What are the limits to government borrowing?

on Jun8
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THE SCALE of Joe Biden’s plans is hard to exaggerate. Where the American president’s former boss, Barack Obama, pivoted quickly to deficit-cutting after the trials of the global financial crisis, Mr Biden’s first budget, which he unveiled on May 28th, will borrow unapologetically. The plans assume that annual fiscal deficits will exceed 4% of GDP through to the end of the decade; net public debt will rise to 117% of GDP in 2030 from 110% today. The largesse raises two big questions. One is whether, coming on top of past stimulus packages, it will contribute to an overheating of America’s economy in the short term. The other important question is whether in the longer term America can prudently afford to loosen the purse-strings for a sustained period. As crisis has hit and interest rates have fallen, politicians have felt more able to run up debts than in the past. But the issue of whether and when limits to borrowing might apply still remains. Recent research casts light on these constraints.

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In a new working paper, Atif Mian of Princeton University, Ludwig Straub of Harvard University and Amir Sufi of the University of Chicago attempt to gauge governments’ room to run. Their analysis (which does not incorporate the effects of the pandemic) builds on recent work that estimates how the “convenience yield” on government bonds—or the amount by which a bond’s yield is reduced because of the safety and liquidity benefits it offers investors—varies with the size of the debt burden. Other things equal, the greater the volume of outstanding bonds, the higher the return investors demand. Work by Arvind Krishnamurthy of Stanford and Annette Vissing-Jorgensen of the University of California, Berkeley, suggests, for example, that a 10% increase in the ratio of debt to GDP pushes government-bond yields up by 0.13-0.17 percentage points. (In practice, of course, other things are not always equal: the long-run effect of increased bond supply on safety and liquidity premia may be offset by other factors, such as a short-run surge in demand for safe assets prompted by financial instability, leading to falling bond yields amid rising debt loads.)

Because the supply of bonds matters, Mr Mian and co-authors write, a level of government debt that is too low can result in an interest rate that slinks towards zero. But rates cannot fall much further below zero; the result is narrower scope for central banks to stimulate activity, and therefore lower economic growth and higher unemployment. The problems of debt sustainability are often associated with high debt levels, which push the interest rate above the economic-growth rate. When that condition is met, the debt burden grows steadily even in the absence of new borrowing. But the authors raise the theoretical possibility of another source of fiscal-sustainability problems: when too low a level of debt leads to serious deflation, dragging the growth rate into negative territory and below the interest rate.

In between those two extremes, the researchers argue, lies a “Goldilocks zone” in which a fiscal free lunch is possible. They flesh out a point highlighted in 2019 by Olivier Blanchard of the Peterson Institute for International Economics: that when the interest rate on public debt is below the economy’s growth rate, existing debt burdens have essentially no fiscal cost. In such cases, existing debt will decline as a share of output even if no new taxes are levied—though a government that continues to run deficits may nonetheless add to its debt pile. Assuming a balanced budget and based on estimates of the convenience yield on Treasuries, the authors reckon that America’s Goldilocks zone—the maximum level of debt you could reach and then stabilise without raising taxes—could extend up to about 260% of GDP. (The uncertainty around their estimates means the limit could lie between 230% and 300% of GDP.)

There is also a range of indebtedness across which governments may run deficits in perpetuity without increasing the debt burden. America, they estimate, could run a deficit of 2.1% of GDP for ever so long as its debt is below 130% of GDP (after which threshold the largest deficit that could be run in sustained fashion without raising the debt burden drops steadily towards zero).

This logic suggests that though supersized deficits may be appropriate now, America cannot run them for ever. Doing so would cause debt to rise, potentially out of the Goldilocks zone and into riskier territory. And the longer America waits to shrink its deficit to the maximum sustainable level, the closer to surplus (or the further into surplus) that level will be. Mr Biden may take some comfort from the fact that his borrowing is manageable for now. Even so, it could eventually limit America’s fiscal freedom.

Bonds away

Importantly, a Goldilocks window is not fixed. Slower economic growth could shrink the safe zone by narrowing the gap between growth and interest rates—unless, that is, an economic slowdown also causes a sharp drop in interest rates, pushing them closer to zero and necessitating fiscal stimulus. Rising inequality may lead to calls for redistribution, but because the rich tend to buy government bonds in disproportionate numbers, levelling the income distribution may reduce the scope for a fiscal free lunch. That also means, the authors note, that efforts to address wide deficits through progressive taxes may not bear much fruit: taxes on high earners will hoover up money that might be used to buy bonds.

Analyses such as these are trying to understand circumstances outside of historical experience, and necessarily come with large uncertainties and assumptions attached. Budget-setting politicians too have uncertainties to navigate, and must do so carefully. Government borrowing plays a starring role in today’s macroeconomic zeitgeist. A balance of sorts is still required, between making good use of the government’s capacity to borrow, and acknowledging that limits to public borrowing are not so distant that they can be ignored altogether.

This article appeared in the Finance & economics section of the print edition under the headline “Pace your debts”

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