Friday 26 June 2015

The government must run deficits, even in good times.

It is my view that it is very important to keep things simple and this is what I will aim to do here. I will get down to the simplest identity and build from there using empirical data. I will draw conclusions which  logically follow from the data and base assumptions. But despite the elementary nature of the idea, I still think that what it will show is very informative and the conclusion it leads to is one that the current government in the UK would be appalled to consider.

Although the conclusion will be surprising to some people, I believe that every step of the logic shown here is undeniably true. I would be very interested if someone can show me a faulty link in the chain.

The starting point is the basic identity here:

If GDP in one year is given by £A, then the total amount of money spent on domestic goods and services is £A. 
If nominal GDP the next year grows by proportion n, then GDP in year two is given by £A*(1+n) and the total amount of money spent in year two is also £A*(1+n). 
What it means is that, if, for example, growth is 2% and inflation is 2%, then a total of 4% more money MUST be spent in year two than was spent in year one. 

The question I will mainly be answering in the rest of this post is 'where does this money come from?'. I will not just try to answer this question in the abstract but to quantify the effect of different sources of money.

When money is spent in an economy then it contributes to nominal GDP. Nominal GDP growth is the increase in A above. The economy can be simplified to how much money was spent and how much of that leads to real growth and how much to inflation. I will try to show, using empirical data, the source of funding for our economic growth and how this leads to the conclusion that we have a big problem now.

I am trying to keep things simple so I will avoid using any long equations, but to see this idea broken down into greater detail, it can be seen in the model I develop here and give an example of here (where I explain that the next crash we will have could well be a painful one).

I am not too concerned with the supply side during this discussion; it is a different issue. For example, better infrastructure and training will increase future real growth by improving productivity. There are two sides to an economy and both are important. However all of this is irrelevant for this analysis because it is just looking at the importance of demand. Deficiencies in supply will be shown in inflation figures.

The supply side can expand supply to fill a certain amount of the demand as demand grows. This is dependent upon the spare capacity in the economy. If many people are out of work, then it would be easier to fulfill an increase in demand than if there is full employment. This will show in the numbers. The higher the level of GDP, the higher proportion of the extra spending that will lead to inflation.

In any case, a change in total spending can be defined as the total increase/decrease in GDP plus total increase/decrease in inflation. This is an identity. The next question is, how much does it contribute to real growth and how much to inflation?

A constant quantity of money

Imagine if the money supply stayed constant. Imagine an economy of one million people where there were a total of 100 million coins and no more could ever be made or borrowed.

Also, imagine that there is economic growth in this economy. One year 1 billion units of clogs are made (this economy uses clogs for shoes and fuel, builds shelter from clogs, eats chocolate clogs and is, apart from clogs, a nudist colony so clogs are all it needs). The price of 10 pairs of clogs is 1 coin and everyone spends all their money once so there are an average of 1,000 pairs of clogs per person. But next year, the same amount of work produces 1.1 billion pairs of clogs. What would happen?

There are no more coins. Assuming that people spend 100% of their income from the previous year, the obvious answer would be that the price of clogs goes down and now one coin can buy 11 pairs of clogs.

So the natural state of the economy in growth is deflation.

What's wrong with deflation?

Austrian school economists would point to this and say, what's wrong with deflation? Who says prices have to keep rising? Theoretically nothing says this, but there is a problem.

Although some economists claim that people delay purchases in times of deflation because it will be cheaper to buy things in the future, the most obvious reason that deflation is a problem is the stickiness of prices and wages. Simply put, this means that even when the economy is bad, people are very averse to taking cuts in wages and therefore producers are unable to reduce prices.

If people are buying less and no-one will take a cut in wages then the result is unemployment.

I don't like stating things that I can't back up with data so I will show you some data. This takes 24 OECD countries with credible central banks over the period of 1996 to 2013. I am plotting inflation (y-axis) against real GDP growth (x-axis).

What is shown in this data is that, below 1% GDP growth, average inflation stays reasonably constant at around 1% regardless of the state of the economy. In this data when growth is below 1% then there is very little correlation between growth and inflation. Very approximately speaking, with this data, a 1% reduction in growth is associated with a 0.08% fall in inflation.

The assumption here is that when growth is low, then the economy has capacity to produce more. More money spent does not lead to rises in prices because production can easily be raised. Conversely when money is taken out of the economy, wages and prices are not cut, leading to unemployment.

Above 1% growth, however, we see a different story. Now the economy is running closer to capacity. Here, empirically we see that a 1% increase in real GDP is associated with a 0.36% increase in inflation

This graph shows price stickiness in action. More data is required to confirm this, but, if supported by other studies, it is very important.

Why do central banks target 2% inflation?

The above graph demonstrates exactly why a 2% inflation target for the central bank is a minimum reasonable target. The reason is that it is extremely important to be on a part of the curve where a reduction in spending is not all taken out of real GDP. 

The graph above approximately suggests that 1% is on average the minimum inflation level; in periods of negative growth in the period of study, inflation is still around 1%. In order to be safely above this point, central banks aim for 2% inflation. Unfortunately they can't reach this level at the moment; this is because of the lack of demand explained later.

When inflation is above 2%, real growth averages 2.8%. When it is below 1%, real growth averages 0.9%

Why not target higher? Looking at the graph, it seems that there is a reasonable chance that a higher inflation target would lead to more growth. There is another reason as well; in my opinion a higher inflation target, maybe 3%, is needed to reduce inequality between savers and workers, as I discuss here.

The economic theory says that a lower target is to keep 'economic stability', but often economic arguments end up protecting people who are already wealthy, and this is a further example.

The other risk of a higher inflation target is that in order to achieve that target under the current system, more debt is needed to be taken; this means that historically high growth periods can lead to later crashes when debts can not be repaid. However, this need not be the case if the inflation target is hit without unsustainable debt. More on this later.

Conclusion 1: Inflation targeting should target a minimum of 2% because of the stickiness of inflation at 1%. Personally, I believe an even higher inflation target of maybe 3% would help rebalance the economy, as discussed here.

So, where does the money come from?

At the beginning, I pointed out that in order to have GDP growth, more money must be spent each year. Now, it is possible that there is a natural spending rate of over 100% of GDP. This would mean that for every £1 received in year one, maybe £1.05 is spent in year two. This is possible because the money can be spent by one person and then spent again within the same year. The 'velocity' of money goes up.

However, whilst this is possible I aim to show that this does not happen in our economy. In fact, I will show that the savings rate is greater than zero, meaning that actually less money is spent in the next year than is received as income in the previous year. I would speculate that if there were no debt in society, and if wages as a share of GDP were a lot higher, then we may indeed have a coefficient of spending greater than 1. However, this is not the economy that we live in, so the only option is to provide more money.

Since seigniorage (new banknotes made by the central bank) is relatively tiny, we need to look elsewhere. There are three main sources of new money:

  1. Private banks. Every time a bank makes a loan, it is creating new money. As this excellent report by the Bank of England explains, banks pretty much produce money from nowhere. They create a credit and a debit. One side of it may be the mortgage on a house and the other side is cash in someone's bank account. This extra money is mostly just adding to people's bank accounts, but partially spent in the economy. 
  2. Corporate debt. Every time a company issues a bond, it is effectively printing new money. This is because it creates the bond and then people with savings in cash use it to buy the bonds. As far as the savers are concerned they have got a (slightly less safe) equivalent of cash. But now the company also has the actual cash to spend, so there is an increase of money type instruments in the system. 
  3. Government debt. This is the same as the corporate debt described above, but is even closer to cash because it is backed by the sovereign.
If these parties did not choose to add new money to the system, then, under the current system, there is no new money added to the money supply. This means that, without existing savers spending more money than that being saved by new savers or an increase in the velocity of wages, there will be no increase in nominal GDP.

Note that all three of these methods above mean increasing debt levels. In the economy as it is, there is no way of sustainably increasing nominal GDP without an increase in debt.

This is quite an important point, no? And yet, if the savings rate is not negative, it must be true as a) more money must be spent each year for GDP to rise and b) there is no other significant source of new money.

However, it is a point that is largely ignored in discussion over monetary and fiscal policy.

Conclusion 2: In the current system, the only way to increase the money supply is using new debt.


As I discuss here, there is nothing good for society about people saving money. If people could save something useful, like the environment, then they would be doing a social good. But saving numbers on a computer screen does nothing.

Going back to our clog economy, it assumes that 100 million coins are spent per year. If people continue to spend the equivalent of all of their income, then this will continue and every year 100 million coins will be spent. Some people can save in this system, but others will spend their existing savings and the two will cancel.

But what if people decided to save 10% of their income and no existing savings were spent? In this case, only 90 million coins would be spent the next year. This is deflationary, as I discuss in more detail here. And as we have seen above, deflationary actions end up with unemployment due to stickiness of wages.

In the Western economies, I believe that there is too small a share going to the workers in the form of wages. And after this, too much of that income is then spent on rental or interest on houses. These are both, I believe, largely due to the high private debt economy that has built up over the past 40 years. More on this is here.

Because workers spend most of their income, and the savers (eg pension funds and wealthier people) spend a far smaller proportion, this leads to an economy that saves too much. This means that there is now even more money that needs to be replaced each year. Servaas Storm and C. W. M. Naastepad (pg 130) find the discrepancy between savings rates on profits and on wages to be 0.41 for OECD countries and Onaran And Galanis find the gap to be 0.44 for the Euro Area 12 countries, so this has been empirically shown to be the case.

In addition to this, foreign savings need to be taken into account. This comes in the form of a current account balance. A surplus means that domestic savings are going abroad. In the UK and US there is typically a deficit, meaning that foreigners are putting their savings in the UK and US. This increase in saving in local currency takes money out of the economy. As I discuss here, there is not a one for one relationship between a current account deficit and loss of domestic demand; some of the saving is just a transfer of savings from domestic to foreign savers. In any case, wherever the saving comes from, it reduces demand in the economy.

So structural excess saving makes the problem even worse.

Conclusion 3: If people are not (net) spending (on domestic goods and services) all of their income from time period 1  in time period 2, then the spending in time period 2 will be lower than that in time period 1. This spending will have to be replaced with new money to keep GDP up at the level from time period 1.
How to keep GDP up without new money?

There are ways to keep GDP up without providing new money. They all involve getting people to spend more of existing money. These include:
  • Looking at government spending and focusing it on spending where the highest multiplier on GDP is. For example, spending on foreign weapons systems do not increase domestic GDP but paying higher unemployment benefits mean almost guaranteed spending in the economy.
  • Getting people to spend existing savings. This can be done using certain government policy. For example, in the UK recently the government announced that pensioners can take out their full private pension on retirement instead of being forced to buy annuities. This would bring forward spending (just in time for the election in this case).
  • The wealth effect of increasing stock markets means that people with investments spend a bit more even if they did not earn it as income. This has been one effect of the recent QE programmes which, contrary to public belief, did not print new money. They replaced one form of money (government bonds) with another (cash), but in doing so increased asset prices and reduced longer term interest rates.
It all comes down to direction of money in the economy to those who will spend it and in the short term there are stimulus measures that can be used. The recent stock market and bond rally is in example of a one-off stimulus measure which has helped to increase spending in the economy by making people wealthier. However, most of these measures have a one-off impact.

If spending needs to be increased then new money will need to be produced.

What is the best way to get new money into the economy?

Since the economy needs new money to grow, and since relying on debt to do this is not optimal for various reasons discussed below, it would seem that the obvious thing to do would be for the government to provide new money. That is to say that if the nominal GDP growth target is 5% per year then 5% of GDP in new cash should be created by the government and spent in the economy in a way that has a multiplier of 1 on spending.

This would create a stable economy that does not rely on debt to grow.

However, this is not the way the economy runs. So working with what we have, there are two main sources of new money. Either private sector debt or government debt.

The predictability of nominal GDP growth

The economy is not as complex as some people would have you believe. If you can predict how much will be spent then you can predict the GDP. This is not straightforward because some parts of predicting spending are difficult; for example, a prediction about consumer confidence next year would be made incorrect in the case of a crash. However, I will separate GDP into four components:

  1. New money coming in as increase/decrease in debt levels.
  2. Confidence of consumers; this affects the propensity to spend.
  3. Wealth effect on existing savings; if share prices have gone up people are richer and spend more.
  4. The structural effect on the economy of previous debt levels; increased debt levels exert a drag on the economy.
A note on point 4. As discussed above, I believe that debt weighs on the potential growth of an economy because of the redistribution of income from those more likely to spend to those more likely to save. The more debt, the higher the structural savings in an economy will be. For this reason I include total debt in the regression.

Using OECD data from 24 countries from 1996 to 2013, I am able to run a regression to see the effect of all of the components. I use the following to represent each of the four components:

  1. For new money coming into the economy I look at the change in private sector debt levels. Government debt is more tricky to put into a regression as it is counter-cyclical and so it is difficult to separate the impact of increased spending from the reason why it is increased - for this reason I use only private sector debt for this component.
  2. For confidence I use the change of change of debt as a proxy. Typically an increase in confidence causes a reduction in the increase of debt because more money is spent in the economy. Lower confidence forces people to take out more new debt than the previous year.
  3. For the wealth effect I take the return from the S&P 500 index the year before the year in question. This could also be a predictor of consumer confidence so serves two purposes.
  4. For the structural effect of debt,  I look at the total level of government and private sector debt.
Amazingly, using ONLY debt related data and the stock market index return the year before, I can create a proxy that is 71% correlated to the actual nominal GDP growth in a country in a year during this time period. This is without knowing anything else about the country or the time.

A scatter plot of the proxy against the actual growth in nominal GDP is shown below:

A robust regression gives the following equation to predict nominal GDP growth:

NGDP growth estimate = 

7.00% + 0.13*IncrPSD - 0.017*TotDebt +0.06*S&PRet - 0.09*ChgofChgDebt

Where IncrPSD is the increase in private sector debt in the year divided by GDP, TotDebt is the total private and public sector debt level divided by GDP, S&PRet is the return of the S&P 500 index from the year before and ChgofChgDebt in the change in IncrPSD from the previous year.

For the technically minded, the p-values for all of these are zero to at least thirteen decimal places. This means that the results are very statistically significant.

It is important to bear in mind here that government deficit is not included. Since this was an average of 3.9% throughout the period, we can assume that growth would have been considerably lower had the government been running balanced budgets. 

Note that all of these factors primarily relate to the demand side of the economy. One predicts how much money will be spent by looking at how much is received and what the propensities to spend of the receivers are.

Conclusion 4: Nominal GDP can be predicted using only a prediction of cash flow. It is not necessary to look at the supply side of the system.
Conclusion 5: New private sector debt has a multiplier of 0.13 on nominal GDP. This makes it an inefficient way of stimulating spending vs government spending. 
Conclusion 6: Existing debt exerts a drag on the economy equivalent to 1.7% of the level of debt. This is an average of all different interest rates and marginal propensities to spend, but as an example it could correspond to an interest rate of 4% and a difference between the marginal propensities to spend between payer and receiver of 42.5% (4%*42.5% = 1.7%).

Putting some numbers in for government and private sector debt

I am going to make my first assumption here that is not backed up with any data. It is about the multiplier of government spending. Because this is a subject of intense economic debate, I am going to assume that it is close to what I believe to be a reasonable consensus. It is very dependent upon what the money is spent on. In any case, I believe that studies put the multiplier on real GDP to be approximately 0.8. For this reason, using the inflation assumption discussed below, I am going to assume that the multiplier on nominal GDP is 1. This would correspond to a (reasonably conservative) estimate of the fiscal multiplier as 0.72 on GDP, with a multiplier of 0.28 on inflation.

So we have a multiplier on private sector debt of 0.13 and a multiplier on government debt of 1.

We have average nominal GDP growth throughout the period of 4.0%, average government borrowing of 3.9% and average change in private sector debt of 11% of GDP.

Putting this all together, it means that if we take out the contributions of government and private sector debt, we get a nominal GDP growth of -1.3% per year (4% -3.9%*1 - 11%*0.13).

This, I believe, is the savings rate of the economy. For every £100 spent in year 1, only £98.70 is spent in year two, with £1.30 being saved.
Conclusion 7: The average net savings rate from income over the time period of 1996-2013 was 1.3%. This sending was replaced in the economy by spending of borrowed money.

This is a broad approach. Looking at the US and UK separately gives:

UK had average nominal growth of 4.2%, average govt deficit of 4.8% and average private sector debt increase of 12.2%, giving:
Estimate of UK Net Saving per Annum = 1*4.8% + 0.13*12.2% - 4.2%  = 2.2%

US had average nominal growth of 4.8%, average govt deficit of 5.9% and average private sector debt increase of 10.5%, giving:
Estimate of US Net Saving per Annum =  1*5.9% + 0.13*10.5% - 4.8%  = 2.5%
The savings rates of the US and UK are higher than average, probably partly due to the effect of the persistent current account deficits.

Conclusion 8: The savings rates mean that we need to create new spending of this amount on top of the amount required for inflation and real growth. Giving an example of 5% nominal GDP growth, we need to find an extra 7.2% spending in the UK. If we are to avoid increasing private sector debt, and assuming government multiplier of 1, it means a government deficit of 7.2% per year on average.

Growth vs Inflation

The equation can be plotted against real GDP growth and inflation separately to give an idea of the breakdown between real growth and inflation contained in this nominal GDP growth. The plots below show the two separated.

Conclusion 9: On average, when more money is spent in an economy, 72% goes towards growth, 28% goes towards inflation. This obviously will change depending on how close the economy is to full capacity, but it is a useful rule of thumb.
Also notable on the graph is that 0% predicted nominal growth gives inflation of approximately 0.9% and growth of approximately -0.9%. Price stickiness in action.

It actually is not too far away from the rule of John Taylor, which implies that a 1.5% rise in interest rates (which causes a certain amount of a reduction in spending) should lead to a 3% fall in growth and a 1% fall in inflation. So his rule suggests that as a rule of thumb, 75% of money spent is growth increasing and 25% of money spent  is inflationary.

This yields the surprising conclusion that I am in agreement with John Taylor.

Where are we now?

Since the second world war, the economy has been growing using a combination of government debt and private debt. When more stimulus was needed, interest rates were reduced and more debt taken out. This private debt has got larger and larger until the crash of 2008. 

Since 2008 it has not been possible to encourage substantially more private debt. Interest rates have finally hit bottom but due to poor growth prospects, high house prices, and high real interest rates charged by banks, even at zero base rates it has been very difficult to stimulate more growth. The UK government has tried its best with schemes such as Funding for Lending and Help to Buy, but it has faced strong headwinds.

It is now difficult to get more private debt even if it were desirable. And for this reason we are in a secular stagnation in the West. The previous ways of funding economic growth are no longer there and we are still paying for the old ways.

Not all money is created equal

Supposing the government created £10 billion of new money, would it cause growth and inflation?

The question is where it is spent. If it were spent on increasing welfare payments to those with incomes below the poverty line, the chances are it would be spent in the economy so quickly that it would actually be spent again before the year is out. This gives it a multiplier greater than one on nominal GDP.

If, on the other hand, they just put it in my bank account as a gift, and even supposing I went on a Brewster's Millions style spending spree, it would make virtually no difference to the economy.

My point here, is that when creating money we really want it to be used in the most efficient way possible to boost growth. When private banks create money it is not very efficient as very little is spent in the economy.

We should concentrate on producing money that gives the maximum economic impact, whilst removing money that has less economic impact. This means increasing government debt (or even better, allowing monetarisation) and reducing private debt.

Do we want a high private debt society or a low private debt society?

In some ways, this is a value judgement. Do we want a society where house prices are so high that very few people starting work today in London will ever be able to afford one? Do we want a society where workers are rewarded less and rentiers rewarded more? Do we want an economy with high levels of instability, prone to pro-cyclical booms and busts?

In some ways though, it is just a matter of common sense. In order to get the spending required to increase GDP, we need to make a decision whether to increase private or public sector debt. Since the drag on the economy by both is comparable, the only question is which provides more of a stimulus.

Spending by the government is probably about 8 times more efficient at stimulating the economy and therefore, if we have decided we want debt then we have to choose government debt over private debt.

The other important consideration is that when a private sector debt crisis occurs, usually the government needs to take some of the loss onto its books anyway. So even using the narrow criteria of trying to keep government debt down, choosing the private sector debt route may end up with a worse outcome.

Can we struggle along as it is?

The answer here is yes, just about. But it is with low growth and greater risk of financial crisis. Taking a government multiplier of 1 we get a trend growth, using the equation above of:

NGDP trend estimate = 

3.1% + 1*AveIncrGov+ 0.13*AveIncrPSD - 0.017*TotDebt 

Where AveIncrGov is the average annual increase in government debt levels and AveIncrPSD is the average annual increase in private debt levels (both are divided by GDP total at the start of the year) .

A sustainable debt ratio is one where the economy can grow and debt to GDP ratio does not rise from year to year. As an example, supposing we had a government debt of 100% of GDP and nominal GDP growth of 5%, we could increase government debt by 5% per year without increasing the ratio of government debt to GDP.

If we assume, as we had in 2013 in the UK on OECD figures, 214% of GDP private sector debt and 93% government debt and decide that these are the levels we wish to keep, then there is actually a solution that can make these levels sustainable: it targets 10% nominal GDP growth and has government deficits of 9.3% of GDP per year.

I would not advise such a drastic course of action, however. There may be unforseen consequences; inflation would be above target and credibility of the central bank may be put in doubt.

Going back to reality for now, with the UK government running deficits similar to where we are at the moment, we have a shortfall in spending. Nominal GDP growth of around 4% can be achieved but the cost would be an increase in private sector debt of around 10% per year.

The government is actually planning to reduce the deficit to zero in the next five years. It will be a good test of the equations above. I don't think it will be good for much else.

But even if the government is sensible and keeps deficits where we are now, the system is inherently unstable and will eventually collapse.

An equilibrium

An example of a sustainable economy is one where we have very high government debt but very low private debt. It works as follows:

Imagine we were happy as a society with 150% government debt levels. By increasing government debt to reach that point, we would give stimulus to the economy. When the economy heats up, instead of reducing government spending we could raise interest rates and therefore not increase total level of private debt whilst the economy is growing (reducing the ratio of private debt to GDP).

At 150% government debt to GDP, with private sector debt down to 150% of GDP too, assuming that the government took most of the responsibility for spending new money, both private and public sector debt would be going down relative to GDP every year.

As a worked example, with 150% government debt and 150% private sector debt, a 5% nominal GDP growth target could be hit with a 7% increase in government debt and a 0% increase in private debt. This reduces both government debt to GDP and private debt to GDP ratios.

The resulting economy is one built on stable foundations, not speculation caused by increases in private debt. Rentier capitalism is reduced due to the relative reduction in debt levels and inequality will be reduced. And the debt levels are sustainable.

Conclusion 10: The only 'sustainable' level of government debt is a high one. This is because it allows a higher government deficit without increasing the ratio of debt to GDP.

Risks of running high government debt

There have been a lot of scare stories about how too high levels of government debt will 'scare bond markets' and risk bankrupting the country. This may be true for a country that has borrowed in another currency (see Greece), but for the issuer of a sovereign currency this is ridiculous. The reason is simply that if there is any perceived credit risk on the government debt, the central bank can buy unlimited quantities of it, in what are termed 'outright monetary transactions' (the promise by the ECB to use these saved Spain and Italy from default in 2012).

To put it simply, it is impossible for a sovereign state to default unless it chooses to. For an example of high government debt with very low interest rates one only needs to look to Japan. With a couple of exceptions of default by choice (eg Russia 1998) every single sovereign debt crisis ever has been because the state can not issue the currency in which the money is owed. The central bank needs to agree to stand behind the currency and this risk disappears. A credible central bank should maintain an inflation target and as long as it does this, there is no risk to the debt.

The other risk is that nominal economic growth powers away and real interest rates rise. As Marlo would say, it sounds like one of them good problems. Although the government would have more interest to pay, the economy would be in healthy shape and able to take it. Also, in this circumstance, it is much better that the government owes a smaller amount of money then the situation where private debt is much higher given above.

In any case, the cost to productivity of the paying of interest is already, to a large extent, included in this calculation. The coefficient for existing debt is -1.7%. As previously stated, this could correspond to a 4% average interest payment, with a 42.5% difference in marginal propensity to consume between payer and receiver. If interest rates were higher then either the sustainable rate of debt would be a little higher, or the government could divert some of the other (non-interest payments) part of the budget to people with a higher propensity to consume.

The two routes to 150% government debt to GDP ratio

We are in a situation now where we have two broad choices ahead of us (or somewhere in between of course). Let me pave out the two roads we can take.

1) Increase government debt by an average of, say 9% of GDP per year, going down to 7% of GDP per year as private sector debt to GDP reduces. This will enable interest rates to rise and private sector debt to reduce. It will enable a nominal GDP growth of 5% per year. It will lead to a sustainable growth not relying on private debt bubbles. It will put us, in ten years time, with a government debt to GDP ratio of below 150%, a strong, vibrant economy and much lower private debt to GDP levels.
 2) Keep a balanced government budget and encourage private sector debt. Imagine that we can encourage 20% of GDP per year of private debt. This will lead to sluggish average nominal GDP growth of maybe 1-2% in the good times.  It will lead to a large build up of private debt to GDP. Inequality will increase, house prices will continue rising. In maybe ten years time, when we have 300% private debt to GDP and government debt of around 80% of GDP we will have a crash. The government will need to bail out the banks and pick up the pieces of the economy. Most of the real growth will be wiped out. In the few years after this next crash government debt will still rise to 150% of GDP. A GDP that is significantly lower, a society that is more divided along lines of wealth and an economy burdened with huge levels of private and public debt.

Overall Conclusion

New money needs to be created to keep up nominal GDP growth. Since we have tried the private sector debt route to growth and since it has a) failed to keep the economy stable, b) led to a rentier economy and c) can't even give us growth any more, we need to find a new way of creating the new money.

Here, in my opinion, there are only two choices.

1) Allow central banks to create new money, corresponding to 5-7% of GDP per year which it gives to the government.

2) Allow governments to run larger deficits.

Trying to keep government debt low is unsustainable, destroys growth prospects and creates private debt crises.

Counterintuitively, the only 'sustainable' level of government debt is a high level.


  1. Good stuff.

    I wish we had continued the post-crisis stimulus in the U.S. until gov't debt/gdp reached about 150% , because I think we'd be in much better shape now with private debt/gdp lowered by 40-50 points or so. Even if the combined debt/gdp was the same ( ~ 240% of gdp ) or somewhat higher than it is today , the economy would be more robust because of the reduced debt overhang on the private sector.

    The Japan experience is tough to evaluate. They seemed to get a good tradeoff of public vs private leverage with their gov't spending from ~ '95-2005 , but then they backed off on the deficit levels. Now public debt/gdp seems to rise continuously with little or no offset in private debt/gdp.

    The political bias against deficits is so strong ( on the left and the right , US and UK ) that I don't have much hope that we'll see 150% gov't debt/gdp levels unless we have another crisis.


    1. Thanks Marko,

      I fear that you are correct and that we are going to reach it the wrong way.

      In Japan, I would argue that the government are not spending enough and it is because of all those people saying they need to reduce their debt. A few percent more of government spending in the right place should bring more growth and reduce the debt to gdp ratio. In fact any spending with a multiplier of more than 0.5 reduces the debt to gdp ratio at their level of debt - surely this is possible?

      It seems to me that the real danger of high debt are all those people saying you need to reduce it. Apart from that, interest rates are low and the central bank can always step in. But the 'responsible' people are causing the problem that they claim they are trying to solve.

  2. Well said
    Remembering Angela Merkels debt break, threat for entire Europe.

  3. Good post. I wonder how China and other emerging countries are situated with respect to total debt and government to private debt ratio. They seem to be able to maintain a high nominal growth rate. I recall that China has a high savings rate as well.

    1. Thanks.

      China is an fascinating economy, and I recommend Michael Pettis and Anne Stevenson Yang for further understanding.

      The high savings rate is forced by government policy that subsidises investment on a massive scale. The government keeps spending up with high borrowing (both public and private, often state backed) for investments, but it also has high GDP growth which makes the ratios look not too bad. The huge government spending brings growth as predicted above, but the model is unsustainable.

      The low consumption rate is a huge problem because at some point the investment needs to have a return and if the consumer has no spending power it can't. They are stuck in a position where they need to keep investing more to keep the economy growing even though the return is now often negative.

      Anyway, better to read the experts on this than myself. It is very different from the situation in the West and I really do recommend reading about it.

      But the one thing China has in its favour is that the opacity of the government means that it can effectively print money to write off bad debts, therefore reducing the problem of a debt overhang when the crash finally does come. In the West we have decided to protect savers from inflation at the expense of the economy.

  4. Sorry I can't add anything substantive, but really enjoyed your essay and thanks for taking the time to write it! I had a nice joyous laugh from this, "As I discuss here, there is nothing good for society about people saving money. If people could save something useful, like the environment, then they would be doing a social good. But saving numbers on a computer screen does nothing."

    1. Max, thank you. Hearing things like this make it worthwhile.

  5. Compelling case, brilliant post. I want to know what you think about the case of economies such as Ghana (where I'm from) with external debt at 40% of GDP and where any attempt at derailing from the fiscal and monetary tightening demanded by the IMF leads to a sharp depreciation of the currency, raising the debt level in local currency terms and hiking the yield demanded by subscribers to our foreign currency denominated bonds.

  6. Thank you Jerome, very kind.

    First, I think borrowing in foreign currency must stop. It can really destroy the economy, as you know. It like a time bomb. International rules do not support countries like Ghana, they enforce misery for many years.

    How to do this? The government must show that it is credibly targeting a low-ish inflation level. I don't know anything about Ghana, but I'd say you need an independent central bank and credible fiscal rules in place to make sure inflation stays below, say, 5% and that foreign and domestic investors believe it will permanently stay below that level. If investors have confidence in the government, then you should be able to borrow in your own currency. The real interest rate may be quite high, but the potential for growth in Ghana is too. Real growth should come and investors will have more confidence in lending to your government.

    In bad times the currency will go down but that will protect the economy, not bankrupt the government.

    Basically, even if it costs a lot more you must borrow in local currency. At worst it means interest payments to your own citizens.

    The other option is to have the central bank lend money to the government. Once again, a credible inflation target must be hit to maintain economic stability. Everything is the same as above, terms of government discipline, otherwise it is a slippery slope to chaos. But if they do set up institutions which maintain discipline, I see no problem with this approach.

    The third option is a hybrid where government borrows money on the market but the central buys the bonds if the interest rate gets too high due to default risk.

    Infrastructure projects that increase future growth are a good idea to get people to work. Education and training also important to improve the supply side.

    1. Thanks for the reply. A bit more info:

      Ghana depends on export of cocoa, gold and oil. Inflation has been a constant problem until the time of the commodity boom in 2011-2013 when inflation remained under 10%, the cedi (our currency) was stable and government was able to borrow on the international market at relatively low rates.

      The commodity slump hit us hard - inflation is at 18.5%, our latest eurobond issue was at an interest rate of 10.75% (even with a world bank guarantee) and the CB raised interest rates to 26%, a 13 year high. We went for an extended credit facility with the IMF and have reduced our deficit from 10.2% in 2014 to 7.1% in 2015. But among the conditions for borrowing is that the government can't borrow from the CB.

      We're in an election year and the government is targeting a deficit of less than 6% but everyone is doubtful because spending goes up in election years. The strategy of the government is to borrow long-term to settle short-term debt and to increase domestic tax revenue (which it has succeeded to do).

      The cost of production is so high that almost everyone wants government debt. 79% of banks' portfolio is government debt. Had I my way, the government should spend this money since the private sector is unwilling to invest right now. But the deficit targets agreed with the IMF and the fear of a depreciating the currency makes that a difficult option. It's quite a fix.

    2. Your reply is fasinating and I have looked on the internet to get further details.

      The first thing to say is that Ghana's economy should on the face of it be healthy despite the obvious impact of the commodity boom and bust cycle. Capacity for growth is high. Unemployment appears low and real growth has historically been pretty high. I don't know but there may be some issue of distribution of income (often there is in commodity economies); the more evenly distributed, the higher domestic demand will be.

      The issues facing Ghana (from my limited understanding) are:

      1) During the commodities boom, the power to buy foreign goods went up a lot. Standards of living increased in this sense. With the commodities bust this has reversed. There is nothing that can be done about this; the currency has to go down and buying power has to be reduced.

      A 30% drop in the currency has caused inflation to be very high but this is not anything that can be remedied. It is just the way it is.

      The only inflation that should concern a central bank or government is that of domestic goods and services. This is a sign of an overheating economy. Inflation forced by external issues is a sign of a weakening economy and is not a reason to tighten policy - if anything the opposite.

      So Ghana does have an inflation problem but if this is largely due to the commodity bust then it is unfortunate but should be ignored.

      2) Increasing foreign debt may enable a higher standard of living but still must be avoided at all costs. The IMF has only one thing in mind - getting its money back. It wil force austerity to pay back the loans and can't abide a falling currency that will make it harder for it to get its money back. To a certain extent the natural resources Ghana has are priced in a foreign currency so there is a certain matching of asset and liabilities, but still it is much much better to avoid these traps. Just the presence of the IMF in Ghana can lead to bad policy decisions - tightening of fiscal policy just to make sure that creditors get their Dollars and Euros back.

      3) From points 1 and 2, the conclusion is that Ghana must accept that it has lost a lot of relative wealth in the commodities bust. The situation is tough and will lead to hardship, the standard of living attained before can not be got back quickly. This can be partly ameliorated with a wider distribution of government spending, giving more to those most in need.

      However, what it must not do is make the situation worse by borrowing in foreign currency to keep pretending things are OK. Things are not OK, but they will deteriorate rapidly if you try to pretend they are. Borrowing from the IMF will, unless commodity prices pick up again, probably end badly after years of underperformance.

      Instead it should prioritise avoiding unemployment. If there is unemployment then more government money should be spent on investment projects until there is low unemployment again.

      If the IMF is an obstacle to this, then it shows why they need to be paid back as soon as possible. Their rules, whilst some may improve competitiveness etc, are in general a curse on the economy. They are not your friends, they are taking money from you and don't care about the effects.

      The currency should be allowed to fall further if necessary. It will pick up as economic growth comes back.

      This is my view on the situation - I hope it is of interest.

    3. Your suggestions make sense. Perhaps our currency is overvalued and it's not worth maintaining it with further external borrowing. Now all that is left is the political will.

      Thanks. And I hope to read a lot more of your work.

    4. As I say, I don't know anything about Ghana and it may be wrong. But I do believe that there are basic principles of money and a healthy long-term economy relies on sticking to them.

      And from what I see the prospects for Ghana look excellent if they can avoid the traps as it appears well run.

      Thank you for your interest and I hope you can use whatever influence you have in Ghana to bring about more good policy.

  7. From Canada, how do you see this challenge (IMF was a bad deal)
    Our Bank of Canada, around 1973/4, allowed private banks to be a 'middle man' in lending. Instead of our national bank lending to provinces/municipalities to do work projects, etc. they allowed private banks to insert themselves as lenders, thus taking a profit and essentially causing our national debt to rise.

    1. Your link didn't go to anything specific so I don't really know much about the situation you describe.

      There are legitimate reasons to get private banks to lend the money rather than the central bank. It means that the projects will probably be more commercially viable and less politically motivated.

      It could also lead to banks cherry-picking the most profitable projects and under-investing in those that the country most needs.


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