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The exaggerated importance of government debt

“Fiscal illusion” sounds like the kind of thing Derren Brown might do to your wallet in front of a packed theatre.

But actually, fiscal illusions are what perturb experts at places such as the Office for Budget Responsibility and the Institute for Fiscal Studies.

They refer to various official statistical artefacts and quirks exploited by ministers, such as the fact that student loans or spending on private finance initiative construction projects don’t show up in the national deficit.

But could there be a fiscal illusion to make those look like trivialities? Could the greatest fiscal illusion of all be the idea that reducing elevated levels of public debt should automatically be a priority for governments? Olivier Blanchard is one of the world’s most respected macroeconomists and the former chief economist of the International Monetary Fund.

Giving the annual American Economic Association presidential address last week, Blanchard argued something along those lines.

Put simply, his thesis is that if the market interest rate at which a government can borrow is lower than the economy’s expected growth rate, there is little social cost from the debt because the government can simply roll its borrowings over when they come due – without having to raise taxes or cut spending and without risking a dangerous debt spiral.

Blanchard noted that the US government can currently borrow for 10 years in financial markets at around 3 per cent a year, but that America’s projected nominal GDP growth rate is higher, at around 4 per cent.

The gap is even bigger in the UK, where our own government can borrow for just 1.3 per cent but the expected nominal growth rate is 3.6 per cent.

When one considers the positive impact on growth of higher government deficits in a time of private sector retrenchment (and the negative impact of over-hasty deficit reduction) the Blanchard finding becomes an even more significant result.

“The welfare costs of debt may be small or even altogether absent,” he suggests.

These are not entirely novel arguments. Many economists have made the related point in recent years that a government can stabilise its debt pile so long as the deficit as a share of GDP does not exceed the trend GDP growth rate – and that it’s not necessary to eliminate borrowing entirely to achieve this, despite what some politicians insist.

But the fact that these points are being advanced from one of the most influential pulpits in the world of academic economics is significant.

It’s important to stress what Blanchard is not saying. He isn’t arguing government debt levels never matter or that politicians can always happily borrow and spend without limit. Interest rates may rise. Trend GDP growth rates may fall. Borrowing to spend on white elephants is inherently wasteful.

But his analysis suggests that politicians, their advisers and civil servants need to have a much more sophisticated appreciation of the costs and benefits of government borrowing for the welfare of the population. They need a far more nuanced approach to fiscal policy, one that takes into consideration interest rates and the condition of the overall economy.

The issue of public borrowing has shaped American and European politics over the past decade. Their influence in the UK has been especially profound. The coalition government successfully created a grossly misleading narrative that the spike in the deficit in 2009 was due to Labour profligacy (rather than the recession) and that its austerity policies were the only possible remedy.

When the former Labour leader Ed Miliband forgot to mention “the deficit” in a speech before the 2015 general election, he was beaten up by even the non-partisan sections of the media for neglecting what was widely seen as the most important issue of the day.

But if Blanchard’s analysis is right, it was a justified omission. The national debt just doesn’t matter as much as we’re led to believe.


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