How much government debt is too much?
For those tracking the wild gyrations of the UK gilt market since chancellor Kwasi Kwarteng’s "mini" Budget of September 23, that has become a highly pertinent question.
Until recently, the economic orthodoxy was that high levels of government debt were to be avoided, and budget deficits should be addressed quickly.
This approach underpinned the period of austerity under the Conservative-led government of 2010-2015 in the aftermath of the global financial crisis.
When attempting to calculate debt sustainability there are only two cases: either the real rate of interest (hereafter referred to as ‘r’) exceeds the real rate of growth in the economy (or ‘g’), or the real rate of growth exceeds the real rate of interest. As Mr Micawber might have put it, in the first case, result misery. In the second case, result happiness.
In the first case, in a world where the real rate of interest exceeds the real rate of growth (r>g), a government must run a primary budget surplus if it wants to keep its debt-to-GDP ratio steady.
The wider the gap between r and g and the greater the existing ratio of debt to GDP, the larger the budgetary surplus will have to be. If the surplus is less than the required amount, the level of government debt will grow exponentially, without limit. It will explode, in other words.
A different state of affairs
During the period from 1970 to 2000, we estimate that the r-g gap in the major economies averaged some 2.5 percentage points. Of necessity, most governments ran small budget deficits over these years, so that debt grew only slowly.
But for much of the past 20 years or so, governments have got used to a very different state of affairs.
Over the period from 2000 up until last year we estimate that r averaged around 0.5 per cent across the major economies, while g averaged around 1.8 per cent. In this world, a government can run a primary deficit indefinitely and maintain a stable debt-to-GDP ratio.
Even if the deficit is too large to maintain debt stability, the debt-to-GDP ratio will not explode, it will just gradually move to a higher equilibrium level.
Operating in a world where real rates of interest on government debt are less than an economy’s trend rate of growth presents governments with a tempting opportunity.
It seemingly allows them to spend more or less what they like, without having to worry too much (if at all) about how they will pay it back. They appear to have access to a magic money tree (MMT).
Seduced by this approach, some have even taken the MMT acronym and transformed it into a theory: so-called ‘modern monetary theory’.
The difficulty for proponents of the magic money tree approach, and where the current UK government risks coming unstuck, is that long-run real rates of interest move around. So too does an economy’s trend real rate of growth.