The recent policy debate over whether its time for interest
rates to start to rise after being at the lowest levels since the Great
Depression for nearly five years shows just how much of a policy box
governments are in when it comes to fiscal and monetary policy. Never mind the debate over whether there is a trade-off between monetary stimulus and financial stability. Raising rates to reduce the perverse
incentives on long-run economic behavior and activity comes with the risk of destabilizing
public finances by raising debt service costs.
On the one hand, the global economy has been stagnating for
five years and it can be argued still requires monetary stimulus in the form of
low interest rates and fiscal stimulus in the form of deficits and expansionary
fiscal policy. On the other hand,
low interest rates are having perverse economic effects in the form of
encouraging excessive risk taking and potential asset bubbles as well as
reducing the returns to savers.
Moreover, much like the case for home buyers, low interest rates have also been a factor in reducing the
burden to governments of acquiring debt.
Here is the policy box. Low interest rates and the size of public sector debts
and deficits are not mutually exclusive policy choices. Any move that raises interest rates
will substantially raise debt-servicing costs and actually worsen many
countries fiscal positions at least in the short run. Let’s take the example of Canada. For the 2011-12 fiscal year, total expenditures for the
federal government were 271.423 of which 31 billion dollars was debt service
costs with a net debt of 650.1 billion dollars (see Federal Fiscal Reference Tables). The debt service share of total
federal government expenditures is 11.4 percent and the “effective interest
rate” on the net debt was 4.8%. If the effective interest rate is simply one
percentage point higher – at 5.8% – then debt service costs would have been
37.7 billion dollars or 14 percent of total federal expenditure. Just one percentage point in the
effective interest rate on the entire net debt increases spending by almost
seven billion dollars without any stimulus increase on government programs or spending
on goods and services. It is
simply a transfer to bondholders.
Take the United States federal budget as a second
example. In 2012, total spending
by the US federal government was 3.537 trillion dollars of which 220 billion
was net interest for a debt service share of 6.2 percent of federal expenditure
(see US federal budget documents). Net financial debt in 2012 was 10.282
trillion dollars resulting in an “effective interest rate” of only 2.1
percent. An increase in the
effective interest rate by 1 percent to 3.1 percent raises debt service costs
to 319 billion dollars thereby raising federal spending by 99 billion dollars
and bringing the debt service share of federal spending to 9 percent.
By historic standards, these are small
increases in the effective interest rate on net debt. Larger increases would
have even greater impacts on the bottom line. A return to the rates of even the mid to late 1990s would be
nothing short of catastrophic in terms of the havoc they could wreak on public
sector budgets. Now of course,
interest rate increases are phased in gradually as debt rolls over but my point
remains the same. Despite the
perverse long-term impact of low interest rates on economic incentives when it
comes to private saving and investment behaviour as well as government debt
accumulation, the short-run impact of raising interests on government budgets
will also be harsh and substantial.
Borrowing from Nick Rowe’s recent pole analogy – policy makers are like
tightrope walkers with a balancing pole that has interest rates on the one side
and government budgets on the other. If interest rates are raised, the other side will not necessarily move up
to counterbalance without deliberate fiscal policy action – it can move down and toss you over. At the same time, raising interest rates and new austerity on the fiscal side to counteract the effect of high interest rates on government budgets – well, that is the kind of nightmare that must keep central bankers and finance
ministers on the edge of their seats. The C.D. Howe piece by Paul Masson on why interest rates should go up outlines and deals with two major objections to raising them – yet the effect on public sector budgets is not one of them.
Worthwhile Canadian Initiative 
Livio, you are correct in noting that debt service costs rose markedly between 1971, 1981, 1990.
Average GDP deflator growth was 8.7% between 1970-82, 3.8% between 1983-91 and 1.3% between 1992-99.
Following each regime shift, income growth slowed down as legacy interest costs rose. Debt/GDP rose markedly. It wasn’t as if debt burdens just rose because of completely reckless public finances. Something purposely happened to cause it.
For your story to have the umpf to bring it to ‘time bomb’ territory you would have to lay out the scenario for a major regime shift. I don’t think you’ve made that argument.
The other possibility is major irresponsibility by governments to manage finances. Governments in Canada have been doing OK and very well by international peer comparisons particularly given these are very abnormal times we are in.
I don’t disagree with the premise that governments should manage finances responsibly. I do disagree with the characterization that debt is a ‘time bomb’. The irony is that the government that has been the least responsible (in my mind) is the province with no debt costs.
Alternately, you could have skipped all of that and, realizing that most governments carry debt at a maturity of around 7 years, just look at 5-10 year yields in Canada, and inferred an interest rate of about 1.6%. Then compare that to an expected GDP growth rate of 4% (2% inflation + 2% real growth) to determine that interest expense not a burden, and that in fact the burden of government would be reduced if Canadians carried substantially higher debt burdens.
Now, yes, we can play “what if” games and assume that the interest rate would go up, but historically this happens when NGDP goes up. The spread is what matters, and the spread between NGDP and interest rates has been negative, not positive, for both Canada and the U.S.
Mark,
“For your story to have the umpf to bring it to ‘time bomb’ territory you would have to lay out the scenario for a major regime shift.”
The required major regime shift, of course, is a significant downward shift in the interest rate term structure. If, as discussed above, government locks in term borrowing at rates which, ultimately, turn out to be much higher than realized short rates, then that’s a bad trade. That bad trade was without a doubt a big part of the debt growth story of the ’80s and early ’90s. But it obviously can’t happen again, to any significant extent.
rsj’s last comment is absolutely the bottom line. The present value of government debt must be carried forward at current market rates. When the 30 year bond is yielding 2.5%, there is no universe in which you can claim any economic relevance of a 4.8% “effective interest rate.” Apart from confusing net and gross debt (if that’s what’s going on), we are not going to get anywhere if we confuse old bond coupons with current interest. It’s like if I go out and buy an old 10% coupon bond and claim I’m making a 10% return on my investment.
RSJ, where are you getting your inferred interest rate numbers from? At least for the federal government, we know what the average interest rate on its debts were – in 2011-12 it was 2.65%, down from 4.61% in 2008, and from just under 6% a decade ago. For the provinces, those numbers are probably slightly higher (reflecting their slightly higher credit risk) – recall that we’ve only been talking about the federal government, but the provinces are every bit as indebted as the federal government, and have considerably less fiscal flexibility (since they provide politically sensitive services and have less revenue raising flexibility).
Livio’s point, and it’s a good one, is to wonder what happens to the government’s finances when cost of government debt migrates back to something closer to its long term average. And while Canada is probably in pretty good shape (I wouldn’t say the same thing about all our provinces),
Bob,
rsj gets his numbers from current market yields of Canadian government bonds. It’s the only thing that is of any interest and it’s what I’ve been harping on about in the last few comments. If market interest rates suddenly sky rocket, the accounting carry costs of debt will continue to decline for a few years, and we’d look really good compared to current NGDP growth. But it’s the wrong measure. If you want to understand the sustainability of your interest carry costs you need to look at forward measures. Ie market yields, not old bond coupons. (For the third time)
Mark,
Although I agree with K that we aren’t likely (at least in Canada) to see a repeat of the interest rate regime of the early 80’s or 90’s again, I think you’re right that policy regime change in the real risk. So, for example, in Europe (and Japan) the likely “regime” change is a demographic change. Between higher health care and pension costs and declining population growth (or, in cases like Japan and important chunks of Europe, absolute population declines), the ability of governments to finance their outstanding liabilities are likely to be stressed.
Bob,
“Livio’s point, and it’s a good one, is to wonder what happens to the government’s finances when cost of government debt migrates back to something closer to its long term average.”
Yes, while pretending that NGDP growth doesn’t also go back to its long term average. If there’s one thing that’s strong in the historical data it’s that historical nominal growth is strongly correlated with and higher than historical interest rates. So no, it’s not a good point.
Bob,
I don’t think I said that we won’t see high interest rate regimes again (though I agree that we probably won’t). What I’m saying is that over any reasonable period they will be accompanied by even higher NGDP growth, and there will therefore be no debt service burden at a constant debt/GDP ratio.
The real risk is that lower growth and inflation will be accompanied by a lower and likely negative nominal natural rate leading to a permanent liquidity trap. The resulting debt deflation spiral is the only circumstance in which debt service cost is likely to become a problem (negative nominal growth with zero nominal service cost. The only thing that’s critical is escaping the liquidity trap.
RSJ, where are you getting your inferred interest rate numbers from?
K is right.
The estimate of 1.6% I made in the comment at 10:54 am was by looking at yields in the maturity range of canadian debt in the 5-10 year range. Because of this, I knew that it could not be the case that Canadian government interest expense was the 4.8% figure cited. Now we know that Livio was citing the “interest ratio” which is a ratio of gross interest expense divided by revenue — something completely uninteresting and which has no bearing on government interest expense, sustainability of debt, etc.
The other estimate I cited was for net interest expense divided by net general government debt from the OECD, to get a 1.26% figure. Or, you can look at gross interest expense divided by gross debt to get a 1.7% figure.
All of these figures are less than the NGDP growth rate.
Again, if Livio is going to argue that future interest rates will exceed the NGDP growth rate for prolonged periods of time, he needs to have a reason for believing this, rather than saying, “Let’s pretend something unprecedented will happen”. If I tell you that in the future, the equity risk premium will consistently be 10%, I damn well better have a reason for this before I can get you to worry about it.
Moreover, it is scare-mongering to call such a bizarre and historically unprecedented occurrence a “time bomb”. One reserves the word “time bomb” for something that we expect to happen in the future, like driving without changing your oil.
No sane person should worry about NGDP growth rates being consistently below risk free rates. Let’s first see this virgin birth happen before we worry about it.
K, RSJ,
I had a lenghty comment that got eaten, so I won’t repeat it. But the jist of it was that the “debt is sustainable” if I<g(NGDP) story makes sense only if you ignore the stochastic element of human history. No doubt the Greeks, Spaniards and Portuguese told themselves that their debtloads were sustainable (a conclusion fully supported by the market that was willing to lend them money at German rates) right up until the moment when US financial markets imploded. I.e., they were sustainable until they weren’t. And it remains to be seen whether the debtloads of other Euro-zone economies are actually sustainable (yields have dropped on Spanish and Italian bonds recently, but last year they were on the knife edge of spiralling into the unmanageable zone). For them, austerity may not be a policy choice.
And, unfortunately, history is littered with these sorts of stochastic elements. We saw a big run up in debt levels in the 1970’s, coinciding with a sharp decline in TFP growth. Ok, no worries, our debt levels were low, so we could manage that. Then we saw the high interest rates of the 80’s and 90’s, well, we managed that (although, at considerable cost in the case of Canada). Next it’ll be an aging population (and corresponding pension and health care costs) and declining populations (in countries like German, Italy and Japan). Maybe they can manage those (though I wouldn’t bet on it, at least not without radical changes in those societies – does anyone see the Japanese accepting significant immigration?). And after that, there’ll be something else – wars, breakups (any bets one what happens to Spain if Catalonia decides it wants out?), global warming, plague, zombies. There’s always something.
And note, a lot of those shocks don’t show-up in the interest rate or the NGDP growth rate, they show up on either the revenue or expenditure side of the government ledgers.
And I don’t disagree with you about the risks of the liquidity trap. But that just illustrates my point, because of a high starting debt level, the Euro-zones countries are caught between trying to get out of the liqudity trap with short-term borrowing, at the risk of pushing the borrowers past a tipping point of unsustainable debt. Nasty choice and one that, with the benefit of hindsight, I bet they wish they had avoided.
Sorry, part of that comment was cut off. The end of the second sentence should read “if we ignore the stochastic eleement in human history”.
RSJ,
“Now we know that Livio was citing the interest ratio which is a ratio of gross interest expense divided by revenue — something completely uninteresting and which has no bearing on government interest expense, sustainability of debt, etc.”
Where do you think the interest payments come from if not from tax revenue?
Bob,
“We saw a big run up in debt levels in the 1970’s”
Except, we didn’t. The inflation, for the most part, ate the deficits. The Trudeau liberals basically ran balanced primary deficits, and as discussed above, interest payments are more than covered by growth. By 1980 Canadian federal debt was 20% of GDP, about the same as in 1970. The debt runup began in the early ’80s and continued until 1996 when it hit 70%. For the most part Mulroney did it, but interest coverage did not contribute to the debt ratio in the ’80s either. Like I said above, I wouldn’t be surprised if there was a significant negative impact from treasury issuing long dated bonds into the Great Moderation (bad trading).
“Next it’ll be an aging population…”
What we want to avoid is a situation where interest is sustainably higher than NGDP growth. Barring the virgin birth, there are two ways I see that could happen:
1) Massively higher government debt. No, not 100% or 150% debt/GDP. Something more than Japan or post-war Britain, both of which have proven to sustain extremely low nominal yields. I.e. 300%+. To me, for there to be significant upward pressure on rates, the quantity of government debt has to be ballpark around the same as the quantity of other capital assets. That’s still a long way off, and it’s not a question of 10 or 20% more or less of debt. It’s a question of hundreds of percent.
2) NGDP growth goes negative, and interest rates, of course, stay above zero. In this case zero nominal rates will be well above the natural rate which causes a positive feedback disaster. This scenario is the actual near term likely one, and is exactly where we will go as a result of an exogenous growth slowdown (ageing). The interesting thing about this scenario is that it is actually aggravated by too little debt, since it is a low natural rate of interest which causes the economy to get trapped. More debt and more inflation puts the liquidity trap further out of reach.
Frank,
“Where do you think the interest payments come from if not from tax revenue?”
More debt, of course. If NGDP grows at 5% then you can finance up to 5% interest by additional borrowing and still keep debt/GDP constant.
Bob,
One more comment. This made me think:
“the “debt is sustainable” if we ignore the stochastic element in human history”
I think this is actually exactly backwards. If NGDP grew at exactly 5% every year, with 100% certainty, I suspect the nominal short rate would be much higher than if NGDP grew at an average of 5% but with lots of risk around that average. The uncertainty of nominal growth is the source of systemic risk to equity returns, which in turn increases investor demand for the risk-free asset. I.e. the greater the systemic risk, the lower the risk-free rate for any given level of expected NGDP growth, and the greater the quantity of government debt that is sustainable.
K,
“Where do you think the interest payments come from if not from tax revenue?”
“More debt, of course. If NGDP grows at 5% then you can finance up to 5% interest by additional borrowing and still keep debt/GDP constant.”
???
If Nominal GDP grows at 5% and the federal government collects no tax revenue, it can finance up to 5% interest by additional borrowing? Is that what you are saying?
Assuming no primary deficit and a constant debt/GDP ratio, yes, exactly. That’s how the math works.
K,
Would you buy the bonds of a company when you know that they are repaying the interest to you with money they borrowed from someone else? Ponzi finance works great on paper – the math works. In real life, not so much.
Why is a constant Debt / Nominal GDP ratio important when it is not a legal constraint on the ability of a government to borrow?
You might argue that it measures the effectiveness of government borrowing, but you could look at just Nominal GDP for that result. You might argue that the markets will signal when government borrowing is effective / ineffective through the interest rate mechanism but if the government is making interest payments with additional debt, then the interest rate is really controlled by the government and not the markets.
K, “If the economy is dynamically inefficient (and there are good theoretical reasons as well as empirical evidence that it is – see above graph), then there’s a free lunch to be had in increasing unfunded public expenditure.”
Hold on, this is not dynamic inefficiency. You’re looking only at the risk free rate, not the return on capital. If the economy really were dynamically inefficient, then “crowding out” of investment would increase economic growth (turning the argument against deficits completely on its head).
The only free lunch available here is to reduce the cost of taxation.
Except that this free lunch exists only in theory, since we can’t predict what will happen.
Hold on, this is not dynamic inefficiency
Yes, this is the point made here: http://finance.wharton.upenn.edu/~rlwctr/papers/8814.PDF
The only free lunch available here is to reduce the cost of taxation.
Well, that’s what it means to run deficits. No one is claiming any other kind of free lunch.
The problem is that we are not running enough deficits. If we were, then the interest rate on government debt would average the NGDP growth rate, instead of being substantially below it.
Which begs the question, why don’t we take advantage of the free lunch? I think there is deficit bias against running deficits, just because households are scared of the word “debt”, and view the government as another household. It doesn’t help that irresponsible economists keep pretending that the debt is equal to the present value of primary surpluses, despite all the evidence that governments typically run primary deficits while reducing the debt/income ratio.
Unfortunately the “debt is bad” meme is popular now, and a lot of people are preying on this meme to encourage austerity and fear, primarily because they have a deep philosophical discomfort with the notion that government has such enormous fiscal policy space.
then the interest rate is really controlled by the government and not the markets.
Yes, that’s what it means to be a currency issuer. Interest rates are set by governments as soon as governments issue currency. The only mechanism that would cause those rates to go up is inflationary pressure. Note that having a bunch of wealthy bond holders sit around a table and complain that they don’t like deficits is not the same as inflationary power. They have to rush out and spend money, and do so to the point that inflation starts to go up.
And I think there is a big difference between “I would prefer a higher rate” and “I am going to spend down my wealth”. That space, where on the one hand bondholder preferences are catered to and on the other, people are willing to part with wealth in order to consume on a mass scale, is (IMO) the reason why risk free rates are below the NGDP growth rate. And I think those who like to think of the financial markets calling the shots, rather than ordinary consumers, don’t like to have their impotence exposed. They would much prefer to have a euro-style arrangement where rates reflect investor preferences rather than consumer preferences.
Max,
“The only free lunch available here is to reduce the cost of taxation.”
When the risk free rate is asymptotically below the growth rate that is a form of dynamic inefficiency – but I agree that the meaning of that is subtle in a stochastic economy.
I do agree that I only made the case for a Pareto improving tax cut. I do however also think that the case for growth-raising public investment is excellent, and also pretty easy to make.
As to the free lunch existing only in theory, that could be true. As far as I’m concerned, though, it’s equally likely to be even bigger than expected in practice.
“Unfortunately the “debt is bad” meme is popular now, and a lot of people are preying on this meme to encourage austerity and fear, primarily because they have a deep philosophical discomfort with the notion that government has such enormous fiscal policy space.”
People have a deep discomfort with governments that do stupid shit with money whether its borrowed or not. And that is born out by evidence, not philosophy.
That is a type of libertarian fantasy. In reality, government social benefit programs are wildly popular whereas there is deep ambivalence about handing decisions regarding interest rates over to the financial markets. In order to counteract this popular desire for social spending yarns must be spun about how governments “can’t afford” to do things that are welfare enhancing.
But Frank R.’s comment is revealing, because at the end of the day, the deficit scolds are not motivated by any real concern with the budget, because if they reviewed the record, they would know that that risk-free rates are less than the growth rate. The concern is over an activist and powerful government. Government programs, whether they be social health care, or employment insurance, or pensions are wildly popular. So the people need to be convinced that the government — which is really just them — is limited somehow and cannot afford to carry these programs out. In the capital markets, each person’s say is weighted by their wealth, which means that the top 300,000 people have as much say as the bottom 100 million people. Most people have no say. But with government, they do have a say, which scares the market fanatics as well as the wealthy to know end. It is fear of democratic decision making and social expenditures, in principle, which drives the hand waving about deficits. It has absolutely nothing to do with any real solvency concerns.
RSJ,
You have me mistaken for some other guy.
“In reality, government social benefit programs are wildly popular…”
And all of them have a dedicated source of tax revenue (Social Security, Medicare, Medicaid).
“In order to counteract this popular desire for social spending yarns must be spun about how governments “can’t afford” to do things that are welfare enhancing.”
Wrong. Just plain wrong. This is not about government’s “can’t afford”. Again you have me confused with a different guy. The only stipulation I have made throughout this argument is that for a government to avoid a Ponzi financing scheme, tax revenue must exceed interest expense. The government bears a cash flow risk but not a solvency risk.
“The concern is over an activist and powerful government.”
The writers of the U. S. Constitution had the same concerns.
“..the deficit scolds..”
Again wrong guy. Government debt scold – yes, unproductive activity scold – yes, deficit scold – no.
“It is fear of democratic decision making..”
It is fear of bad decision making. And yes decisions that are reached democratically can still lessen marginal welfare. Governments can and do kill off their own citizenry on occasion.
“In reality, government social benefit programs are wildly popular…”
And all of them have a dedicated source of tax revenue (Social Security, Medicare, Medicaid).
That is a specific American political choice, and in counterpoint it isn’t true in Canada, and this is a Canadian blog, after all.
Up here, the dual role of Social Security as poverty relief and income replacement are done by two different programmes. Old Age Security is paid for by the Federal Government out of the Consolidated Revenue Fund, general revenues. The Canada/Quebec Pension Plan is paid for by CPP/QPP dues and investment returns. OAS handles poverty relief. CPP/QPP does income replacement.
There is no dedicated levy for Canada’s health system, that comes out of general provincial revenues or transfers from the Federal Government, which themselves come from general federal tax revenues.
Well, Frank, if you don’t like a particular program you have to argue against it on its merits, rather than arguing in bad faith, saying “We cannot afford it”.
RSJ,
“Well, Frank, if you don’t like a particular program you have to argue against it on its merits, rather than arguing in bad faith, saying we cannot afford it.”
Again, you must be reading someone else’s writing and attributing it to me. I have already said that a government does not bear solvency risk and so the whole concept of a government being able to “afford” something is meaningless. It is the U. S. government’s decision making processes (spending and financing) that I have a problem with.