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With Low Interest Rates, Should We Really Ignore Budget Deficits?

Desmond Lachman profile picture
Desmond Lachman
352 Followers

Summary

  • The key factor overlooked by proponents of increased public spending is that a country's future public debt burden is not simply determined by the country's economic growth rate and by its government's borrowing cost.
  • Rather, it is also determined in an important way by the government's primary budget balance.
  • Even if a country's government can borrow at a low inflation-adjusted interest rate relative to the country's economic growth rate, it can still have its public debt-to-GDP ratio on an ever-increasing path if it has a high primary budget deficit.

A dangerous idea seems to have gained wide currency in both academic and economic policymaking circles. It is the notion that in a world of low interest rates, governments should not feel themselves constrained in their public spending decisions by budget deficit considerations. This idea risks taking many countries further down the path toward unsustainable public finances that, in the end, could lead to economically disruptive government debt crises.

Here is the basic argument of those who suggest that low interest rates should give governments license to increase public spending at will: In a world of low interest rates, a country's real economic growth rate would likely exceed the government's after-inflation adjusted borrowing costs. That, in turn, it is argued, would allow countries to grow their way out of any public debt problem.

The key factor overlooked by proponents of increased public spending is that a country's future public debt burden is not simply determined by the country's economic growth rate and by its government's borrowing cost. Rather, it is also determined in an important way by the government's primary budget balance (that is, its budget balance after interest payments have been excluded). Even if a country's government can borrow at a low inflation-adjusted interest rate relative to the country's economic growth rate, it can still have its public debt-to-GDP ratio on an ever-increasing path if it has a high primary budget deficit.

An arithmetical example not too far from the current US situation might illustrate the point. If a country's public debt-to-GDP ratio was 100 percent and if its real economic growth rate exceeded its real borrowing rate by 1 percent, the

This article was written by

Desmond Lachman profile picture
352 Followers
Desmond Lachman joined AEI after serving as a managing director and chief emerging market economic strategist at Salomon Smith Barney. He previously served as deputy director in the International Monetary Fund's (IMF) Policy Development and Review Department and was active in staff formulation of IMF policies. Mr. Lachman has written extensively on the global economic crisis, the U.S. housing market bust, the U.S. dollar, and the strains in the euro area. At AEI, Mr. Lachman is focused on the global macroeconomy, global currency issues, and the multilateral lending agencies.

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Comments (2)

d
When the dollar falls 50% vs world currencies will be the time to consider deficits. Until then, there is no cost in borrowing and we should use it to restructure the economy. Bringing home most manufacturing is an obvious use for these $trillions.
S
Studies show debt above 75% GDP reduces future growth, no matter how low the interest rates. USA now over 110%. Like barnacles on the hull of a ship, eventually you cannot move forward until you clean the hull in drydock. Only question is who will lose the most when our $26 TRILLION debt is restructed. The banks taking 50% losses or the poorest with massive inflation?
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