Assume the current public debt to GDP ratio is 100 per cent and that central banks keep nominal interest rates and inflation constant and zero. Governments that promote fiscal austerity claim they can reduce the the public debt to GDP ratio by pushing the primary budget into surplus even if the public spending contraction creates a negative real GDP growth rate. Under the circumstances outlined, this claim is correct.
Answer: True
The answer is True.
First, some background.
While Modern Monetary Theory (MMT) places no particular importance in the public debt to GDP ratio for a sovereign government, given that insolvency is not an issue, the mainstream debate is dominated by the concept.
The unnecessary practice of fiat currency-issuing governments of issuing public debt $-for-$ to match public net spending (deficits) ensures that the debt levels will rise when there are deficits.
Rising deficits usually mean declining economic activity (especially if there is no evidence of accelerating inflation) which suggests that the debt/GDP ratio may be rising because the denominator is also likely to be falling or rising below trend.
Further, historical experience tells us that when economic growth resumes after a major recession, during which the public debt ratio can rise sharply, the latter always declines again.
It is this endogenous nature of the ratio that suggests it is far more important to focus on the underlying economic problems which the public debt ratio just mirrors.
Mainstream economics starts with the flawed analogy between the household and the sovereign government such that any excess in government spending over taxation receipts has to be "financed" in two ways: (a) by borrowing from the public; and/or (b) by "printing money".
Neither characterisation is remotely representative of what happens in the real world in terms of the operations that define transactions between the government and non-government sector.
Further, the basic analogy is flawed at its most elemental level. The household must work out the financing before it can spend. The household cannot spend first. The government can spend first and ultimately does not have to worry about financing such expenditure.
However, in mainstream (dream) land, the framework for analysing these so-called "financing" choices is called the government budget constraint (GBC). The GBC says that the budget deficit in year t is equal to the change in government debt over year t plus the change in high powered money over year t. So in mathematical terms it is written as:
Which you can read in English as saying that Budget deficit = Government spending + Government interest payments - Tax receipts must equal (be "financed" by) a change in Bonds (B) and/or a change in high powered money (H). The triangle sign (delta) is just shorthand for the change in a variable.
However, this is merely an accounting statement. In a stock-flow consistent macroeconomics, this statement will always hold. That is, it has to be true if all the transactions between the government and non-government sector have been corrected added and subtracted.
So in terms of MMT, the previous equation is just an ex post accounting identity that has to be true by definition and has not real economic importance.
But for the mainstream economist, the equation represents an ex ante (before the fact) financial constraint that the government is bound by. The difference between these two conceptions is very significant and the second (mainstream) interpretation cannot be correct if governments issue fiat currency (unless they place voluntary constraints on themselves to act as if it is).
Further, in mainstream economics, money creation is erroneously depicted as the government asking the central bank to buy treasury bonds which the central bank in return then prints money. The government then spends this money. This is called debt monetisation and you can find out why this is typically not a viable option for a central bank by reading the Deficits 101 suite - Deficit spending 101 - Part 1 - Deficit spending 101 - Part 2 - Deficit spending 101 - Part 3.
Anyway, the mainstream claims that if governments increase the money growth rate (they erroneously call this "printing money") the extra spending will cause accelerating inflation because there will be "too much money chasing too few goods"! Of-course, we know that proposition to be generally preposterous because economies that are constrained by deficient demand (defined as demand below the full employment level) respond to nominal demand increases by expanding real output rather than prices. There is an extensive literature pointing to this result.
So when governments are expanding deficits to offset a collapse in private spending, there is plenty of spare capacity available to ensure output rather than inflation increases.
But not to be daunted by the "facts", the mainstream claim that because inflation is inevitable if "printing money" occurs, it is unwise to use this option to "finance" net public spending.
Hence they say as a better (but still poor) solution, governments should use debt issuance to "finance" their deficits. They also claim this is a poor option because in the short-term it is alleged to increase interest rates and in the longer-term is results in higher future tax rates because the debt has to be "paid back".
Neither proposition bears scrutiny - you can read these blogs - Will we really pay higher taxes? and Will we really pay higher interest rates? - for further discussion on these points.
The mainstream textbooks are full of elaborate models of debt pay-back, debt stabilisation etc which all claim (falsely) to "prove" that the legacy of past deficits is higher debt and to stabilise the debt, the government must eliminate the deficit which means it must then run a primary surplus equal to interest payments on the existing debt.
A primary budget balance is the difference between government spending (excluding interest rate servicing) and taxation revenue.
The standard mainstream framework, which even the so-called progressives (deficit-doves) use, focuses on the ratio of debt to GDP rather than the level of debt per se. The following equation captures the approach:
So the change in the debt ratio is the sum of two terms on the right-hand side: (a) the difference between the real interest rate (r) and the GDP growth rate (g) times the initial debt ratio; and (b) the ratio of the primary deficit (G-T) to GDP.
The real interest rate is the difference between the nominal interest rate and the inflation rate.
This standard mainstream framework is used to highlight the dangers of running deficits. But even progressives (not me) use it in a perverse way to justify deficits in a downturn balanced by surpluses in the upturn.
The question notes that "some mainstream economists" claim that a ratio of 80 per cent is a dangerous threshold that should not be passed - this is the Reinhart and Rogoff story.
Many mainstream economists and a fair number of so-called progressive economists say that governments should as some point in the business cycle run primary surpluses (taxation revenue in excess of non-interest government spending) to start reducing the debt ratio back to "safe" territory.
Almost all the media commentators that you read on this topic take it for granted that the only way to reduce the public debt ratio is to run primary surpluses. That is what the whole "credible exit strategy" hoopla is about.
Further, there is no analytical definition ever provided of what safe is and fiscal rules such as those imposed on the Eurozone nations by the Stability and Growth Pact (a maximum public debt ratio of 60 per cent) are totally arbitrary and without any foundation at all. Just numbers plucked out of the air by those who do not understand the monetary system.
MMT does not tell us that a currency-issuing government running a deficit can never reduce the debt ratio. The standard formula above can easily demonstrate that a nation running a primary deficit can reduce its public debt ratio over time as long as economic growth is strong enough.
Furthermore, depending on contributions from the external sector, a nation running a deficit will more likely create the conditions for a reduction in the public debt ratio than a nation that introduces an austerity plan aimed at running primary surpluses.
Here is why that is the case.
A growing economy can absorb more debt and keep the debt ratio constant or falling. From the formula above, if the primary budget balance is zero, public debt increases at a rate r but the public debt ratio increases at r - g.
Consider this example which is captured in Year 1 in the Table below.
To make matters simple, assume a public debt ratio at the start of the period of 100 per cent (so B/Y(-1) = 1).
Assume that the rate of real GDP growth is minus 2 per cent (that is, the nation is in recession) and the automatic stabilisers push the primary budget balance into deficit equal to 1 per cent of GDP. As a consequence, the public debt ratio will rise by 3 per cent.
The government reacts to the recession in the correct manner and increases its discretionary net spending to take the deficit in Year 2 to 2 per cent of GDP (noting a positive number in this instance is a deficit).
The central bank maintains its zero interest rate policy and the inflation rate also remains at zero.
The increasing deficit stimulates economic growth in Year 2 such that real GDP grows by 2 per cent. In this case the public debt ratio falls by 0.1 per cent.
So even with an increasing (or unchanged) deficit, real GDP growth can reduce the public debt ratio, which is what has happened many times in past history following economic slowdowns.
Economists like Krugman and Mankiw argue that the government could (should) reduce the ratio by inflating it away. Noting that nominal GDP is the product of the price level (P) and real output (Y), the inflating story just increases the nominal value of output and so the denominator of the public debt ratio grows faster than the numerator.
But stimulating real growth (that is, in Y) is the other more constructive way of achieving the same relative adjustment in the denominator of the public debt ratio and its numerator.
But the best way to reduce the public debt ratio is to stop issuing debt. A sovereign government doesn't have to issue debt if the central bank is happy to keep its target interest rate at zero or pay interest on excess reserves.
The discussion also demonstrates why tightening monetary policy makes it harder for the government to reduce the public debt ratio - which, of-course, is one of the more subtle mainstream ways to force the government to run surpluses.
Now the assumptions in the question:
The following Table shows three cases:
As a result of modelling the assumptions in the formula (above) we can see that the change in the debt ratio (B/Y) is zero in the event of Case A, falls in the event of Case B (by 1 per cent) and rises in the event of Case C (by 1 per cent).
As long as the primary surplus as a per cent of GDP is exactly equal to the negative GDP growth rate, there can be no reduction in the public debt ratio, under the circumstances (which are the most benign possible).
So it is possible under Case B where the primary budget surplus is 3 per cent (noting that the surplus is presented as a negative figure) and the contraction in real GDP is 2 percent for the debt ratio to fall.
How likely is it that this would occur in the real world when the government was pursuing such a fiscal path? Answer: unlikely.
First, fiscal austerity will probably push the GDP growth rate further into negative territory which, other things equal, pushes the public debt ratio up. Why? The budget balance is endogenous (that is, depends on private activity levels) because of the importance of the automatic stabilisers.
As GDP contracts, tax revenue falls and welfare outlays rise. It is highly likely that the government would not succeed in achieving a budget surplus under these circumstances.
So as GDP growth declines further, the automatic stabilisers will push the balance result towards (and into after a time) deficit, which, given the borrowing rules that governments voluntarily enforce on themselves, also pushed the public debt ratio up.
So austerity packages, quite apart from their highly destructive impacts on real standards of living and social standards, typically fail to reduce public debt ratios and usually increase them.
So even if you were a conservative and erroneously believed that high public debt ratios were the devil's work, it would be foolish (counter-productive) to impose fiscal austerity on a nation as a way of addressing your paranoia. Better to grit your teeth and advocate higher deficits and higher real GDP growth.
That strategy would also be the only one advocated by MMT.
That is enough for today!