With the UK parliament in Brexit gridlock, the Labour opposition is calling for a general election. Although its policy over Brexit and a second referendum is causing splits in the party, the Labour party is generally agreed that pubic expenditure on health, education and transport infrastructure needs to increase – that there needs to be an end to fiscal austerity. However, to fund extra public expenditure would require an increase in taxes and/or an increase in government borrowing.
One of the arguments against increasing government borrowing is that it will increase public-sector debt. The desire to get public-sector debt down as a percentage of GDP has been central to both the Coalition and Conservative governments’ economic strategy. Austerity policies have been based on this desire.
But, in the annual presidential address to the American Economics Association, former chief economist at the IMF, Olivier Blanchard, criticised this position. He has argued for several years that cutting government deficits may weaken already weak economies and that this may significantly reduce tax revenues and potential national income, thereby harming recovery and doing long-term economic damage. Indeed, the IMF has criticised excessively tight fiscal policies for this reason.
In his presidential address, he expanded the argument to consider whether an increase in government borrowing will necessarily increase the cost of servicing government debt. When the (nominal) interest rate (r) on government borrowing is below the nominal rate of economic growth (gn), (r < gn), then even if total debt is not reduced, it is likely that the growth in tax revenues will exceed the growth in the cost of servicing the debt. Debt as a proportion of GDP will fall. The forecast nominal growth rate exceeds the 10-year nominal rate on government bonds by 1.3% in the USA, 2.2% in the UK and 1.8% in the eurozone. In fact, with the exception of a short period in the 1980s, nominal growth (gn) has typically exceeded the nominal interest rate on government borrowing (r) for decades.
When r < gn, this then gives scope for increasing government borrowing to fund additional government spending without increasing the debt/GDP ratio. Indeed, if that fiscal expansion increases both actual and potential income, then growth over time could increase, giving even more scope for public investment.
But, of course, that scope is not unlimited.
Articles
Presidential Address
Questions
- What do you understand by ‘fiscal illusion’?
- What is the justification for reducing government debt as a proportion of GDP?
- What are the arguments against reducing government debt as a proportion of GDP?
- Explain the significance of the relationship between r and gn for fiscal policy and the levels of government debt, government borrowing and the government debt/GDP ratio.
- Under what circumstances would a rise in the budget deficit not lead to a rise in government debt as a proportion of GDP?
- Does Blanchard’s analysis suggest that a combination of both loose monetary policy and loose fiscal policy is desirable?
- Under Blanchard’s analysis, what would limit the amount that governments should increase spending?
Now here’s a gloomy article from Robert Peston. He’s been looking at investors’ views about the coming years and sees a general pessimism about the prospects for long-term economic growth. And that pessimism is becoming deeper.
It is true that both the UK and the USA have recorded reasonable growth rates in recent months and do seem, at least on the surface, to be recovering from recession. But, according to investor behaviour, they:
seem to be saying, in how they place their money, that the UK’s and USA’s current reasonably rapid growth will turn out to be a short-lived period of catch-up, following the deep recession of 2008-9.
So what is it about investor behaviour that implies a deep pessimism and are investors right to be pessimistic? The article explores these issues. It does also look at an alternative explanation that investors may merely be being cautious until a clearer picture emerges about long-term growth prospects – which may turn out to be better that many currently now predict.
The article finishes by looking at a possible solution to the problem (if you regard low or zero growth as a problem). That would be for the government to ‘throw money at investment in infrastructure – to generate both short-term growth and enhance long-term productive potential.’
Note that Elizabeth also looks at this article in her blog The end of growth in the west?.
The end of growth in the West? BBC News, Robert Peston (26/9/14)
Questions
- What is meant by the ’25-year yield curve for government bonds’? Why does this yield curve imply a deep level of business pessimism about the long-term prospects for UK economic growth?
- What are the determinants of long-term economic growth?
- Looking at these determinants, which ones suggest that long-term economic growth may be low?
- Are there any determinants which might suggest that economic growth will be maintained over the long term at historical levels of around 2.6%?
- Do demand-side policies affect potential GDP and, if so, how?
- What policies could government pursue to increase the rate of growth in potential GDP?
- What current ‘dramas’ affecting the world economy could have long-term implications for economic growth? How does uncertainty about the long-term implications for the global economy of such dramas itself affect economic growth?
- Is long-term growth in real GDP an appropriate indicator of (a) economic development and (b) long-term growth in general well-being?
The growth rates of the Western world have been somewhat volatile for the past decade, with negative growth sending economies into recession and then varying degrees of economic recovery. Growth rates elsewhere have been very high, in particular in countries such as China and India. The future of economic growth in the west is hotly debated and whether the western world has been forever changed by the credit crunch remains to be seen.
The article below from the BBC, written by Robert Peston, the Economics Editor, addresses the question of the future of the western world. Opinions differ as to whether the west is finally recovering from the recession and financial instability or if the credit crunch and subsequent recession is just the beginning of many years of economic stagnation. The article in particular focuses on the yield curve and the trends in government debt or gilts. This tends to be a key indicator of the expectations of the future of an economy and how confident investors are in its likely trajectory. Though technical in places, this article provides some interesting stances on what we might expect in the coming 2-3 decades for economic performance in the West.
Note that John also looks at this article in his blog Cloudy Skies Ahead?
The end of growth in the West? BBC News, Robert Peston (26/9/14)
Questions
- Which factors affect the economic growth of a nation?
- Confidence from consumers, firms and investors is always argued to be crucial to the future economic growth and in many cases, the recovery of an economy. Explain why this factor is so important.
- What is the yield curve and what does it show?
- How can the yield curve be used to offer predictions about the future strength of an economy?
- Why are governments seen as the safest place to lend?
- If Larry Summers is correct in saying that it is a negative equilibrium interest rate that is needed to generate full employment growth, what does this suggest about the future economic performance of the western world?
- In the article, there is a list of some of the key things that make investors anxious. Review each of these factors and explain why it is so important in generating anxiety.
Nearly two years ago, France lost its triple A credit-rating and the news has only got worse. Unemployment has risen and economic growth in France has remained low and this is one of the reasons why France’s credit rating has been downgraded further from AA+ to AA. A high credit rating doesn’t guarantee market confidence, but it does help to keep the cost of borrowing for the government low. Thus, this downgrading could spell trouble for French borrowing costs.
Standard and Poor’s (S&P), who downgraded the French credit rating, is expecting government debt to rise to 86% of gross domestic product and believes that unemployment will remain above 10% until 2016. While the French government has put various reforms in place to boost the struggling economy, S&P don’t believe they are sufficient and have been very public in criticising the government’s effort. They were quoted as saying:
We believe the French government’s reforms to taxation, as well as to product, services and labour markets, will not substantially raise France’s medium-term growth prospects and that on-going high unemployment is weakening support for further significant fiscal and structural policy measures.
Following the downgrading, the return for those investors purchasing French debt did begin to rise, echoing the theory that the cost of borrowing would rise. 
The yield on French government 10-year bonds increased from 2.158% to 2.389%. The outlook given to France by S&P was ‘stable’, implying that there is a relatively low chance that S&P would change France’s credit-rating again in the next two years.
Many were surprised at the downgrading of France’s credit rating, but this may be the nudge that President Hollande needs to push through extensive labour market reforms with the aim of reducing unemployment and generating growth in the economy. Despite this latest move by S&P, the other credit rating agencies have yet to take similar action. Perhaps they are more convinced by the Finance Minister, Pierre Moscovici who claims that France’s debt is ‘one of the safest and most liquid in the world.’ He commented that:
They are underestimating France’s ability to reform, to pull itself up … During the last 18 months the government has implemented major reforms aimed at improving the French economic situation, restoring its public finances and its competitiveness.
It will take some time for the full impact of this development in France’s economy to become apparent. The cost of borrowing has already risen only time will tell what will happen to market confidence over the coming weeks. However, what is certain is that pressure is already mounting on Francois Hollande. The following articles consider the French economy.
France told to reform labour market after second credit rating downgrade The Guardian, Phillip Inman (8/13/13)
France’s credit rating cut by S&P to AA BBC News (8/11/13)
S&P lowers France rating on reform doubts, markets unfazed Reuters, Nicholas Vinocur (8/11/13)
Hollande approval rating slumps as France downgraded The Telegraph, James Titcomb (8/11/13)
S&P cuts France’s credit rating by one notch to double-A Wall Street Journal, William Horobin (8/11/13)
Five charts that show the state of the French economy The Telegraph (8/11/13)
France rating downgrade heaps pressure on Francois Hollande Financial Times, Michael Stothard (8/11/13)
Questions
- What does a double A rating mean for the French economy?
- Which factors will be considered when a ratings agency decides to change a country’s credit rating?
- France’s unemployment rate is one of the key factors that S&P has considered. Why is France’s unemployment rate so high? Which type(s) of unemployment are increasing?
- Use a diagram to illustrate the unemployment that France is facing.
- If a country does see its credit rating downgraded, what might this mean for government borrowing costs? Explain why this might cause further problems for a country?
- Markets have been ‘unfazed’ by the downgrade. How do you think markets will react to over the coming weeks? Explain your answer.
- What action could the French government take to ensure that S&P is the only ratings agency that downgrades their credit rating?
High levels of government debt and the adverse effect this has on the economy has been a key influencing factor in the fiscal consolidation efforts across the world. A key factor providing evidence in support of the connection between high government debts and low economic growth was a paper by two Harvard economists. However, the data used in their research has been called into question.
As we saw in a previous post, It could be you, Carmen Reinhart and Kenneth Rogoff presented a paper back in January 2010. Their research suggested that when a country’s debt increases above 90% of GDP, economic growth will slow considerably. (Click here for a PowerPoint of the above chart.) As you might expect, given the timing of this research, policymakers were intrigued. For those governments in favour of cuts in government spending and increases in taxation to bring the government debt down, this research was dynamite. It seemed to provide the evidence needed to confirm that if left to grow, government debt will have a significantly adverse effect on growth. Here was evidence in favour of austerity.
But, did a simple error create misleading information? A student at the University of Massachusetts Amherst was trying to replicate the results found by Reinhart and Rogoff, but was unable to do so. Thomas Herndon contacted the Harvard professors and they sent him the spreadsheets they had used in their calculations. Looking through it, an error in calculating the average GDP was spotted. However, the student and his supervisors also engaged in further research and came across other inconsistencies. This led to a draft working paper being published in April. The paper did find the same correlation between high debt levels and low growth, but the outstanding results found by Reinhart and Rogoff disappeared. Responding to the error, the Harvard professors said:
We are grateful to Herndon et al. for the careful attention to our original Growth in a Time of Debt AER paper and for pointing out an important correction to Figure 2 of that paper. It is sobering that such an error slipped into one of our papers despite our best efforts to be consistently careful. We will redouble our efforts to avoid such errors in the future. We do not, however, believe this regrettable slip affects in any significant way the central message of the paper or that in our subsequent work.
So, how might this correction and the implications affect government policy? Are we likely to see a reversal in austerity measures? Only time will tell.
Articles
Seminal economic paper on debt draws criticism Wall Street Journal, Brenda Cronin (16/4/13)
Reinhart, Rogoff … and Herndon: The student who caught out the Profs BBC News, Ruth Alexander (20/4/13)
Reinhart and Rogoff publish formal correction Financial Times, Robin Harding (8/5/13)
The 90% question The Economist (20/4/13)
Reinhart and Rogoff correct austerity research error BBC News (9/5/13)
Harvard’s Reinhart and Rogoff publish formal collection CNBC, Robin Harding (9/5/13)
Rogoff and Reinhart should show some remorse and reconsider austerity The Guardian, Heidi Moore (26/4/13)
The buck does not stop with Reinhart and Rogoff Financial Times, Lawrence Summers (5/5/13)
Meet Carmen Reinhart and Kenneth Rogoff, the Harvard professors who thought they had austerity licked – and Thomas Herndon, the student who proved them wrong Independent, Tim Walker (22/4/13)
Papers
Growth in a time of debt American Economic Review (May 2010)
Does high public debt consistently stifle economic growth? A critique of Reinhart and Rogoff Political Economy Research Institute, Herndon, Ash and Pollin (April 2013)
Questions
- How do high government debts arise?
- In order to reduce government debts, cuts in government spending and increases in taxation are advocated. How does theory suggest that these changes in fiscal policy will affect economic growth?
- What are the arguments (a) in favour of and (b) against austerity measures?
- How might the correction made by Reinhart and Rogoff affect policymakers and their austerity plans?
- What are the key messages from Reinhart and Rogoff’s paper?
Presidential Address: Public Debt and Low Interest Rates
