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Don’t worry for the debt, r-g will solve the problem


She is also among the anti-austerity elite. An anti-austerity protester interrupted the ECB’s President, M. Draghi in 2015. Credit: Ralph Orlowski/Reuters


Jean-Pierre Dumas

October 20, 2020

The Philosopher’s stone

At last, we have found the philosopher’s stone. Austerity is dead and buried under the IMF/WB auspice. We would like to present four ideas:

1. Yes indeed it is not time for fiscal adjustment. “First you worry about fighting the war, then you figure out how to pay for it.” C. Reinhart. This is pragmatism.

2. The theoretical automatic debt reduction by Prof. Blanchard rests on a special case. Mr. Blanchard “forgets” to take into account the primary balance in its demonstration. And generally (almost always) the primary balance has been higher than the differential r-g; thus, the debt ratio was increasing in the past for all developed countries (except for Germany which implemented a fiscal adjustment before the crisis). Since governments are now QE addicts, it will not disappear. Therefore, don’t imagine that tomorrow the debt ratio will decline automatically and perpetually.

3. If the IMF’s job was to finance loans against conditionalities what will be the next conditionalities imposed on poor countries who cannot enjoy a free lunch as rich countries do? Is it also the funeral of one of the most important concepts in economic policy, sustainability, which was the IMF’s raison d’être? If this is the funeral of austerity on what ground to require adjustment to poor countries only; since developed countries can indulge in fiscal binge without restriction? It would be interesting to know the IMF position on this matter.

4. The death of austerity does not mean the perpetual debt reduction, on the opposite. We transfer the debt burden on our children and grandchildren, do we have something realistic to propose to reduce this excessive debt burden?

1 This time is different

The time of free lunch has arrived. We are learning in a FT article by C. Gilles that "this week austerity was officially buried" (Oct. 16, 2020). This is, of course, an historical date. At last economists have discovered the philosopher’s stone.


All rich countries are running fiscal deficit never seen before; it is nobody’s fault, it is exogenous, this is a pandemic phenomenon


Figure 1 Fiscal balances as a percentage of GDP


Source: International Monetary Fund, World Economic Outlook Database, October 2020


Globally, the IMF forecasts a world fiscal deficit of $12 tn equivalent to 12% of GDP (it was estimated at two percent during the financial crisis).


The Euro Zone (EZ) fiscal deficit is estimated by the FT at almost one trillion this year (8.9% of EZ GDP) with France at the top (€227 bn) (Germany €207 bn).


This unprecedented scale of fiscal stimulus responds to the covid pandemic.


Figure 2 Growth EZ countries projection for 2020


Source: FT M. Arnold & S. Fleming, “Eurozone budget deficits”, FT, Oct. 19, 2020


These fiscal deficits have the mechanical effect to increase the public debt to GDP ratio of all countries.


Figure 3 Public debt ratio from 2007 to 2020


Source: IMF/WEO/Oct. 2020


These deficits are possible because they are financed by money creation by the big central banks through quantitative easing. This is nothing else than fiscal deficit monetization.


Traditionally, the economic theory and the reality teach us that monetization of deficits leads to inflation (M. Friedman) and outflows of external reserves (the monetary approach to the balance of payments). Nothing happens, zero inflation in the US, the euro area and Japan. The reality does not follow the theories…


2 This is not the time for fiscal adjustment

Of course, this is no time for fiscal adjustment; since we face such an alignment of planets (huge fiscal deficit, without all its negative effects) it will be inappropriate to change cap.


Since March 2020, we have found the philosopher’s stone, we, the rich countries’ leaders are going to use it to prevent an explosion of unemployment and negative growth for years. Who can criticize them? A great French thinker said, before criticizing a head of state, I should ask myself what I would have done at its place (R. Aron). Exactly the same, so no need for criticism.


Now this is one thing to follow a Keynesian policy during an unprecedented crisis, this is another thing to justify it through a theoretical argument which hides a large part of the reality. An increase in deficit translates automatically in an increase of debt. According to Professor Blanchard, this debt outburst will not need an increase of taxes, the debt ratio will decline automatically. We beg to disagree.


3 Professor Blanchard “forgets” the primary balance in its demonstration

Professor Blanchard tells us, don’t worry about the debt ratio, it will decline automatically. Prof. Blanchard’s thesis is not wrong but it is a particular case which will not work.


The Blanchard’s arguments are now well known (see O. Blanchard, Public Debt and Low Interest Rates, PIIE, Feb. 2019), the interest rate (r) is lower than the rate of growth (g) for most advanced countries and he thinks that this will last for the next 10 years.


In this case the public debt policy is limited to “debt rollovers”, the issuance of new debt to pay old debt is enough without the necessity to raise new taxes). Therefore, an increase in debt may have no fiscal cost.


“The government can just roll over the debt, issuing new debt to pay for the interest, and debt will increase at the rate of interest. But output will increase at the growth rate and, if the growth rate exceeds the interest rate, the debt-to-GDP ratio will decline over time without the need to ever raise taxes.”

O. Blanchard, 2019


Clearly, the debt ratio moves only through two variables, the rate of growth and the interest rate, if the rate of growth is higher tan the interest rate, then bye-bye the intertemporal fiscal constraint. The debt ratio will decline over time, this, of course, insufficient.


“If the interest rate paid by the government is less than the growth rate, then the intertemporal budget constraint facing the government no longer binds”

O. Blanchard, 2019.


Mr. Blanchard has found the end of the intertemporal budget constraint. This deserves at least a Nobel prize.


This is the credo of all economists and economic newspapers (FT and TE included).


Let’s take a case study, the US in the recent past.


1) It is true that the interest rate is low and declining in spite of a growing debt burden.

Figure 4 US, the interest rate* is not increasing in spite of a rising debt ratio


Source: IMF/WEO 0ct. 2020 & US art. IV, July 2020

*The implicit interest rate is the nominal interest paid by the government; it is the interest expenses divided by the public debt stock.


The effective real interest rate is close to zero (but is not nil) for the whole period.

2) It is true that real interest rates (r) have been lower than the real rate of growth (g) in the past


Tableau 1 US, r-g* is negative except in 2020, exceptional year


Source: IMF

r = real implicit interest rates. g = real GDP growth rate for the same year. If r-g negative, the debt ratio (stock of debt to GDP) is supposed to decline. r-g positive in 2020 because there is a strong recession this year.


According to O. Blanchard, interest rates will remain below the growth rates for a long period. Why not? The argument of a saving glut flowing from China (B. Bernanke) is not very convincing since China runs a balanced current account nowadays.


Therefore, since r-g is and will be negative in the future, no need to panic, the debt ratio will decline.


3) In this case why did the public debt ratio increase in the US?

Why, did the US debt ratio increase (see Figure 4)? This is because the primary deficit was higher than r-g. Its own example defeats its thesis. This is the case for all developed countries, except Germany which succeeded reducing its debt ratio from 82% of GDP in 2010 to 60% in 2019. Germany is the only country which applies a Keynesian policy, surplus in good time, deficits in bad time.


O. Blanchard mentioned only r-g as the debt driver. This is, of course, insufficient and, he knows it, why in this case he does not mention it?


The debt ratio to GDP (Dt/Yt) will change according to three variables:

1. The rate of growth (g) (the debt ratio will decline with an increase of g).

2. The interest rate (r) (the debt ratio will increase with r). Therefore, if r-g is negative, the debt ratio will decline.

3. But it will also depend of the primary balance (the fiscal balance without interest payments). If the primary deficit is higher than the differential r-g, then the debt ratio will rise.

The equation of the dynamic of the debt ratio is:



dDt = debt ratio variation from one year to another

rt = real interest rate for year t

gt = real rate of growth for year t

dt-1 = stock of debt t-1 (known)

pbt = primary balance t


If pbt = 0, and r-g negative, then the debt ratio whatever its initial level will automatically decline and if r-g is expected to be negative, then there are no concerns, the debt ratio will be on a declining trend (This is the essence of Mr. Blanchard’s thesis).


The borrowing costs in advanced countries is below or close to zero for short- and long-term period, the nominal rate of growth will always be higher than a zero-interest rate (except in 2020), so why to be concerned by the debt burden? For Mr. Blanchard, the primary balance is nil. In the real world, the primary balance is not nil, it is always above r-g.


Let’s pursue our simple case study; r-g was negative in the US but its primary balance was almost always above r-g; thus the US debt ratio was growing.


Tableau 2 US: Even when r-g was negative, the primary balance was more negative, thus the debt ratio increased every year, except in 2014 and 2017


Source: IMF 2020, US art. IV report (IMF cr 20/241).


Conclusion r-g is a condition to have a debt ratio declining it is not a sufficient condition. We don’t remember reading this in the various papers written by O. Blanchard. What is more amazing is that all insider economists (and the FT and TE, to name the most prestigious) repeat the same story. No worry, r-g is negative thus, the debt ratio will decline gently and automatically, this is wrong.


Who can seriously believe that in the future, the primary deficit will be below r-g? The government of rich countries are QE addicts, they have understood that the great central banks are going to finance their deficit whatever it costs, there is no incentive to limit fiscal deficits in the future; therefore the primary deficit (pbt) will be higher than r-g and the public debt ratio will continue to rise. This is not a one-off increase in debt, but a permanent one. In addition, all these public debt data are grossly undervalued, they do not take into consideration contingent liabilities due to aging.


4 The funeral of the concept of sustainability?

Finally, we shall not forget that this fiscal stimulus is possible only for rich countries which incur debt in their own currency through quantitative easing. The big central banks are buying government bonds without restraint. This policy of debt monetization is not possible for low-income countries even for emerging market countries (if they borrow in dollars).


If the IMF is in the job of financing loans against conditionalities what will be the next conditionalities imposed on poor countries who cannot enjoy a free lunch as rich countries do? Is it also the funeral of one of the most important concepts in economic policy, sustainability, which was the IMF’s raison d’être? If this is the funeral of austerity on what ground to require adjustment to poor countries only; since developed countries can indulge in fiscal binge without restriction?


5 Is the future debt burden we impose on our children and grandchildren sustainable?

If there is indeed today, more benefit than cost to reduce public debt, an economist must look at the longer terms, because in the long run our children (and grandchildren) will be alive. Whatever think the Keynesians, the present debt ratio was not sustainable before the crisis and à fortiori will not be in the future.


So what to do if we don’t believe naively that the zero interest rate will automatically do the job?


1. The only way is to reduce latter the primary deficit (and even go to a primary surplus), the debt dynamic equation is inescapable. A permanent structural fiscal deficit will need fiscal adjustment. But politicians don’t want to raise tax or reduce expenditure (it is not popular, particularly in a period of election) in addition they are encouraged by the insider Economists and finally the monetization of the fiscal deficit has worked so far well.

2. The second less painful solution might be to follow the Japanese example, continue the QE policy. I don’t see other explanations to the present Japanese debt ratio amounting to 266% of GDP (projected in 2020) than a permanent monetary financing of their fiscal deficit. This works in a united country with people who accept no yield on their savings. Will this solution work for other countries? Inflation at that level of debt financing may shoot up. Anyway, European countries are considered following a Japanification way (high government, growing old population, sluggish growth). The difference is that the Japanese model works with low unemployment, this is not the case of the European one.

3. The third solution is to cancel a part of the public debt through the consolidation of the treasury and central bank balance sheets. This solution is not orthodox and may not be the most favored by Germany, but if the US and Japan start, the ECB will have to follow suit. We cannot continue with debt ratios above 130% of GDP with the only prospect of a permanent increase.

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