A few years ago, the most attractive theory of fiscal sustainability came from economists such as Olivier Blanchard, who made the case that as long as real interest rates were low and the real interest rate on debt stayed below the growth rate of the economy, then public debt may have no fiscal cost. John Cochrane explained the theory in these pages a few years ago:
The argument is straightforward. Bond investors are willing to lend money to the U.S. at extremely low interest rates. Suppose Washington borrows and spends, say, $10 trillion, raising the debt-to-GDP ratio from the current 100 percent to 150 percent. Suppose Washington just leaves the debt there, borrowing new money to pay interest on the old money. At 1 percent interest rates, the debt then grows by 1 percent per year. But if GDP grows at 2 percent, then the ratio of debt to GDP slowly falls 1 percent per year, and in a few decades it’s back to where it was before the debt binge started.
Cochrane also warned about believing this theory blindly.
As you can imagine, a “debt doesn’t matter” message was not wasted on politicians who are always looking for reasons to spend more and more money.
Never mind that Blanchard’s theory, while an interesting thought experiment, was not realistic or applicable to the U.S. fiscal condition. Blanchard adopts a zero-primary balance (deficit – interest payments) assumption (meaning that spending on public goods and services and revenue are equal) to argue that if r remains below g, a one-time increase in debt is only temporary as debt levels will eventually decline. In other words, interest rates must stay low for decades to come, growth must stay higher than rates too, and big deficits must end.
In the real world, we haven’t had zero-primary balance in over two decades, and looking forward they aren’t getting any better. While interest rates were low in the decade leading up to Blanchard’s paper, they certainly haven’t been since, and it is unclear how long it will take for them to decline back to their previous levels. As for growth, well it hasn’t been great for over two decades, and it doesn’t look awesome looking forward, either.
Cochrane explained it well:
Yet an end to big borrowing is not in the cards. The federal government borrowed nearly $1 trillion in 2019, before the pandemic hit. It borrowed nearly $4 trillion through the third quarter of 2020, with more to come. If we add additional and sustained multi-trillion-dollar borrowing, and $5 trillion or more in each crisis, the debt-to-GDP ratio will balloon even with zero interest rates. And then in about ten years, the unfunded Social Security, Medicare, and pension promises kick in to really blow up the deficit. The possibility of growing out of a one-time increase in debt simply is irrelevant to the U.S. fiscal position.
The bottom line is that this idea that we shouldn’t worry about growing spending and government debt as long as interest rates stay lower than growth was never an option for us, given the state of our current and future finances.
That said, the question of how much growth can help us get our of debt is an interesting one. In a paper last year, Arnold Kling and I noted that growth was one of the several factors that helped the debt-to-GDP ratio decline dramatically from 106 percent after World War II (1946) to 23 percent in 1974. We wrote:
After World War II, the most dramatic reduction in the US debt-to-GDP ratio occurred during 1946 to 1974 (see figure 1), owing largely to primary surpluses during most of that period. The reduction was also aided by rapid real economic growth, a severe inflation shock in 1969–1979, and financial repression. A period of growing debt and high interest rates soon followed as bond “vigilantes” punished the government for its prior inflationary transgressions. The debt-to-GDP ratio again fell during 1994 to 2001, thanks to robust growth and spending restraint, before resuming its growth, which continues today.
In an excellent paper for AEI back in 2010, Kling had this table:
As you can see, the surplus years also had serious GDP growth in excess of the interest rate. As a result of these factors, between 1950 and 1969, debt-to-GDP had declined from 79 percent to 29 percent. Inflation took the debt-to-GDP ratio down to 23 percent between 1970 and 1974. In other words, growth matters, but so do primary surpluses (lower spending than revenue).
Now, a new paper looks specifically at the share that GDP growth played on the post-war debt-to-GDP decline. Here is a tidbit:
Without primary surpluses and interest rate distortions, the debt/GDP ratio falls only from 106% in 1946 to 74% in 1974, rather than falling to 23% as in reality. Over the three decades after World War II, the natural erosion of debt from economic growth was considerably smaller than is often suggested.
Bottom line, we should be grateful that legislators engaged in real austerity after the war until the end of the ’60s, as opposed to the way they have behaved since, especially since the Great Recession.
Obviously, economic growth is super important. But it is not a solution to the U.S. government growing debt.