Re: Does Debt Matter

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

In reply to 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 wrote:
> 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? <

Per:
Good questions.

First, the relation between private wealth and private demand should not be
very surprising. The Friedman-Modigliani theories of consumption stress the
importance of wealth for private consumption demand. These theories have
been shown to yield very good predictions of consumer demand in most
industrialised countries. Investment demand should also be heavily dependent
on the own capital of firms. Which means that both consumption and
investment demand are related to wealth.

[I should add here that my own investigations into the Swedish case show
that wealth works fine as the ONLY economic factor (aside age structure of
population etc) in explaining consumption -- provided wealth is factored
into a volume and a price-level component. Adding flow variables like
non-property disposable income does not add any explanatory power to the
regressions. Indeed, the coefficient for disposable income (roughly 0.3 --
the "marginal propensity to consume") indicate that there is in fact NO
CAUSAL RELATION going from disposable income to consumption. This is so
because the households' wealth is roughly 3 x annual consumption, and since
annual data has been used, the effects of wealth changes WITHIN each year
would account for this disposable income effect.]

Secondly, the example I set out was in terms of proportions, percentages,
and highly simplified. When dealing with demand--supply relations we must
add some dynamics to the scheme. But before we do, we must make clear the
meaning of "supply". My own opinion on this is clear: The domestic product
is basically a flow of services, and services must be sold on a fix-price
basis, the quantity being determined by the level of demand. This means that
the quantity of services EFFECTIVELY supplied must adapt passively to the
demand. But there is another category of EQUILIBRIUM supply, which does not
adapt to the level of demand. The equilibrium supply level is set by a host
of factors, like the stock of real and human capital, the level and
structure of taxation, the level of (real) rates of interest, etc. Whenever
this equilibrium supply level is exceeded by the aggregate demand
(=effective supply), then prices and wages will tend to inflate.

In my simplified example, I had tacitly assumed that this level of
equilibrium supply is constant. In reality it grows with the human and real
capital stock, and it is also affected by rates of taxation and interest. By
lowering taxation and interest rates, the point of equilibrium can be moved
to a higher level, allowing for more aggregate demand (= effective supply)
without provoking inflation. The limit seems to be zero taxation and zero
real interest rates, which, I believe, were (again) in the final arithmetic
example I gave.

William wrote:
> 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? <

Per:
I don't think we have any major differences in opinion here. The 2--8
percent range are the TOLERANCE LIMITS I would advocate. That is: inflation
should preferrably not be allowed to exceed 8 percent, nor to go below 2
percent at any time. The reason for these limits is that both double-digit
inflation and near-zero inflation (not to speak of deflation proper) may be
harmful to growth and economic stability.

In order to keep within these limits, the government (not necessarily the
central bank) should try to keep inflation somewhere near the midpoint of
this interval. Since the variability of inflation is clearly an increasing
function of the rate of inflation, I reckon the target should be set
slightly below the arithmetical midpoint (which, of course, is 5%). I guess
a 4 percent inflation target would be reasonable. I should add here that
there may be situations when a 4 percent inflation rate is too low. As you
know, I have been advocating a policy of keeping r - g(API) = 0. If the
difference between the GDP deflator and the API rate grows to e.g. 3
percent, then a 4 percent GDP deflator target would imply nominal short
rates of r = 1 percent. Clearly r cannot go below zero, so if the GDP
deflator--API rate difference threatens to send r below zero, the GDP
deflator inflation target should be put somewhat higher to avoid this. I
guess this would be a rare occasion, however.

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.  <

Per:
Oh, you are mixing up the income--spending reflux rate with the
wealth--spending turnover rate here. The former is really much more abstract
than the latter, even if you seem to say the opposite here. Wealth can be
exchanged for money (just changing the FORM of wealth), and money can be
spent. Income, on the other hand, measures the rate of inflow of wealth
(oftenmost in the form of money). Income as such cannot be spent, only the
wealth which accrues by successively earning income. I prefer to think of
income as the RESULT OF SPENDING, rather as the source of spending, if you
see what I mean. Does this make sense??

William wrote:
> 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. <

Per:
There is no such thing as the private sector's incentive to buy gov't debt.
The gov't needs not compete with anyone in this sense, since the gov't has a
monopoly on fiat money (consult Warren on this one!!). The only limit there
is to the size of gov't debt, is the turnover of private wealth into
spending. Gov't net debt will add to private wealth, and adding to private
wealth will fuel private demand. Obviously there is a limit to this, when
the sum of gov't and private demand goes up above the "equilibrium supply"
level and starts causing serious inflation. So, inflation is the only limit
to gov't debt.

A Very High National Debt (VHND) will make possible, provided the economy is
growing secularly, and that real interest rates are kept low, a quite high
rate of gov't borrowing without affecting the debt/GDP ratio. Thus a fairly
large public sector can be maintained without taxing a penny! The obstacle
for a VHND regime is that the private sector's wealth-to-spending turnover
rate is too high. Therefore, large savings incentives may prove necessary to
make room for a VHND without fuelling over-spending and inflation.

William wrote:
> I will withhold further comment on your analysis below pending a
clarification of these points. <

Per:
Well, I am not sure that I am right, I am not sure a VHND regime is
possible, and I am not sure if you have understood what I mean. But I guess
we will sort things out in the coming?!

All best,
Per


Per Gunnar Berglund
Lilla Sallskapets vag 60
127 61  SKARHOLMEN
SWEDEN

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