Re: Does Debt Matter

["Per Gunnar Berglund" <pgb@xxxxxxxxxxxxxxxxxx>]

 In response to William F. Hummel:

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William asked:
> (1)  If debt does matter, what are the negative implications and how do
they develop as a function of increasing debt/GDP ratio?  <

Per:
I see both positive and negative implications. The public debt can be too
small and it can be too large -- there is a hump-shaped relation, I think. I
reckon this question is about the zone where the debt is too large, and the
problem with too large a debt is that it will fuel too much aggregate
demand, which will cause inflationary pressures.

William asked:
> (2)  Is there some limit for the debt/GDP ratio above which conditions
would have to be considered intolerable?  If so, how high is too high? <

Per:
The debt is too high if there is too much inflation. I would argue that
double-digit inflation is too high. My own preference would be an inflation
rate (in the GDP deflator or some similar index) in the range of 2--8
percent per annum. Above 8 percent is "too high", I think.

William asked:
> (3)  If debt does not matter, can the government operate solely on the
sale of interest bearing debt in the open market, i.e. no taxes?  If so, how
would it work? <

Per:
Let me try to provide a first shot at an answer by giving a simple
arithmetic example of the principles involved:

The limit of the debt/GDP ratio is set by the spending propensities, i.e. by
the wealth-to-spending turnover rate. The lower the turnover rate, the
higher the debt/GDP ratio limit. It seems that the capital asset/GDP ratio
varies around 4:1 in the long run. Now, suppose that the private
wealth-to-spending turnover rate is 5:1, and that the whole stock of assets
is privately owned. This means that there will be a spending shortage of 20%
of the GDP, only 4/5 of the GDP will be purchased. Hence the gov't must
"fill in" with another 20% of GDP of demand, to balance the GDP and the
spending.

But, if the gov't should decide to spend only 10% of the GDP there would be
a demand shortage of 10% of the GDP. One way to fill out this gap would be
for the gov't to issue debt instruments of 50% of the GDP, 1/5 of which
would be spent (ex hypothesi) by the private sector. The whole of the GDP
would, again, be purchased, and the system would be balanced. So, there is
clearly a trade-off between the share of the public sector spending on the
GDP and the size of the public debt-to-GDP ratio. The smaller the former,
the greater the latter, and vice versa.

Let us now take things one step further. Suppose we could somehow change the
private wealth-to-spending turnover rate to 8:1. Assuming no public debt,
only HALF the GDP would be purchased. Now, suppose that the gov't buys 15%
of the GDP. There would still be a huge demand deficiency, amounting to 35%
of the GDP. In order to make up for this deficiency, an enormous public debt
of 8 x 35% = 280% of the GDP would be needed -- to fuel another 35% of the
GDP in private spending.

The next step will be to assume that the economy is growing, in real terms,
by e.g. 5% per annum, and that the real interest rate is kept at the zero
level (implying no real net cost for public debt service). If the real GDP
grows at 5% p.a., then the public debt can (indeed must) grow at the same
rate without changing the debt/GDP ratio. Since public debt is 280% of the
GDP, the debt growth will be 2.8 x 5% = 14% of the GDP. The growth of the
real public debt is, of course, tantamount to the real budget deficit, which
means that the real budget deficit can be as high as 14% of the GDP --
permanently.

Since public spending is 15% of the GDP, and 14% of the GDP are borrowed
each year, only 1% of the GDP remains to be collected in taxes (we could
easily set up an arithmetic example where this figure is nil).

Does this make sense, William??

Wondering,
Per


Per Gunnar Berglund
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