Arjun and I have been working lately on a paper on monetary and fiscal policy. (You can find the current version here.) The idea, which began with some posts on my blog last year, is that you have to think of the output gap and the change in the debt-GDP ratio as jointly determined by the fiscal balance and the policy interest rate. It makes no sense to talk about the “natural” (i.e. full-employment) rate of interest, or “sustainable” (i.e. constant debt ratio) levels of government spending and taxes. Both outcomes depend equally on both policy instruments. This helps, I think, to clarify some of the debates between orthodoxy and proponents of functional finance. Functional finance and sound finance aren’t different theories about how the economy works, they’re different preferred instrument assignments.
We started working on the paper with the idea of clarifying these issues in a general way. But it turns out that this framework is also useful for thinking about macroeconomic history. One interesting thing I discovered working on it is that, despite what we all think we know, the increase in federal borrowing during the 1980s was mostly due to higher interest rate, not tax and spending decisions. Add to the Volcker rate hikes the deep recession of the early 1980s and the disinflation later in the decade, and you’ve explained the entire rise in the debt-GDP ratio under Reagan. What’s funny is that this is a straightforward matter of historical fact and yet nobody seems to be aware of it.
Here, first, are the overall and primary budget balances for the federal government since 1960. The primary budget balance is simply the balance excluding interest payments — that is, current revenue minus . non-interest expenditure. The balances are shown in percent of GDP, with surpluses as positive values and deficits as negative. The vertical black lines are drawn at calendar years 1981 and 1990, marking the last pre-Reagan and first post-Reagan budgets.
The black line shows the familiar story. The federal government ran small budget deficits through the 1960s and 1970s, averaging a bit more than 0.5 percent of GDP. Then during the 1980s the deficits ballooned, to close to 5 percent of GDP during Reagan’s eight years — comparable to the highest value ever reached in the previous decades. After a brief period of renewed deficits under Bush in the early 1990s, the budget moved to surplus under Clinton in the later 1990s, back to moderate deficits under George W. Bush in the 2000s, and then to very large deficits in the Great Recession.
The red line, showing the primary deficit, mostly behaves similarly to the black one — but not in the 1980s. True, the primary balance shows a large deficit in 1984, but there is no sustained movement toward deficit. While the overall deficit was about 4.5 points higher under Reagan compared with the average of the 1960s and 1970s, the primary deficit was only 1.4 points higher. So over two-thirds of the increase in deficits was higher interest spending. For that, we can blame Paul Volcker (a Carter appointee), not Ronald Reagan.
Volcker’s interest rate hikes were, of course, justified by the need to reduce inflation, which was eventually achieved. Without debating the legitimacy of this as a policy goal, it’s important to keep in mind that lower inflation (plus the reduced growth that brings it about) mechanically raises the debt-GDP ratio, by reducing its denominator. The federal debt ratio rose faster in the 1980s than in the 1970s, in part, because inflation was no longer eroding it to the same extent.
To see the relative importance of higher interest rates, slower inflation and growth, and tax and spending decisions, the next figure presents three counterfactual debt-GDP trajectories, along with the actual historical trajectory. In the first counterfactual, shown in blue, we assume that nominal interest rates were fixed at their 1961-1981 average level. In the second counterfactual, in green, we assume that nominal GDP growth was fixed at its 1961-1981 average. And in the third, red, we assume both are fixed. In all three scenarios, current taxes and spending (the primary balance) follow their actual historical path.
In the real world, the debt ratio rose from 24.5 percent in the last pre-Reagan year to 39 percent in the first post-Reagan year. In counterfactual 1, with nominal interest rates held constant, the increase is from 24.5 percent to 28 percent. So again, the large majority of the Reagan-era increase in the debt-GDP ratio is the result of higher interest rates. In counterfactual 2, with nominal growth held constant, the increase is to 34.5 percent — closer to the historical level (inflation was still quite high in the early ’80s) but still noticeably less. In counterfactual 3, with interest rates, inflation and real growth rates fixed at their 1960s-1970s average, federal debt at the end of the Reagan era is 24.5 percent — exactly the same as when he entered office. High interest rates and disinflation explain the entire increase in the federal debt-GDP ratio in the 1980s; military spending and tax cuts played no role.
After 1989, the counterfactual trajectories continue to drift downward relative to the actual one. Interest on federal debt has been somewhat higher, and nominal growth rates somewhat lower, than in the 1960s and 1970s. Indeed, the tax and spending policies actually followed would have resulted in the complete elimination of the federal debt by 2001 if the previous i < g regime had persisted. But after the 1980s, the medium-term changes in the debt ratio were largely driven by shifts in the primary balance. Only in the 1980s was a large change in the debt ratio driven entirely by changes in interest and nominal growth rates.
So why do we care? (A question you should always ask.) Three reasons:
First, the facts themselves are interesting. If something everyone thinks they know — Reagan’s budgets blew up the federal debt in the 1980s — turns out not be true, it’s worth pointing out. Especially if you thought you knew it too.
Second is a theoretical concern which may not seem urgent to most readers of this blog but is very important to me. The particular flybottle I want to find the way out of is the idea that money is neutral, veil — that monetary quantities are necessarily, or anyway in practice, just reflections of “real” quantities, of the production, exchange and consumption of tangible goods and services. I am convinced that to understand our monetary production economy, we have to first understand the system of money incomes and payments, of assets and liabilities, as logically self-contained. Only then we can see how that system articulates with the concrete activity of social production. [1] This is a perfect example of why this “money view” is necessary. It’s tempting, it’s natural, to think of a money value like the federal debt in terms of the “real” activities of the federal government, spending and taxing; but it just doesn’t fit the facts.
Third, and perhaps most urgent: If high interest rates and disinflation drove the rise in the federal debt ratio in the 1980s, it could happen again. In the current debates about when the Fed will achieve liftoff, one of the arguments for higher rates is the danger that low rates lead to excessive debt growth. It’s important to understand that, historically, the relationship is just the opposite. By increasing the debt service burden of existing debt (and perhaps also by decreasing nominal incomes), high interest rates have been among the main drivers of rising debt, both public and private. A concern about rising debt burdens is an argument for hiking later, not sooner. People like Dean Baker and Jamie Galbraith have pointed out — correctly — that projections of rising federal debt in the future hinge critically on projections of rising interest rates. But they haven’t, as far as I know, said that it’s not just hypothetical. There’s a precedent.
[1] Or in other words, I want to pick up from the closing sentence of Doug Henwood’s Wall Street, which describes the book as part of “a project aiming to end the rule of money, whose tyranny is sometimes a little hard to see.” We can’t end the rule of money until we see it, and we can’t see it until we understand it as something distinct from productive activity or social life in general.
The counterfactual I’d like to see is what would have happened if debt/gdp ratios ( both public and private ) had been held constant at their 1980 levels. That would at least define a sustainable system.
We’ve managed to maintain a stable private plus public debt/gdp ratio for several years now , but with low growth. I’m not sure it would be wise to argue for increasing our already high leverage now , in spite of the current low interest rates.
When , if ever , can we deleverage ?
The debt -GDP ratio is the outcome here. This is an exercise in accounting for the change in the debt ratio, it doesn’t tell us what might have happened as a result of the ratio following a different path.
I’m just suggesting you could do a similar accounting exercise but by holding debt/gdp constant instead.
Clearly this would mean new debt growth would have slowed and/or interest payback would have been increased , both of which would have subtracted from aggregate demand.
Of course we can’t say how other things may have evolved in reaction to this , but this counterfactual is no more fantastical in this regard than those that you present above.
And it’s an important counterfactual to learn how to study , unless we’re just going to pretend that debt/gdp can – like a certain bean stalk – grow to the sky.
It’s not more fantastical, but it moves out of the realm of accounting and into the realm of causality. We’d have to decide on a fiscal multiplier (or maybe a whole set of them, for various categories of taxing and spending) and then we’d need to make assumptions about the second-order effects on the trade balance, monetary policy, etc.
What I like about accounting exercises like in this post and my various papers is that they don’t require any of these assumptions. They are just ways of describing the data we directly observe.
Nope , I don’t see the difference. To keep either form of debt/gdp constant , you make the necessary interest payments and forego adding debt as necessary , assuming a dollar for dollar impact on current spending.
Also , can you really think that there would have been no second-order effects on the trade balance or monetary policy had , say , your red line counterfactual been realized ?
The choice of counterfactuals is always just that – a choice.
“I don’t see the difference.”
Then you don’t understand anything, sorry.
Hmm.
What if there had been no Reagan tax cuts and no rise in defense spending. What happens under that counterfactual?
In Italy there was high inflation in the 70s but the growth of debt didn’t change much, because people just asked for higher interest rates from italian bonds. I think that this effect of an increase of real interest rates because of a fall in inflation is only temporary (tough it can cause a permanent increase in the debt/gdp ratio).
Yes, another way of presenting this would be in terms of the real interest rate and the real growth rate, rather than the nominal values I use here. I’m rather skeptical that “the real interest rate” has any particular referent in a historical context, as opposed to a hypothetical long run, but I’m not unwilling to present the story that way if it’s easier to convince people. It’s just another way of slicing the data.
Two toughts on real vs. nominal interest rate:
1) I read somewhere (but I can’t find the source nor the data now) that, in the period when Italy had really high inflation, real interest rates on italian bonds were more or less the same than real interest rate on german bonds, though nominal rates were very different. The situation was something like:
Germany – 2% inflation, 4% nominal interest rate (real i=2%)
Italy – 5% inflation, 7% nominal i (real i=2%)
This situation is quite intuitive since the same investors could choose between german and italian bonds, thus real interest rate of both tended to converge.
As Italy disinflated to enter the euro, the nominal interest rate on new italian bonds also fell; but long term “legacy” bonds still carried higher nominal interest, and this caused a partial increase if italian public debt (tough it wasn’t the main driver).
In this situation where there were varius currencies surely the real interest rate, or something like it, id necessarious to make comparisons.
This also shows that the euro didn’t make it easier for periphery countries to go on a debt binge, since in real terms it didn’t really decrease their interest burden.
2) leaving out the problem of different currencies, if we assume that the government (and also private borrowers) keep a primary balance of 0, and that there is 0 “real” growth (to isolate monetary from real effects), the ratio of debt to gdp could be stable only if the average interest rate was equal to the rate of inflation. But where would this “inflation” came from with a primary balance of 0? And what determines the inflation rate? It seems to me that in such a “neutral” ipothesis inflation would be 0, while the interest rate wouldn’t, so that the debt burden would grow indefinitely (or cause a crisis at some unspecified point).
If people want to call an interest rate less a contemporaneous inflation rate the “real interest rate,” then I am willing to give numbers that way. But I don’t think this concept makes sense, from any perspective.
In the case of bonds issued in different currencies, it is not the case that arbitrage by investors will lead to a convergence of “real” interest rates. If I am choosing between German and Italian bonds, the respective inflation rates make no direct difference to me, since I am not holding Italian bonds to finance consumption of Italian goods. What matters rather is the (expected) change in the exchange rate. If investors confident the exchange rate will not change, then *nominal* exchange rates will converge, regardless of inflation rates. This is not controversial.
For a government borrower, what matters is the increase in nominal GDP over the length of the loan. For a business borrower, what matters is growth of earnings over the length of the loan. For consumption loans, what matters is the change in price of the particular basket of goods being consumed now rather than later, again over the length of the loan. (This is the closest to the conventional real interest rate concept, but a very small fraction of loans.) For a home loan, what matters is the home price-rent ratio, and the expected change in price of the house, over the length of the loan. Meanwhile from the bank’s side what matters is the (long) interest rate on its assets relative to the expected (short) rate on its liabilities, again over the length of the loan. There is not a single participant in credit markets who cares about the “real” interest rate as conventionally defined.
But where would this “inflation” came from with a primary balance of 0?
Lots of places. It’s perfectly possible to have positive inflation and a primary balance of zero, in fact this describes most of the modern history of the US.
I think you are mistaken about European interest rates — I think that for most peripheral countries euro was associated with lower nominal rates and if anything higher inflation — but am not going to look up the numbers right now.
I googled a bit and found historical series for EU countries inflation, but couldn’t find the series for “real” yelds. Anyway for inflation:
Italy:
http://www.inflation.eu/inflation-rates/italy/historic-inflation/cpi-inflation-italy.aspx
Very high inflation between 71 and 85, then a sharp fall, then a continuous downward trend from 1990
Greece:
http://www.inflation.eu/inflation-rates/greece/historic-inflation/cpi-inflation-greece.aspx
High inflation up to 92 then a continuous downward trend (I suppose that the greek government tried to rein in inflation because of the Maastricht treaty that created the euro in 92, even if Greece entered the euro in 2001)
Ireland:
http://www.inflation.eu/inflation-rates/ireland/historic-inflation/cpi-inflation-ireland.aspx
Here the serie is shorter, but it looks like high inflation up to 82 and then more or les stable inflation until the crisis
Germany:
http://www.inflation.eu/inflation-rates/germany/historic-inflation/cpi-inflation-germany.aspx
Lower and more or less stable (compared to the other three) inflation, with a slow downward trend
So at least for Greece and Italy the euro didn’t cause higher inflation, in fact inflation continuously fell since the adoption of the euro (this is very different from the popular story). Note that many people in Italy lament the high inflation caused by the euro, but it doesn’t exist in the statistics, if anything we are suffering from long term disinflation.