Notes On The Next Bust

13/8/2020 Notes on the Next Bust: The government must run deficits, even in good times.
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Notes on the Next Bust

Private Sector Debt is the Problem. Much Higher Government Deficits are the Solution.
Except in the Eurozone where Euro is the problem and no Euro the solution.
Friday, 26 June 2015

Are you a hotel owner or
do you know one? This is
The government must run deficits, even what I am doing now...
in good times. RoomPriceGenie.com
It is my view that it is very important to keep things simple and this is what I
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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 The government must run
deficits, even in good times.
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 Rising inequality explained (not
consider. using r-g)
Although the conclusion will be surprising to some people, I believe that every The Economy Simply
Explained
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. A Union of Deflation and
Unemployment
The starting point is the basic identity here:
Just one more thing...
If GDP in one year is given by £A, then the total amount of money The Supremacy of Savings in
our Economic System
spent on domestic goods and services is £A.
Rents and GDP
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 The Incalculable Cost of our
spent in year two is also £A*(1+n). Aversion to Government Debt
What it means is that, if, for example, growth is 2% and inflation is The Problem with Ever Freer
2%, then a total of 4% more money MUST be spent in year two Trade
than was spent in year one.
Why was r greater than g? Will
it continue? And how to
reverse it.
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. Blog Archive
When money is spent in an economy then it contributes to nominal GDP. ► 2020 (2)
►
Nominal GDP growth is the increase in A above. The economy can be ► 2016 (19)
►
simplified to how much money was spent and how much of that leads to real
▼ 2015 (30)
▼
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 ► December (2)
►
conclusion that we have a big problem now. ► August (1)

►
www.notesonthenextbust.com/2015/06/the-government-must-run-deficits-even.html 1/22
► July (1)
►
I am trying to keep things simple so I will avoid using any long equations, but
▼ June (3)
▼
to see this idea broken down into greater detail, it can be seen in the model I
The government must run
develop here and give an example of here (where I explain that the next crash deficits, even in good
we will have could well be a painful one). times.
Why was r greater than g?
I am not too concerned with the supply side during this discussion; it is a Will it continue? And
different issue. For example, better infrastructure and training will increase ho...
future real growth by improving productivity. There are two sides to an The UK Employment
economy and both are important. However all of this is irrelevant for this Miracle
analysis because it is just looking at the importance of demand. Deficiencies in
supply will be shown in inflation figures. ► May (9)
►
► April (9)
►
The supply side can expand supply to fill a certain amount of the demand as ► March (1)
►
demand grows. This is dependent upon the spare capacity in the economy. If
► February (4)
►
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 My DBCF economic
lead to inflation. model (Feb 16 version)
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 How high debt has caused our
could ever be made or borrowed. economic stagnation.
Also, imagine that there is economic growth in this economy. One year 1
About This Blog
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? Ari Andricopoulos
I apply modelling skills learned in

There are no more coins. Assuming that people spend 100% of their income 15 years in the financial markets to
from the previous year, the obvious answer would be that the price of clogs look at the economy.
goes down and now one coin can buy 11 pairs of clogs.
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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.
Savings
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.
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Posted by Ari Andricopoulos at 10:10:00
15 comments:
Anonymous 26 June 2015 at 21:16
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.
Marko
Reply
Replies
Ari Andricopoulos 26 June 2015 at 21:29

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.
Reply
Anonymous 26 June 2015 at 22:13
Well said
Remembering Angela Merkels debt break, threat for entire Europe.
Reply
Elwailly 1 July 2015 at 03:07

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.
Reply
Replies
Ari Andricopoulos 1 July 2015 at 09:56
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.
Reply
Max Rottersman 11 February 2016 at 05:19

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."
Reply
Replies
Ari Andricopoulos 11 February 2016 at 10:14

Max, thank you. Hearing things like this make it worthwhile.
Reply
readjerome 21 March 2016 at 21:54

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.
Reply
Ari Andricopoulos 21 March 2016 at 22:24

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.
Reply
Replies

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.

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.
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.

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.
Reply
Anonymous 29 March 2016 at 00:14

From Canada, how do you see this challenge (IMF was a bad deal)
www.comer.org
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.
Reply
Replies

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.
Reply
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Notes On The Next Bust - The Government Must Run Deficits, Even in Good Times

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13/8/2020 Notes on the Next Bust: The government must run deficits, even in good times.

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Friday, 26 June 2015

conclusion that we have a big problem now. ► August (1)

In any case, a change in total spending can be defined as the total

A constant quantity of money

Imagine if the money supply stayed constant. Imagine an economy of one

I apply modelling skills learned in

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

What's wrong with deflation?

Although some economists claim that people delay purchases in times of

Above 1% growth, however, we see a different story. Now the economy is

Why do central banks target 2% inflation?

The graph above approximately suggests that 1% is on average the minimum

Conclusion 1: Inflation targeting should target a minimum of 2%

So, where does the money come from?

1. Private banks. Every time a bank makes a loan, it is creating new

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

This is deflationary, as I discuss in more detail here. And as we have seen

So structural excess saving makes the problem even worse.

How to keep GDP up without new money?

The wealth effect of increasing stock markets means that people

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

The predictability of nominal GDP growth

1. New money coming in as increase/decrease in debt levels.

A note on point 4. As discussed above, I believe that debt weighs on the

A robust regression gives the following equation to predict nominal GDP

NGDP growth estimate =

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

It is important to bear in mind here that government deficit is not included.

Conclusion 4: Nominal GDP can be predicted using only a

Conclusion 5: New private sector debt has a multiplier of 0.13 on

Conclusion 6: Existing debt exerts a drag on the economy

Putting some numbers in for government and private sector debt

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

We have average nominal GDP growth throughout the period of 4.0%,

average government borrowing of 3.9% and average change in private sector

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

Estimate of UK Net Saving per Annum = 1*4.8% + 0.13*12.2% -

Estimate of US Net Saving per Annum = 1*5.9% + 0.13*10.5% -

Conclusion 8: The savings rates mean that we need to create new

Conclusion 9: On average, when more money is spent in an

Where are we now?

Not all money is created equal

The question is where it is spent. If it were spent on increasing welfare

We should concentrate on producing money that gives the maximum

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

Spending by the government is probably about 8 times more efficient at

Can we struggle along as it is?

NGDP trend estimate =

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

Where AveIncrGov is the average annual increase in government debt levels

If we assume, as we had in 2013 in the UK on OECD figures, 214% of GDP

the system is inherently unstable and will eventually collapse.

An example of a sustainable economy is one where we have very high

Imagine we were happy as a society with 150% government debt levels. By

The resulting economy is one built on stable foundations, not speculation

Conclusion 10: The only 'sustainable' level of government debt is

Risks of running high government debt

To put it simply, it is impossible for a sovereign state to default unless it

In any case, the cost to productivity of the paying of interest is already, to a

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

Estimate of UK Net Saving per Annum = 14.8% + 0.1312.2% -

Estimate of US Net Saving per Annum = 15.9% + 0.1310.5% -

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