In both cases, the basic argument is the same: Good debt boosts the growth rate of the economy, “g”, enough so it outpaces “r” – the real rate of interest.
In the 2010s, some economists argued that since interest rates were so low, the government should take on more debt and spend more on the theory that “g” would be greater than “r”. The flaw in this argument is that both variables change over time.
It is not enough to argue the government should take on debt to spend more or cut taxes. No matter what interest rates are, the true test of fiscal health comes down to risk management. Good risk management increases the odds that your bet pays off or, at the very least, doesn’t leave you deeper in debt.
That requires picking the right investments and managing the cost of your debt – that is, attempting to manage “r” and “g” in an uncertain world.
Good risk management starts with investing the borrowed money in something that will probably pay off. Some economists argue that any government spending is worth taking on debt for – even paying people to dig holes and then refill them – because it creates jobs.
Tax cuts can increase growth – but rarely enough to pay for themselves.
This is not the case. The return on a government dollar of spending can vary between 5¢ and $5. Simply stimulating the economy in the short term does not always create value – not just because some projects are better than others, but because of opportunity costs.
Spending money on digging and refilling holes means less money and labour spent on more productive pursuits that bring more growth over time.
And even if you pick a project that is projected to create value, say installing electric-vehicle charging stations, you need to ensure the project’s execution leads to a positive return. Many supporters of the Infrastructure Investment and Jobs Act, the CHIPS Act and the Inflation Reduction Act were dismayed that their value to taxpayers was undermined by excessive regulations and the need to appease different political groups, which drove up costs and time.
Many of the laws’ opponents, meanwhile, were sceptical that the government could ever execute efficiently, which is one reason so many Republicans prefer tax cuts. But the devil is in the details here, too: Tax cuts can increase growth – but rarely enough to pay for themselves. It depends on what the existing tax rate is, how the tax breaks are structured, and so on.
And just like spending, changes to the tax code are subject to political pressure.
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Another virtue of risk management is that it accounts for time frame. An investment project might appear to pay off for the first five years, but the benefits eventually wane, and the debt is still there. Perhaps the initial wave of government investment in a favoured industry immediately puts people to work and boosts GDP, but over time, distortions and waste undermine the productivity of the overall economy.
Then, there are details such as how the debt is structured, which is as critical as the investment itself. Risk management is rarely straightforward here. Shorter duration bills normally pay lower interest rates, so if you expect rates to be lower in the future, it is cheaper to issue short-term debt and roll it over as it comes due. But you can also bet wrong about the future of interest rates, and the government has made some bad bets lately.
The figure above shows the average maturity of government debt against the 10-year interest rate. Most of the 2010s featured interest rates below 3 per cent, even near zero toward the end, but the average duration of government debt was just over five years.
The government could have issued more 10-, 20- or 30-year bonds and faced lower payments today. But it didn’t, and now rates are higher. Debt maturity did increase as rates fell, but not by much. The government did not take full advantage of the record-low rates.
Perhaps policymakers believed low rates were the new normal and would last a long time. If so, it was bad risk management. No market condition lasts forever, and good risk management accounts for that.
Debt enthusiasts like to argue that, when it comes to taking on debt, you can’t compare the government to a household: governments can print their own money to pay their bills. But it does not follow that risk management is not necessary; in fact, it becomes more important, if more difficult.
President-elect Donald Trump believes his policies will inspire growth despite adding to the debt. Credit: Bloomberg
Unlike households, government debt spending (even on good projects) can increase inflation, which pushes up the cost of borrowing even further. So governments need to be more discerning about what investments they make and how they manage their debt – because their debt will last for many decades and can create an even bigger burden on future generations.
The US is on course to run up ever-increasing debt over the next several decades. How much to worry about this gets a lot of attention. Much less is paid to how the government is managing this risk: what it is doing to make its existing spending more productive and efficient, whether it is structuring its debt to minimise rate risk, and how it can manage risk to avoid higher rates in the future.
So go ahead, worry about the nation’s debt. But also pay attention to the nation’s risk management.
Bloomberg
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Allison Schrager is a Bloomberg Opinion columnist covering economics. A senior fellow at the Manhattan Institute, she is the author of An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk.
