Monday's Macro Memo: "How much debt do we need? My answer: 70% of GDP"
In a post in 2015 I pointed out that government debt is not a bad thing. Here, I elaborate on that idea and I ask, and answer, a simple question: how much debt do we need? My answer: 70% of GDP is a good guess.
In a recent post, Simon Wren-Lewis asks and answers some of the same questions I discuss here. My focus is narrower than Simon’s. I will focus in on the question: what is the right amount of debt? I will also abstract from one reason why debt should not be zero. That reason, discussed here by Martin Wolf, and here by Isabella Kaminska, is that the public sector does not only accrue debt; it also owns public assets. I will claim that, even if we did not need to build roads and bridges, it would still be a good idea for the public sector to accumulate debt. My argument is based on a remarkable implication of basic economic theory that was first discussed by Paul Samuelson. If we borrow from our children and our grandchildren, everybody, including all future generations, will be better off.
If a household borrows money to pay for a new car, that debt might be paid back over a period of five years or more. Debt that is accrued to help pay for an investment good, like a car, is widely understood to be a good thing. By borrowing to pay for a car, we arrange for the series of benefits we receive by driving to work or to school every day to be matched with the series of payments we make as we pay back the loan used to purchase the car. Debt accrued by a household to facilitate an investment is widely perceived to be privately beneficial.
Suppose instead, a person borrows to pay for an extravagant lifestyle. Instead of taking out a loan and buying a car, that person maxes out their credit cards to throw expensive parties. To pay back that debt, he or she will need to plan for a period of austere living in future years. Debt accrued by a household to finance an extravagant lifestyle is widely perceived to be deviant behaviour that is discouraged by social norms. But should we apply those same norms to government behaviour?
If government borrows money to pay for a new road or rail network, the new transportation infrastructure will generate benefits to future generations. It is only fair that those generations should help pay for the investments they enjoy and, for that reason, debt accrued to pay for social investment is widely recognized to be socially beneficial. The principle that all government debt should be used to finance infrastructure investments is sometimes called the golden rule of public finance. It is a commonly held belief that government debt should only finance government investment; but it is a belief that does not survive more careful scrutiny.
Governments are not like households. If a household borrows from a bank it will eventually need to repay the money it borrowed. If a government borrows money from the public, it may never repay that money. It is a myth that government debt is repaid by running public surpluses. In reality, the ratio of outstanding debt to GDP shrinks as the economy grows faster than the interest rate at which the government is borrowing.
In the title to this post I raised the question: How much debt do we need? Economic theory provides an answer to that question and it is never zero. In a series of papers that I am writing with Pawel Zabczyk of the Bank of England, soon to be circulated, we show that a fairly standard model of trade between generations can lead to some very non-standard conclusions. We use Samuelson’s overlapping generations model, which has been widely used to analyse questions of trade between people of different generations. For a calibrated version that we use as an example, the right answer to my opening question; How much debt do we need? is 70% of GDP.
The main theme of my work with Pawel is that governments are not like households. That point has been made many times by many people. Paul Krugman, for example, makes the case here in a NY Times piece. Although the reason often given is that government expenditure can raise employment through a fiscal multiplier, there is a more fundamental reason why we should not eliminate government debt. And this reason applies even if the economy is always operating at full employment. Debt facilitates trade between current and future generations.
The figure of 70% that I give in this blog is based on some back of the envelope calculations that Pawel and I use to calibrate our theoretical paper and my subjective confidence bands around that figure are large. The optimal size of public sector debt in the UK might be 5% and it might be 140%. But of one thing I am certain. The right answer to my question; how much debt do we need? is never zero!