Kevin Carmichael: Economics 101 tells us high public debt is bad. But what if the textbooks need updating?
Andrew Scheer keeps saying that a vote for Justin Trudeau this autumn will be a vote for higher taxes.
That’s a reasonable deduction. The budget deficit has increased to about $20 billion from zero in 2015, so the debt is growing. That’s bad, according to most economics textbooks. Government borrowing puts upward pressure on interest rates, and it crowds out private capital because investors prefer risk-free government bonds to risky bets on entrepreneurs. The situation can’t be allowed to persist, and since Trudeau appears allergic to spending cuts, debt dynamics will force him to raise taxes.
“Higher deficits today mean higher taxes tomorrow,” Pierre Poilievre, the Opposition finance critic, wrote in a column for the Toronto Sun at the end of November. Economics 101, albeit with a partisan twist.
But what if the textbooks need updating?
As the federal Conservatives seek policy inspiration in their old university notebooks, the economics profession is asking whether public debt matters, at least to the extent that it thought it did.
Last month, Olivier Blanchard, the former International Monetary Fund chief economist, stole the show at the American Economic Association’s annual meeting by arguing the rule that public debt means higher taxes probably is wrong; as long as nominal gross domestic product exceeds the “safe rate,” or the interest rate at which governments borrow, there is no obvious economic reason to raise taxes, according to his research.
Blanchard, who now is a professor emeritus at Massachusetts Institute of Technology and a senior fellow at the Peterson Institute for International Economics, presented a paper that shows such a relationship tends to be the norm in major developed economies; therefore, a country such as the U.S. could reduce its debt burden simply by rolling over existing bonds because nominal growth will exceed the interest rate.
“In a way, there is no fiscal cost,” Blanchard said in a lecture on Jan. 4. “We can discuss the semantics, but you can see what I have in mind: You don’t need to raise taxes to finance the additional debt.”
You don’t need to raise taxes to finance the additional debt.Olivier Blanchard, economist
The Trudeau government has been applying a variation of this theory since it decided to ditch its promise to run only small deficits for a few years. (The deficit is the equivalent of about one per cent of GDP, which is still pretty small by most standards.)
In Canada, nominal growth will average 3.9 per cent between 2018 and 2022, and the yield on the 10-year bond will average 2.9 per cent, according to the mean estimate of the 14 outside economists who advised Finance on the fall economic update. The debt is on track to shrink as a share of GDP, which matters more than the absolute level. No tax increases required.
Nevertheless, Scheer appears to think that Trudeau is vulnerable on debt and taxes. On Jan. 29, the Opposition forced the Liberals to defeat a motion that called on the government to promise that it wouldn’t raise taxes in the future. It’s a tweak of Scheer’s pre-Christmas assault, which focused simply on the deficit. As you evaluate the new critique, keep in mind that the theory on which it is based hasn’t really been updated for the post-crisis, low-interest-rate age in which we live.
For example, Jonathan Ostry, the Canadian economist who is the deputy director of the International Monetary Fund’s research department, showed in 2015 that countries that can borrow relatively cheaply are better off living with their debts than adopting austerity for austerity’s sake.
In 2016, Stephen Poloz, the Bank of Canada governor, published a paper that suggests the Harper government’s decision to balance the budget contributed to the surge in household debt; a better policy mix would have allowed the central bank to raise interest rates, avoiding the credit bubble.
And last month, Jason Furman and Lawrence Summers, Harvard University economists who served in President Barack Obama’s administration, published an article in Foreign Affairs that calls on American politicians to get over their debt obsession.
No one seriously argues that the cost of capital is holding back businesses from investing. Cutting the deficit, then, is unlikely to spur much private investment.Jason Furman and Lawrence Summers, Harvard economists
“Textbook economic theory holds that high levels of government debt make it more expensive for companies to borrow,” they wrote. “But these days, interest rates are low, stock market prices are high relative to company earnings, and major companies hold large amounts of cash on their balance sheets. No one seriously argues that the cost of capital is holding back businesses from investing. Cutting the deficit, then, is unlikely to spur much private investment.”
That’s a lot of brainpower amassed against the Conservatives’ contention that Trudeau’s fiscal policy inevitably leads to higher taxes.
Still, Team Trudeau shouldn’t feel smug. Blanchard said his research shouldn’t be used as an excuse to pile on debt. And Furman and Summers raised an important political economy concern: the debt-to-GDP ratio that Trudeau favours might be the right gauge, but it’s nuanced, and “nuance doesn’t sell.”
To keep the fiscal prudes from winning the political argument, the former Obama economists advise American policymakers to match new spending with program cuts or extra revenue, except during recessions. “If something is truly worth doing, it should be worth paying for,” they wrote.
Dozens of countries use budget rules as a check on spending. Trudeau scrapped the one that Harper had put in place. If he wants to win the debt debate with Scheer, he may need to replace it. The prime minister has tossed too many promises to run on his word alone. And Olivier Blanchard’s new algebraic calculations — no matter how brilliant — aren’t yet taught in school.