Great Leap Forward


This is the fourth part of the series on sovereign deficits and debt. (Last week I erred in identifying the post as the third part in the series on math sustainability—it was the third part of the whole series but only the second piece on math sustainability; in a sense, this is the third part of the math series.) The series was started in response to my Economonitor Ed Dolan’s original post detailing agreements and possible disagreements with the MMT approach.

To recap very quickly we agreed that sovereign government cannot become “insolvent” and forced to involuntarily default on commitments in its own currency. We moved on to “math sustainability” and agreed that so long as the interest rate paid on sovereign debt is below the GDP growth rate, then government does not necessarily face explosive growth of deficits and debts. And we agreed that the overnight interest rate is a policy variable, so that the central bank could keep it below the growth rate if desired. And we agreed that Treasury could use a “debt management” strategy to ensure that its average rate paid would be “low”—near to the Fed’s target rate, and if the Fed was pursuing a low rate strategy then on likely growth rates usually used in these types of models then the Treasury’s rate paid could be kept below the growth rate.

(Of course in recession the growth rate can go below zero but the interest rate would remain at zero or above; however this argument about sustainability is about the long term, not about cyclical problems.)

Now that always leads to the question: but if the Fed did pursue such a low interest rate policy, we’d get inflation that would force the Fed to raise its target rate above the growth rate to fight the inflation. Here was my one sentence response from last week:

“Here’s the preview: if deficits increase inflation rates, then “g” (GDP growth rate) rises so that even if the Fed raises “r”, we can keep g>r.”

Ed Dolan responded in the comments section this way:
“I think the part that will be more interesting to me is coming in Part 4. It will need to explain two things:
1. Even if it is possible always to keep g>r (both nominal) as inflation accelerates, would we really want to do so? Is there always some steady rate of inflation that guarantees g>r, or does it take continuously accelerating inflation? Are there any conditions under which accelerating inflation itself can undermine real output growth?
2. Suppose inflation is initially triggered not by monetary policy, but by an exogenous shock to real output (say, a natural or man-made catastrophe), or by attempts by the government to increase spending even after the economy has reached full employment (as in the “mission to Pluto” example of your MMT text). How can we be sure that the monetary policy operations needed to hold interest rates at an arbitrarily low nominal level will not induce further inflation?”

So let us begin to answer these questions. Today I’ll tackle question #1, or at least part of that question.

Let me begin with a blog I wrote a few months ago (quoted in Scott Fullwiler’s series over at NEP that I’ve drawn on several times in my own series–so here I am quoting Scott’s quote of me, which seems a bit strange!):

“As Randy Wray explained a few months ago, the negative income effect of low interest rates has been significant in offsetting any fiscal stimulus:

But there’s a darker side. The low deposit rates and the high fees are wiping out savers. I’m not telling you anything you don’t know. You cannot even get half a percentage point on your savings at banks. Sure, your mortgage rate has also fallen, but the net effect has drained consumer’s income. Here’s a quote from a Credit Suisse report:

The side-effect of the Fed’s near-zero interest medicine – the collapse in personal interest income over the last few years. The decline in interest income actually dwarfs estimates of debt service savings. Exhibit 2 compares the evolution of household debt service costs and personal interest income. Both aggregates peaked around $1.4 trillion at roughly the same time – the middle of 2008. According to our analysis of Federal Reserve figures, total debt service – which includes mortgage and consumer servicing costs – is down $206bn from the peak. The contraction in interest income amounts to roughly $407bn from its peak, more than double the windfall from lower debt service.

Let’s put that in perspective. Remember the Obama fiscal stimulus? About $400 billion a year for two years—let’s say almost 3% of GDP. There’s been a big debate about whether it “worked”. Only the truly crazy believe it did not save us from an even worse recession than what we actually went through.

Well, QE is removing an amount of aggregate demand from the economy equal to half of the Obama stimulus. And that is not just for two years—it goes on and on and on, year after year after year, as long as the Fed pursues ZIRP.

So QE is supposed to stimulate the economy by taking 1.5% of GDP away every year?

Just as we learned in the case of Japan—which experimented with ZIRP over the past two decades—extremely low rates take more demand out of the economy than they put in. So the Fed has mistaken the brake for the gas pedal: QE slams on the brakes but the Fed thinks it is sending more gas to the economy. The only thing we can be thankful for is that the Fed is driving a rickshaw, not a Buick. The damage it can do is not lethal.

Don’t get me wrong, I’m not against ZIRP—I’d have ZIRP all the time—but we need to understand that it does not stimulate the economy.

And we just found out last week that QE completely removed again almost $90 billion of income from the private sector in 2012.”

This is something that is almost always left out of analysis. When interest is paid, it goes somewhere. There’s a nearly impregnable belief that if the Fed raises rates that must slow the economy because higher rates discourage borrowing and spending. However, we know that most spending by consumers and firms is not interest sensitive. So what if higher rates have little impact on borrowing and spending? More interest is paid, and more is received. What is the net impact? Well, economists think it probably depends on who borrows and who spends, and their relative propensities to spend. If we take from those who spend 100% of their income (heck, for a decade American consumers happily spent $1.06 for every dollar of income—no matter what the interest rate was!) and give to those who spend only 50% then raising rates might depress the economy.

But what if the biggest debtor is the government? That is, what about Japan? For the sake of argument let us say that Japanese households are net savers and have managed to pay off all their debt, while government has debt outstanding equal to 200% of GDP. Then raising rates could be highly stimulative as consumers holding that debt get more interest income and consume much of it, while government does not cut its spending even as rates rise. And it turns out that you don’t have to go all the way to Japanese levels to get such an effect.

My UMKC colleague Linwood Tauheed and I modeled this effect some years ago, using a systems dynamic model he developed. We plugged-in a range of estimates for the relevant parameters (interest elasticity of spending, propensities to consume, and public and private debt ratios) obtained from mainstream empirical work. We found that once the government’s debt ratio rises above 60% of GDP then for plausible parameter values you can actually stimulate growth by raising rates. To be sure, it is a model and like any model the results all depend on assumptions. But we played it as safe as we could by taking mainstream estimates. It certainly appears that as you increase the government’s debt ratio relative to the private debt ratio then there are cases in which that will stimulate the economy. This is why I said that if the Fed raises rates, growth might rise to keep g>r. In addition to the debt ratios we need to know who holds the debt and what their propensity to consume the nation’s output is. (Note that even if the debt is held by foreigners payment of interest to them could induce them to buy our exports. We did not explicitly model that. Note also that much of the government debt is held by financial institutions and figuring out what the effect on spending might be can get very sticky or hairy or maybe sticky and hairy.)

This is certainly not meant to be an “I Win, Q.E.D. (quod erat demonstrandum)” argument. But let us think of the scenario usually imagined.

Government is hell-bent on running up deficits. That causes growth to rise, toward full employment. Inflation starts to pick up. Now this actually makes it easier to maintain growth rates above interest rates: g>r. But the Fed responds (with horror!) by jacking up rates, trying to get r>g. That increases private sector’s interest income, causing spending to rise and growth to continue to increase.

Ed wonders if I can guarantee that g remains above r? No. But I envision two scenarios.

a)      Policy-makers impose constraints to fight inflation. I realize that our hyperinflationary Austrians presume that policy-makers always and everywhere love to induce inflation. I do not observe that in the real world. Even though economists cannot find detrimental economic effects from “moderate” inflation (up to annual rates way into the double digits—even as high as 40% per year), the population hates inflation. And therefor so do politicians.

b)      But let us say I’m wrong about that. In the next election in reaction to the austerity-loving President Obama, the population chooses the party that promises to run up deficits to stoke the fires of inflation. (I’m not sure which party waiting in the wings that might be, but bear with me.) Once elected, the politicians oblige.

Here’s the deal. Tax revenues depend on economic performance. Faster growth generates even faster growth of tax revenues. Back in early 2007, my Levy Institute colleague Dimitri Papadimitriou and I showed that by the mid 2000s federal tax revenues were growing at a pace well over double GDP growth. We warned:

Revenues are now increasing at a rate of almost 15 percent on a year-over-year basis, far outstripping growth of government spending (growing half as fast), nominal GDP growth (less than 7 percent), and real GDP growth (just over 3 percent). The current situation, with tax revenues growing five times faster than real GDP, is historically unusual, reminiscent of the period before the Reagan-era recession. However, the late 1970s and early 1980s was a period of high inflation, which drove tax revenue growth through “bracket creep.” The mounting real tax burden was somewhat moderated by the rapid growth of nominal income. Comparing tax revenue growth with the rate of growth of nominal GDP, one finds that the current period is even more unusual: there is no other extended period since the 1970s in which taxes have risen twice as fast as nominal GDP. Thus, the real tax burden is rising at a faster pace today precisely because nominal incomes are not growing very quickly. Finally, many of the previous periods that saw tax revenues increasing at more than 10 percent per year were followed closely by recession: 1972–74 (average = 12 percent); 1977–81 (average = 15 percent); 1999–2000 (average = 10 percent). The exceptions (1984–85, 1996–98) were during earlier stages of economic expansions, with average growth rates of tax revenues a bit lower than 10 percent. Source:

As an aside, we predicted that these fiscal headwinds, combined with rising oil prices and overburdened consumers would lead to a recession and financial crisis. Can anyone remind me what happened in 2007? And the Queen thought no one saw it coming.

The point here is that if we get the high growth, high inflation scenario, the deficit will fall. That is what it always does. President Clinton even got a budget surplus (that killed the economy). That reduces the necessity of keeping the interest rate paid below the growth rate to maintain math sustainability.

While I do not believe in “equilibrium seeking free markets” I do recognize that the economy has something like a self-regulating thermostat. It works something like the thermostat on my boiler that sends hot water through hundred year old cast iron radiators that heat my home. Set at an energy conserving level of 58 degrees, the actual house temperature drops to somewhere around 56, the heat kicks in and raises it to 60 then shuts off, but the hot water in the radiators continues to increase the house temperature to 64 or so (hotter near the source, colder near the windows) before it begins the inevitable fall back toward 56.

Deficit hysterians want to have it every which way all at once. Uncontrolled deficit spending causes debt ratio to rise without limit but without inducing economic growth. Even as inflation rises, for some reason nominal GDP growth doesn’t rise. Bond Vigilantes and/or the Fed push nominal rates above nominal growth rates (or you can do it in real terms—doesn’t matter because as we learned in third grade you can divide both sides by the inflation rate) and the debt ratio grows toward infinity.

Note the steps in that chain of “logic”:

a)      Bigger deficits don’t increase GDP growth

b)      Higher inflation doesn’t increase GDP growth, so cannot keep g>r, and cannot increase tax revenue

c)       Higher interest rates and thus interest income doesn’t increase spending or taxes


So forever we’ve got deficits (largely to pay interest—that never gets spent), growing debt ratios, high interest rates (again, that create income that won’t get spent), high inflation, and low tax revenues.

It’s quite a story. Requires a “radical suspension of disbelief” as the late Hyman Minsky would say.

Next time, let’s look at this “self-regulating” system some more. Preview: watch the Supersize Me movie and recall Herb Stein’s quip that unsustainable processes eventually stop.


Ron RonsonJanuary 24th, 2013 at 1:25 am

You are claiming that to believe that it is not possible to have sustainable govt debt (that is: to have g>r) you have to believe that the following three things are true (or I suppose that the combined effects would lead to r>g and eventual debt problems)

a) Bigger deficits don’t increase GDP growth

b) Higher inflation doesn’t increase GDP growth, so cannot keep g>r, and cannot increase tax revenue

c) Higher interest rates and thus interest income doesn’t increase spending or taxes

I assume that GDP used here is real and not nominal and that you are referring to long term growth and not just growth out of a recession ?

Is so then

a) At full employment any additional govt borrowing may be service the debt or to pay for real resources in the economy. If the former then the effects will be neutral. If the latter then the effects on GDP depend upon where the money comes from and how it is spent. The discussion on this could go either way so I will call it neutral.

b) At full employment how can inflation increase growth ? Short term it can push growth by going above full employment but that is not sustainable in the long run.

c) Some people earn interest others pay it so the effect should be neutral no matter what the interest rate is. I don't see how this is changed if the govt is the debtor.

So assuming full employment it seems a dangerous argument to propose using govt debt, inflation and high interest rates to drive g > r. These policies could drive nominal g above r, but only by driving higher inflation which seems likely to negatively affect RGDP.

Perhaps there is an assumption here that by default we will never have full employment and govt deficits are needed to achieve this ? If so then I still feel that using debt to finance govt spending may prove unsustainable (and risky if attempts were made to make it sustainable by inflationary policy) and other means of financing the required govt spending would be optimal.

Neil WilsonJanuary 24th, 2013 at 12:04 pm

c) Higher interest rates and thus interest income doesn’t increase spending or taxes

You might want to add a (d) there for countries outside the US.

(d) Export-led countries will stand idly by watching their markets disappear while your 'currency collapses' and theirs goes sky high. Just like the Swiss did with the Euro.

We should call these the Zombie Myths. They just won't die.

olly100January 24th, 2013 at 12:58 pm

"Even though economists cannot find detrimental economic effects from “moderate” inflation (up to annual rates way into the double digits—even as high as 40% per year), the population hates inflation".

It can destroy people's savings. That's a detrimental economic effect, and that's why people hate it.

What research are you basing your claim on (that economists cannot find detrimental effects)?

Edward StevensJanuary 24th, 2013 at 2:51 pm

And we agreed that the overnight interest rate is a policy variable, so that the central bank could keep it below the growth rate if desired.
— agreed, but with consequences–one of which is that the rich, excluding pesnion funds who are big stock holders, have tended to get richer– which I suspect you decry
— and as you might have noticed, while public sector net dent growth has been lagr–my word– private sector credit growth–both households and coproarions has been minimal
— and since C is still larger than G–even in the world of the communitarian–I would think we need private sector credit growth to rise at some point so employers can hire employees when the time comes that the so-called output gap is narrowed.

A borrower like the Federal Government can only pay back loans when it has a surplus of cash– in the government's case that is limited in theory by the future GDP growth and the government's take from that growth.
Anything that limits future growth or the government's ability to take from others to give to others limits its debt capacity.

LRWrayJanuary 24th, 2013 at 3:54 pm

John Carney of cnbc offers what I'll call a "friendly amendment":

He argues that some of our Austrian hyperinflationaries are moving away from the view that policy makers always and everywhere push for inflation. In fact, some now see the central bank as a patsy for bankers, who realize high inflation leads to social unrest.

Makes some sense to me.

olly100January 24th, 2013 at 7:55 pm

If the UK currency collapses, is that really going to hurt a country like China, for example? The US may no face a BOP constraint, but this is not necessarily the case for other countries.

Ed Dolan EdDolanJanuary 24th, 2013 at 8:15 pm

1. "we agreed that the overnight interest rate is a policy variable, so that the central bank could keep it below the growth rate if desired"

Actually, we agreed on that in only a very limited sense. We still need to look at the case where the economy is operating with a zero or positive output gap and inflation is accelerating. If the central bank can keep r<g only by accepting ever-accelerating inflation, then the proposition is an empty formalism.

2. I think it takes some rather heroic assumptions to believe that the stimulus from raising interest rates will raise g by more than r. As you say, raising nominal r by 2 points when debt is 75% of GDP only increases government outlays by 1.5 percent of GDP. To get a sustained increase in nominal GDP growth of more than 2 points from that, you need some assumptions like these:

a. All or almost all of the interest accumulates to consumers of lower incomes who have high MPCs, not to wealthier consumers with low MPCs, or to financial institutions or to foreign debt holders

b. The increased interest rate does not affect consumption or investment spending. (I know this is part of the MMT mantra, but not everyone buys into it)

c. Even then, we need to assume that the stimulus permanently increase the growth rate of GDP, not just the level relative to potential GDP. The level/rate linkage seems to be a missing piece here.

3. "The point here is that if we get the high growth, high inflation scenario, the deficit will fall. "

This argument, too, works only with some supporting assumptions

a. High growth and falling deficits do not lead Congress to cut taxes and increase outlays, as they usually have done

b. Inflation does not have a negative impact on real GDP. I am skeptical of the argument that inflation up to 40 percent is harmless to real GDP; the numbers I have seen suggest that negative effects start in around 7-10 percent in OECD-type economies. I'd like a reference to the 40% number. But even 40% is low. How can we be sure inflation will stay below 40%?

c. Inflation always raises real tax revenue. Many countries with high inflation experience a "Tanzi effect" in which high inflation reduces real tax revenue.

Without all three of these assumptions, we can't be sure that inflation will lead to restoration of budget balance. Even if all three assumptions hold, I question whether inflation is the best way to bring about budget balance.

L. Randall Wray L. Randall WrayJanuary 24th, 2013 at 9:53 pm

Ed: your point one is nitpicky, seems to me. The whole thing is empty formalism! That is exactly what we are doing–the math sustainability argument is empty formalism. I was trying last week to stay within that. We (should?) agree Fed CAN keep overnight rate below growth rate, but MIGHT NOT WANT TO DO SO.

(And, yes, many MMTers doubt there is any good theory or empirical evidence relating interest rate policy to spending and thus to economic growth. Even the most mainstream economists cannot find it in the data–even after they’ve tortured the data practically to death. And theory tells us it can go either way. For us this is not a mantra–if there were convincing theory and evidence, I’d change my mind. There isn’t any–at least yet.)

And your final conclusion seems strange to me. I’m certainly NOT arguing for inflation on the argument it is the “best way to bring about budget balance”. I DO NOT want to balance the budget and am not interested in finding the best way to do that.

I think your point c overstates your case. Certainly in hyperinflations it is true that inflation outruns taxes (that is Bresser’s argument that budget deficits result from, rather than cause, hyperinflations). But that is not “many countries”. Hyperinflations are (to my mind) very special cases that have to be treated separately. There isn’t an accelerationist path from low to medium to high inflation that then goes right on up to hyperinflation.

Scott provided the classic reference to the empirical work on “cost” of “high” inflation. In any case, I’m not suggesting there is any path to 40% inflation for the US. In our case, “high” inflation would be low double digit.

You raise other issues I’ll try to get to next week–too much to treat in a response.

jonf34January 25th, 2013 at 12:00 am

Just a question I am confused about or maybe a few questions. If you support a zero interest rate policy, doesn't that, be definition, resolve the problem of the debt ever being " unustainable"? Would not a zero rate policy make Tsy bonds a near perfect substitute for cash? Under such condition, why issue bonds at all? ( except that someone requires it. )

The question of interest income still puzzles me. Most working people, prolly well over ninety percent of the population probably do not own them. Or am I just one dumb worker bee? So the people who own them are pretty well off. Why should we give,them risk free,income? I also don't see how interest can control inflation, but I will trust your knowledge. The only reason I can understand Tsy bond income is pension funds. But there are plenty of agency and market investments. So even here it sorta fails?

LRWrayJanuary 25th, 2013 at 1:12 am

JonF: sounds like you are not confused. Outside our "formalistic" approach to this, Zirp makes all sorts of sense for all sorts of reasons. The problem is that there are those who think the central bank can, should, must "fine tune" the economy through manipulation of the overnight rate. Me thinks the Wizard behind the Curtain cannot do it. Zirp Forever! Zero is a very good number for govt IOUs; and so long as we have any positive growth whatsoever, "math sustainability" is solved. Forever.
You ought to be teaching this stuff.

Ron RonsonJanuary 25th, 2013 at 7:21 pm

I can see how a zirp on the overnight rate would work – banks could make any profitable loan they found. This would be sustainable as long as the monetary authority took offsetting action else where to prevent this leading to unacceptable levels of money supply growth.

But how would this with help with ensuring that g > r ? The govt can't borrow at the overnight rate (assuming it not going to finance the deficit entirely out of short-term debt) but at whatever market rate they need to pay to get people to lend to them. What guarantee would there be that this rate is lower than the growth rate ?

JoeJanuary 26th, 2013 at 10:20 am

I admit I am a bit out of my league posting here, but my question relates to your discussion about effects of interest rates on growth and what portion of the population receives the most income from these interest rate increases, i.e. their propensity to spend. I was wondering if you could point me in the right direction to look at this more. Thanks for any help.

L. Randall Wray L. Randall WrayJanuary 26th, 2013 at 1:35 pm

Ron you need to read all parts of this series. I already dealth with so-called government “borrowing” (its own currency!). No, it does not have to pay rates dictated by “markets” or “vigilantes”.

L. Randall Wray L. Randall WrayJanuary 26th, 2013 at 1:38 pm

Depends. I think that is the wrong way of looking at it.
If at full employment agg demand is still rising, you get “true inflation” and should do something about it. If not at full emp then according to Keynes it is not “true” inflation. Depending on source you might want to fight it. Let us say it is due to rising oil price. Is it temporary? or Permanent? Actions to be taken depend. Perhaps you let oil prices rise to encourage conservation; so you’ll get some price rises of output that use a lot of oil. Not necessarily a bad thing.

Ron RonsonJanuary 26th, 2013 at 6:23 pm

I read the other posts and still don't really see how this works.

I'm thinking of a simple model where the monetary authority has 2 policy tools (monetary via the bank rate) and fiscal (tax and borrowing that can be used to control AD).

The monetary authority sets the bank rate to zero and banks lend to anyone who will pay hem interest (factoring in risk).

This would be very inflationary unless the bank uses fiscal policy of control AD, which they have to suppress sufficiently to keep inflation at a reasonable level.

In this way I see that the monetary authorities can control the interest rate. But can they keep it below growth rate ?

My concern here is the following: Businesses will base their desire to borrow on their expected profits. The more fiscal policy is used to reduce AD the lower these expectation will be, and the less they will borrow. The less they borrow the lower the growth rate and hence their can be no guarantee that g > r .

olly100January 26th, 2013 at 10:55 pm

Or, for example:

"the accrual of interest to individuals’ bank deposits can be capped at a certain threshold of wealth, and beyond that level it could be limited to simply compensate for inflation. (Or the social surplus could be divided up equally among everyone and just paid out as a social dividend.) This would yield not exactly the euthanasia of the rentier, but of the rentier “interest” in society".

LRWrayJanuary 29th, 2013 at 1:00 am

Well, we tried to look at that in our paper, cited. Seems to be largely taxes of the "nonwith-holding" variety. Such as on capital gains and Wall St bonuses.. Our tax system is only slightly progressive but when you move virtually all income gains to the very top, it will generate a lot of tax revenue in a speculative boom.

KyleJanuary 31st, 2013 at 5:33 am

Ron, I believe you are missing some vital MMT perspectives and insight in your analysis. Please carefully go through the MMT Primer at the New Economics Perspectives website, or the one at Billy Mitchell's website, and/or read Warren Mosler's 7 Deadly Innocent Frauds book available for free download on his website. These will provide you with the info to fill in the gaps between your viewpoint and MMT.