Re: Does Debt Matter

[wfhummel@xxxxxxxxxxxxxx (William F. Hummel)]

Per Berglund  wrote

>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:
The connection between aggregate demand and size of debt is not
at all clear to me.  Also the assumption that increasing
aggregate demand will necessarily fuel price inflation needs to
be explained.  Why cannot supply grow apace with demand under the
assumed conditions?

>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:
I think a small positive inflation rate is desirable since it
acts as a lubricant to the economy.  However a fluctuating
inflation rate in the range of 2 to 8 percent would be very
troublesome in investment planning, and would negatively impact
business efficiency.  Does the historical record show that good
long term real growth can coexist with a persistent inflation
rate in the high end of your range?

>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.

William:
The analysis here seems to imply that some fraction of the debt
can be "spent."  Certainly the interest earnings can be spent,
but I don't know how the bonds themselves can be spent.  They can
be sold to other parties, but that merely transfers liquidity
between the parties.  It does not by itself increase spending
power.

A related issue that you have not addressed is the private
sector's incentive to buy government debt.  In other words, the
ROI must be more attractive than alternatives.  I think you need
to address the issue of interest rates on the debt and the fact
that the total interest cost on the debt increases without limit
absent taxes.

I will withhold further comment on your analysis below pending a
clarification of these points.

William F. Hummel