Wednesday, 31 May 2017

The optimum national debt / GDP ratio.


Asking what the optimum debt / GDP ratio is, is not a brilliant question in that base money and debt are almost the same thing. So a better question is: what should the sum of the debt and base be?

The debt and base are both assets as viewed by the private sector (which holds those assets) and the more of those assets the private sector has, the more it will spend, all else equal. Thus the optimum amount of debt plus base is whatever induces the private sector to spend at a rate that brings full employment.

The debt plus base will always tend to move towards that optimum if standard Keynsian measures are adopted to deal with recessions.

As for the best rate of interest to go for, there are no desperately good arguments for paying significantly above zero.


Government debt is not the only government liability: there is also central bank issued money (base money) which is a state liability of a sort. Certainly that money appears on the liability side of central banks’ balance sheets.  But the distinction between base money and national debt is largely spurious. That is, national debt is simply a chunk of base money which pays interest because holders of said chunk have handed it over to government for a while. I.e. national debt is effectively a term account at a bank called “government”.

Or as Martin Wolf, chief economics correspondent at the Financial Times put it, “Central-bank money can also be thought of as non-interest-bearing, irredeemable government debt. But 10-year Japanese Government Bonds yield less than 0.5 per cent. So the difference between the two forms of government “debt” is tiny…”

And in practice, very large amounts of debt have been transformed into base money via QE in recent years, with no very dramatic consequences: certainly not the hyperinflation that some thought would result from QE style money printing.

Also, note that advocates of Modern Monetary Theory (MMT) have spotted the relevance of the sum of debt plus base and sometimes call it “Private Sector Net Financial Assets” (PSNFA).

Thus the relevant question is not “What’s the optimum amount of debt?”. A better question is “What’s the optimum “debt plus base?”

The answer to that question is simple, and the answer stems from the fact that the more cash (and assets which are similar to cash) that the private sector has, the more it will spend, all else equal. Thus the optimum amount of “debt plus base” or “PSNFA” is whatever induces the private sector to spend at a rate that brings full employment, i.e. keeps the economy at capacity.

Moreover, government does not even have much choice as to how many dollars worth of “debt plus base” there is. Reason is that if the private sector has less debt plus base than it wants, it will save with a view to acquiring the amount it wants. And that saving causes Keynsian “paradox of thrift” unemployment. Ergo government has to run a deficit to deal with that unemployment, and the deficit increases “debt plus base”.

So if the state (i.e. government and central bank) increase the deficit whenever there’s too much unemployment, and conversely, run a surplus when there’s too much inflation, then “debt plus base” will always tend to move towards its optimum size, though doubtless it will never actually be at its optimum to the nearest dollar (or million dollars, come to that).

Indeed, the latter point is 100% compatible with Keynes’s dictum: “Look after unemployment and the budget will look after itself”.  That is, if there is excess unemployment, then run a deficit. That deficit will eventually and in principle raise the debt to the level at which it induces the private sector to spend at a rate that brings full employment. Though given the constant changes hitting every economy (bank crises, etc), the optimum amount of debt plus base constantly changes.

So…as Keynes so rightly said, stop worrying about the debt: just run a deficit till full employment is achieved. Or conversely, given excess inflation, run a surplus.

Pay interest on government liabilities?

Next, is there any point in paying interest on the debt or base?  Milton Friedman (1) and Warren Mosler (2), who founded MMT,  said “no”. There are however some plausible arguments for paying interest, none of which are desperately convincing. One popular one is that investments like infrastructure should be funded by interest yielding bonds / debt. (Incidentally, as MMTers often point out, a government which issues its own currency has complete control of the rate of interest it pays on its debt.)

However there at least three problems with that “infrastructure” argument, as follows.

1. What about education?

One problem with the infrastructure argument is that the education budget is one huge investment. To illustrate, the benefits of teaching kids to read and write continue to be reaped fifty years later. But advocates of the above “fund infrastructure with bonds” argument never argue for funding education with bonds: a clear inconsistency.

2. Cash shortages.

Much the best argument for borrowing is the simple fact of being short of cash. If a taxi driver wants a new taxi and happens to have enough cash with which to buy it, he’d almost certainly have the nouce to pay cash rather than borrow. Be nice if the country’s leading economists had as much nouce as taxi drivers, wouldn’t it…:-)

Much the same goes for government. That is, governments have a near in exhaustible source of cash: the taxpayer. In addition, governments can simply print money (suitable where stimulus is needed). So why borrow and pay interest?

3. David Hume.

David Hume writing nearly three hundred years ago pointed out that politicians main motive for borrowing is to ingratiate themselves with voters. That is, voters tend to squeal less when government funds spending via borrowing rather than tax.

Interest helps monetary policy work.

One argument for an artificially high level of debt with a correspondingly high rate of interest on the debt is that that helps monetary policy (specifically interest rate adjustments) work. That is, if interest rates are well above zero, then clearly the central bank can cut interest rates come a recession.

Frankly the arguments for that policy are not brilliant. Reasons are as follows.

First, the Bank of England claims interest rate cuts take a year to have their full effect.

Second, there is nothing to prevent an element of variability being built in to matters fiscal, i.e. tax and public spending. For example the UK cut and then raised VAT during the crisis, and all without politicians squabbling over the matter for weeks or months beforehand.

Third, an artificially high debt and rate of interest involves taxpayers having to pay taxes to fund interest paid to rich people simply to hoard cash: what you might call “barmy”.


A possible problem with a permanent zero rate (as advocated by Friedman and Mosler) is that there is then no point in holding government bonds: you might as well just hold cash (base money). But arguably, if the private sector holds excessive amounts of cash, it’s possible the private sector goes mad at some stage, and tries to spend it all at once, the result being hyperinflation. Thus arguably a better option is to pay a miserable rate of interest on government debt, like 0.5%. That induces the private sector to lock up much of its stock of “debt plus base”, thus making it more difficult to spend all at once.

Also, assuming the 2% inflation target is hit, that means an effective or real rate of interest of minus 1.5% on government debt. I.e. the debtor (government) profits at the expense of its creditors. Nothing wrong with that!


Implementing standard Keynsian / MMT policies to deal with recessions will result in the “debt plus base” always moving towards its optimum level.  As for the best rate of interest to pay on the debt, there are good arguments for paying a near zero rate, like 0.5%.



1. Milton Friedman. “A Monetary and Fiscal Framework for Economic Stability”, American Economic Review. (1948)  Para starting “Under the proposal..”.

2. Warren Mosler (founder of MMT). ‘Proposals for the Banking System’. (2010) Huffington Post Business. 2nd last para.

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