Saturday, June 1, 2019

As you were: getting back to budget surplus no longer urgent

Sometimes, changes in fashion are shocking. In economics, the fashion leaders are top American economists. Their latest fashion call is highly relevant to Australia’s circumstances, but will shock a lot of people: stop worrying so much about debt and deficit.

Among the various big-name economists advocating this change of view, the one who made the biggest splash was Professor Olivier Blanchard, of the Massachusetts Institute of Technology, in his presidential lecture for the American Economic Association early this year.

Blanchard was formerly chief economist at the International Monetary Fund, and had a big influence on the advanced economies’ response to the global financial crisis. He offered a simpler version of his lecture in a paper for the Peterson Institute for International Economics in Washington.

When governments spend more than they raise in taxes, they cover their deficit by borrowing via the sale of government bonds. If you run deficits for many years, you rack up much debt.

So the conventional wisdom – which we heard from both sides in the election campaign – has long been that, as soon as the economy has recovered from its downturn, governments should raise more in taxes than they spend, so as to run an annual budget surplus. They use the surplus to buy back some of the bonds the government has issued, and thus reduce its debt.

Why do most people – and many economists still - think this is the right thing to do? Because when you borrow money you have to pay interest. The more you borrow, the more interest. And the only way to stop having to pay interest is to repay the debt.

Blanchard calls this the “fiscal [or budgetary] cost”. In the end, interest payments and repayments of principal have to be covered by the higher taxes extracted from people, which may discourage them from working or distort their behaviour in other ways.

But Blanchard realised there may be no fiscal cost because interest rates are so low – especially for governments, whose debt is regarded as risk-free (or “safe” as he calls it). Governments are almost always able to repay their debts because, unlike the rest of us, they can get the money they need by increasing taxes. Or they could simply print more money.

Safe interest rates in the rich economies – including Australia – are so low that, after you allow for inflation, the “real” interest rate may be close to zero, or even negative. If they’re zero they’re costing the government nothing.

If they’re negative, the lender is actually paying the government to borrow from them (once you remember that, because of inflation, the lender will be repaid in dollars with less purchasing power that the dollars originally borrowed).

But that’s not all. A government’s revenue-raising capacity tends to grow in line with the size of the economy – nominal gross domestic product. And nominal GDP almost always grows faster than the nominal safe interest rate.

If so, the government can go on, year after year, paying the interest on its debt and continuing to run a budget deficit - provided it isn’t too big – without its debt growing relative to the size of the economy.

Now, you may object that interest rates are so low at present only because it’s taking so long for the world economy to recover from the global financial crisis and the Great Recession.

But if interest rates are higher in the future, that will be because there’s stronger demand to borrow relative to the supply of funds available, and this, in turn, should mean the economy is also growing at a faster rate.

In any case, Blanchard and others have shown that nominal GDP growth has been higher than the safe interest rate for decades.

So, unless budget deficits are very high, the value of the debt should decline over time as a percentage of GDP. This, in fact, is the way all countries got on top of the massive debts they incurred during World War II.

The second conventional reason for worrying about government debt is the cost to the economy, which Blanchard calls the “welfare cost”. When governments borrow to fund their deficit spending, they compete with private sector borrowers, driving up the interest rates firms have to pay and so “crowding out” some business borrowers.

This causes firms’ investment in renewing or expanding their businesses to be lower than otherwise which, in turn, leads to less economic growth and job creation than otherwise.

(That’s the standard argument, used since Milton Friedman’s day. It’s still relevant to an economy as huge as America but, in an economy as small as ours, it stopped applying after we floated the dollar and our financial markets became integrated with the global market. In Australia, if crowding out happens, it does so via the inflow of borrowed foreign capital causing our exchange rate to be higher than otherwise and thus making our export and import-competing industries less price competitive.)

But Blanchard argues that, in fact, the welfare cost of high government debt is probably small. If the average rate of return on business investment projects is higher than the rate of growth in nominal GDP, this implies there is a cost to the welfare of people in the economy.

On the other hand, if the safe interest rate is lower than the rate of growth in nominal GDP, this implies a welfare benefit from the government debt. Putting the two together implies that the welfare cost, if any, wouldn’t be great.

Blanchard is quick to warn, however, that these arguments don’t “add up to a licence to issue infinite amounts of [government] debt”. Debt and deficit make sense when government spending is countering the weakness in private sector spending. When this fiscal stimulus succeeds in restoring strong growth in private sector spending, governments should pull back to avoid excessive inflation pressure.

And, to be on the safe side, government borrowing should be used mainly to support investment in needed infrastructure, education and healthcare, so it’s adding to the economy’s productive capacity, not just to consumption.