Thursday, April 25, 2013

Do interest payments on government debt matter?

In an Econbrowser blog post that reflects on what we have learned from the challenge of Reinhart and Rogoff results, James Hamilton argues that we cannot forget that there are costs to government debt. Some of the points he makes are very good and I think they can be accepted by those critical with the Reinhart and Rogoff interpretation of the evidence, but there is one that I cannot understand well.

He argues that

"The main reason that I personally am concerned arises from the fact that, for any level of the interest rate, a higher debt load means that the government will permanently need to spend more money just to pay the interest on the debt. This is not a matter for arcane debate, but rather is a consequence of the most basic arithmetic. At the moment, the interest rate on U.S. government debt is extremely low, so that despite our high debt load, the government's net interest cost is currently quite reasonable. However, most projections call for interest rates to rise over the next few years, and the most recent assessment by the CBO notes that consensus interest-rate forecasts and existing fiscal legislation imply that within a few years, the U.S. interest cost will be bigger than the entire defense budget, and bigger than all of non-defense discretionary spending."

It is true that interest payments on government debt are part of government spending and they will require some form of taxes to generate revenue and taxes are likely to be distortionary. But this cannot be an argument in favor of a reduction of government debt to avoid paying future interests on it. The reason is that to reduce debt you need to find the resources, which means taxes and therefore creating a distortion today. Is it better to create the distortions today or tomorrow? The optimal path of debt (once you have it) depends on arguments that are all related to intertemporal trade offs. Is it better to raise taxes today by a large amount or over the coming years by a small amount? (economic theory tends to suggest that is better to spread the pain over the years). Also, what is the interest rate at which the government can borrow today relative to other interest rates in the economy (which affect how the private sector sees the trade off between paying taxes today or tomorrow)? And there is also the intertemporal tradeoff related to countercyclical fiscal policy (raise taxes when you are close or above full employment).

So the real issue is not how large interest payments on government debt will be in the future. The real issue is about difficult intertemporal trade offs associated to taxation and spending in different years as well as how we think about the interest rate faced by government in the context of how the rates faced by the private sector.

Antonio Fatás
on April 25, 2013 |   Edit