interest, debt implies nothing. The 90% figure was likely a correlation with a) the fact that the countries in question couldn’t denominate debt in their own currency and b) they had high deficits.

So yes, I believe debt against GDP can become arbitrarily large so long as a country isn’t running deficits. Of course, on the long journey to huge debt levels, a country does run deficits, and it’s entirely possible that investors deem this to be unsustainable, causing a debt crisis in the interim. You can parse this as a one-time promised deficit of whatever level you choose. Say, if, the US buys all the gold in the world to build statues and create a Cult of Obama. As long as it does it only once, services all its interest, and doesn’t run a deficit next year to do so.

But that’s not the question being asked. The question that’s being asked supposes an arbitrary debt to GDP. Position has no meaning without regard to velocity which, itself, has no meaning without regard to acceleration. I would actually argue that so long as an arbitrarily high nth derivative of debt is negative, the countries fiscal position would be stable. Of course, this is beside the point in reality because the level of confidence with which an investor can know debt is greater than he can know deficits, and so forth. The nth derivative becomes, basically, unknowable, at which point the investor plays it safe.

You might think my answer is meaningless, and to some extent it is. But that’s because it’s answering a meaningless question.


Edit: Note, I don’t actually thing that our long-term debt is irrelevant. In fact, I depart from Krugman in that I think we had better start talking about rising healthcare costs not just in 20 years, but in 50, 100 today. But, unlike others, I won’t wrongly caricature him as someone who doesn’t care about this, but he definitely seems to discount for the future far more (as in have faith that future politicians aren’t clueless).