Ever since Thomas Piketty published his book on inequality, Capital in the Twenty-First Century, one of the clichés of economic and debt management seems to be the claim that national debt isn’t a problem if interest rates are less than the GDP growth rate. If a country’s GDP grows faster than the accrual rate of its debt, the thinking goes, the relative cost of servicing the debt will decline over time, so the debt is thought to be easily sustainable.
But that is not what Piketty actually says, and the difference matters a great deal. Furthermore, this is a particularly timely topic as many countries have recently passed high-cost stimulus packages and are shouldering greater debt burdens to cushion the economic fallout of the ongoing coronavirus pandemic.
Piketty, Misunderstood
In fact, Piketty is more concerned about how interest rates and the GDP growth rate affect income inequality. As the Economist puts it:
As a general rule wealth grows faster than economic output, he [Piketty] explains, a concept he captures in the expression r > g (where r is the rate of return to wealth and g is the economic growth rate). Other things being equal, faster economic growth will diminish the importance of wealth in a society, whereas slower growth will increase it.
Nevertheless, a lot of analysts seem to think that this analysis also applies to the sustainability of a country’s debt burden. It is much more dangerous for a country to allow its debt to rise, they argue, if r > g than if r < g. For example, a recent Financial Times article about debt sustainability cites the International Monetary Fund as warning that “global public debt will hit its highest level in recorded history, greater even than the peak after the second world war.” It continues:
This seems to portend disaster and require corrective action. But while higher public debt has costs—most significantly if it closes off the ability to respond to a future crisis—there is little cause for immediate alarm. The “safe”, or sustainable, level of national debt is ambiguous and is likely to have risen because of slumping global interest rates.
The article then goes on to argue that one of the keys to judging the sustainability of a country’s debt burden is the relationship between its borrowing cost and its growth rate:
Calculating a safe level of public debt is hard because sustainability depends on both interest rates and the pace of economic growth. If interest rates are 2 per cent and the economy is growing at 3 per cent, for example, then all a country has to do is sit back and wait. As long as it does not borrow more, then debt will gradually dwindle to nothing compared with the size of the economy. If interest rates rise above economic growth, by contrast, then even small debts can get out of hand.
All of this may seem self-evidently true, and it would be true if other things remained equal. But that simply isn’t the case. In fact, the relationship between interest rates and growth is usually much more complicated. It may very well be true in certain cases that the lower r is relative to g, the more sustainable the country’s debt is. This might be the case for external debt, for example, or for the domestic debt of countries that manage their currencies (like China), or countries that cannot control monetary conditions (like the members of the EU), or countries whose currencies aren’t highly credible.
But for countries with monetary sovereignty and a credible fiat currency, like the United States, this just isn’t the case. The reason it isn’t so is not because of modern monetary theory, but because of a kind of fallacy of composition. Of course it is true that if I have a lot of debt, and if my income is rising relative to the cost of my debt, it becomes easier for me to service the debt over time. And if I am able to service the debt now, there is no reason why I will not be able to so in the future—unless, of course, my rising income convinces me to increase my borrowing at a much faster rate than the increase in my income.
The same is true for a business, but it is not true at the macroeconomic level for national debt. At the macroeconomic level, the relationship between interest rates and GDP reveals much more about income transfers and the distribution of income within an economy than it does about the overall sustainability of that economy’s debt. In this respect, conditions operate quite differently for countries than for individuals or businesses.
Basically, at the macroeconomic level, if interest rates are higher than the economy’s growth rate, savers are getting a disproportionately larger share of national income than if interest rates are lower than the economy’s growth rate. We can actually think of the relationship between the two as a kind of tax. When interest rates are higher, borrowers, producers, and speculators are effectively being taxed to subsidize savers and owners of monetary assets. When interest rates are lower, the roles are reversed, in which case it is the savers and owners of monetary assets who are effectively being taxed to subsidize borrowers, producers, and speculators.
To say that debt is not a problem if interest rates are lower than GDP growth, in other words, is just another way of saying that a country’s debt isn’t a problem if an indebted government is running a budget surplus. A government that manages its debt by imposing financial repression is simply managing its debt by imposing a hidden tax on its residents that is used to pay down debt—a tax on savers and owners of monetary assets, in this case.
Interest Rates Affect Income Distribution
This means that whether or not r < g helps debt sustainability in a given instance depends far more on whether the impact of these tax-like transfers is good or bad for future growth than it does on the arithmetic of debt payments. In the case of the United States, for example, repressing interest rates is a double-edged sword. To the extent it provides debtor relief by taxing savers and owners of monetary assets—mostly the wealthy, in which case it redistributes income downward—it helps boost the incomes of ordinary households and so boosts growth. But by subsidizing speculation in the stock and real estate markets, it also shifts wealth upward. Whether or not it makes debt more sustainable depends on how these differing effects affect future growth.
To put it differently, the g variable (GDP growth) is not independent of the r variable (rate of return on wealth), and it is useless to posit a relationship between the two as if they were. Economists love the ceteris paribus condition to make their equations work, but in system theory, ceteris is never paribus.
The point of this piece isn’t to argue whether or not we are better off if r > g or vice versa. It is only meant to point out that, at the national level, the relationship tells us very little about debt sustainability. It tells us instead about the national distribution of income and whether or not its net effect is positive or negative for growth.
Incidentally, lower interest rates can indeed affect a country’s debt burden directly, but they do so by extending the duration of debt and effectively postponing the real cost of debt servicing. This, however, is a very different impact altogether.
Aside from this blog, I write a monthly newsletter that focuses especially global balances and the Chinese economy. Those who want to receive complimentary subscriptions to the newsletter should write to me at chinfinpettis@yahoo.com, stating affiliation. Twitter: @michaelxpettis
Comments(10)
I genuinely didn't grasp that last bit about how - tells us instead about the national distribution of income and whether or not its net effect is positive or negative for growth. - could anyone elaborate on this please.
that would be an ecumenical matter
Alan, earlier Mike had said that r<g subsidizes borrowers, producers and speculators, at the expense of savers and holders of financial assets. Right? And this is a situation that would favor economic growth, economic activity. And we see that saving, the accumulation of financial assets, in itself, is not an economic activity. It is the forbearance from use of resources. And who would be the holders of financial, or debt obligations? Everyone to a more or less, but some very much more than others. And who are the big holders of debt. Well, the wealthy and the powerful individuals and corporations, who get a reward for not taking use of their resources. And so we see that in a world of great inequality of income and wealth, to promote growth, the rate of interest should approach zero, or below.
A deflationary or disinflationary economy tolerates debt less well than an inflationary economy.Wouldn’t a policy of keeping r<g be more likely to mitigate deflationary or disinflationary conditions, and to that extent, help underpin debt sustainability?
When interest rates are higher, borrowers, producers, and speculators are effectively being taxed to subsidize savers and owners of monetary assets. When interest rates are lower, the roles are reversed ... if the problem is a lack of AD then normally we would prefer to tax savers (euthanasia of the rentier?) but as Michael says this also subsidises borrowing to speculate on stocks and property, which is socially useless. then we should prefer r = g most of the time?
Key insight Michael re the relationship between r and g. Because they are related Pickety's premise that you can go on getting a higher r and accumulating financial capital without impacting the rate of return on investment is flawed. So his whole premise of inevitable accumulation of wealth in excess of other incomes is wrong unless you throw out the production function.
Mike, I read your new book. Liked it quite a bit, even though, as I've been following you for years, most of the material was familiar. I saw in Tooze, at first some envy, by a desire to find fault or error. But by the end, his admiration and respect. He was touched by your praise. Though I've looked at two of this books, and don't find myself looking up. He's too narrative and long winded. I like things that increase depth of insight and breadth of understanding. New ways of seeing. The abstraction of many little things, that together point to something otherwise not perceived. Though, the accumulation of truthful fact has value.
The systematic labor arbitrage allowed by free trade between countries of vastly different levels of living standards without exchange rates equilibrating cross trade balances inevitably increases inequality within developed countries by putting downward pressure on wages and increasing profit share of production, thus putting downward pressure on end demand, thus requiring monetary stimulus in the form of lower interest rates allowing higher debt-to-income to stimulate end demand, which fuels asset bubbles as well as the continuing trade deficit because domestic production is not competitive given labor costs and productivity at prevailing exchange rates, which translates into further production offshoring and periodic financial crisis. And so on so forth. This silly game has been going on for 40y years and, despite the abysmal accumulated results, policymakers are still at it today, pushing the world towards its relative debt limit compatible with 0% nominal interest rates. Thank you to Michael Pettis for raising the level of an otherwise astonishingly weak economic debate.
Just imagine the case for a company where the argument goes if the free cash grows faster than the debt then the debt is easily sustainable. Imagine if you are a bank whose free cash grows at 3% and you take on a debt at 2% to pay for a 5% dividend. Yes, it may seem as if 3% growth in free cash will help you manage the 2% debt, but the debt is not used productively and instead just used to pay dividend. And therefore there is no reason to think the 3% growth in free cash will be able to continue. That's the point that is being made here. However the nation whose debt is denominated in its own currency can always just inflate the debt away, but that is a separate topic.
Great topic !!!!!!
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