_ Dirk Niepelt, professor, Bern University. 5 February 2021. Translated into English by Yuri Kofner.
Negative interest rates do not make national debt “free”. No “money is given” to the issuer. Even if the interest rate is below the growth rate, this does not mean that sustainable and, in particular, optimal debt ratios will rise beyond limits.
Nominal and real interest rates are low and in many countries even negative. That is why one can often read that national debt is “free” or “almost free”. Is that correct?
At first glance it is not true, because the buyer of a federal bond has to pay something to buy it. Anything else would be amazing. Ultimately, the business between debtor and creditor serves to exchange purchasing power in the future and the present. The price at which this exchange takes place is the gross interest, not the net interest (i.e. roughly one, not zero), because on maturity the obligee receives interest and principal payment. Only at a net interest rate of minus one hundred percent would borrowing be free. In this unrealistic case, when it falls due, the debt would vanish into thin air because the negative interest rate would eat up the repayment.
The situation becomes somewhat more complicated when viewed over the longer term. Financial policy is sustainable as long as the debt ratio does not explode, i.e. the debt does not grow faster than the national income. A state with a very long horizon therefore never has to pay off its debts, as a simple example shows. Assume that the interest rate is one percent, the state owes one hundred francs and the state primary deficit and economic growth are zero. If the state pays its debts after a year, it has to pay 101 francs. If, on the other hand, he merely stabilizes the debt ratio, he has to pay CHF interest per year and pass on the debt. The present value of the perpetual debt service in this second variant is also 101 francs.
Economic growth and primary deficits or surpluses do not fundamentally change this logic: Financial policy is sustainable as long as the debt ratio remains stable. If the interest rate is above the economic growth rate, sustainability therefore requires primary surpluses, i.e. the state has to raise taxes to finance interest payments. But what happens if the interest rate falls below the growth rate? Will sustainable financial policy then allow permanent primary deficits, and will this effectively make public debt free of charge?
Many columnists are currently arguing that way. In doing so, they often refer to a work by Olivier Blanchard, MIT professor and former chief economist of the IMF, (and sometimes also to the “Modern Monetary Theory” – a narrative that the majority of serious economists reject). Blanchard argues that government bond rates have often been and will likely be below the growth rate for the time being. If this were to remain the case, he correctly concluded, the debt could be increased without this resulting in higher interest payments in the future. Because as a result of economic growth, debts relative to national income would disappear over time and would therefore have no fiscal costs.
But Blanchard’s analysis is misinterpreted or overinterpreted for various reasons. First, the state budget restriction does not vanish into thin air when the growth rate is usually above the interest rate, but only when a permanent rise in the interest rate above the growth rate can be ruled out. This is not the case. Second, risks must be considered, as Blanchard does. A comparison of interest rates and average growth rates is not meaningful. Thirdly, because of their advantageous liquidity properties, government debt yields lower returns than claims against other debtors who have to pay the market interest rate. Public debt, like money, therefore generates seignorage income for the national budget. But that in no way means that the state does not have to observe any budget restrictions.
Even if debt did not create a fiscal cost, it would not necessarily mean that higher debt would be beneficial. Columnists often suggest that Blanchard’s study advocates issuing new debt to fund public investment, but it is not. Rather, his analysis relates to pay-as-you-go transfer systems such as that of the Swiss AHV, whose macroeconomic effects have parallels to national debt. Blanchard therefore does not recommend debt-financed public investments, but rather higher AHV contributions and benefits. In Blanchard’s analysis, however, these also have distributional effects, i.e. prefer individual generations at the expense of others.
What remains as a conclusion? Due to low interest rates, it is currently relatively cheap, especially for states, to convert future purchasing power into current purchasing power. But this does not mean that national debts are “free”. And even if the fiscal costs of government debt disappeared, sustainable and especially optimal debt ratios would remain limited.
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