Thursday, May 5, 2011

Where James K. Galbraith Slays the IGBC Bogeyman

Prof. James K. Galbriath asks, Is The Federal Debt Unsustainable? and concludes:

The significant conclusion is that there is a devil in the interest rate assumption. If the real interest rate on the public debt is assumed to be greater than the real growth rate, unstable debt dynamics are likely. The offsetting primary surplus that is required for stability is an onerous burden for most countries, and to achieve it in the United States would be practically impossible, since the required cuts would undermine GDP growth and tax revenues. This is why the various budget plans now in circulation will not work out, if they are ever implemented. However, where the real interest rate is below the growth rate or even slightly negative, the fiscal balance required for stability is a primary deficit, and the sustainable deficit gets larger as the debt burden grows. This is why big countries with big public debts can run big deficits and get away with it, as the United States has done almost without interruption since the 1930s.

Prof. Galbraith explains why.

"At a reasonable interest rate for risk-free liquid bonds, moreover, the present debt/GDP path of the United States is (or would be) sustainable, especially following modest economic recovery. The CBO’s assumption, which is that the United States must offer a real interest rate on the public debt higher than the real growth rate, by itself creates an unsustainability that is not otherwise there. It also goes against economic logic and is belied by history. Changing that one assumption completely alters the long-term dynamic of the public debt. By the terms of the CBO’s own model, a low interest rate erases the notion that the US debt-to-GDP ratio is on an 'unsustainable path.'

"The prudent policy conclusion is: keep the projected interest rate down. Otherwise, stay cool. There is no need for radical reductions in future spending plans, or for cuts in Social Security or Medicare benefits, to achieve this. Do not change the expected primary deficit abruptly. Let the economy recover through time, and do not worry if the debt-to-GDP ratio rises for a while. If we follow the present fiscal and monetary path for 15 or 20 years—and if that path achieves an acceptable rate of growth and return to high employment, with positive but low inflation—we’ll see a debt-to-GDP ratio higher than now but still within our own postwar experience and that of other wealthy, stable, prosperous countries. At that time, it may well be that the primary deficit will already be below the value required for a stable debt-to-GDP ratio, since the threshold will be higher, and tax revenues rise as incomes recover."

Prof. Galbraith's policy note explicates the point about the IGBC that Trader's Crucible made in Chapter 2: In Which the Traders Crucible slays the Intertemporal Government Budget Constraint, and Mr. Rowe demonstrates his Worth.


The financial crisis and ensuing economic meltdown has led to sharp increases in the deficits and debt levels of many advanced economies. The run-up in public sector indebtedness helped to restore private sector balance sheets, laying the foundation for economic recovery in these regions. But the so-called “sovereign” debt crisis in the Eurozone has undermined the fiscal resolve that has, thus far, kept truly sovereign governments from slipping into a bona fide depression. Fearful of becoming the next Greece, governments that could allow an unlimited fiscal adjustment to restore full employment, are methodically weakening their fiscal support mechanisms and setting themselves on a path to becoming the next Japan.

The definitive MMT work on interest rates, debt, and the IGBC is Scott Fullwiler's Interest Rates and Fiscal Sustainability.

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