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AI Summary. When real economic growth exceeds real interest rates, economies can grow out of debt, but this favorable gap tends to diminish once debt reaches 50–100% of GDP. The U.S. reduced its post-war debt burden of near 100% of GDP through growth rather than austerity, though persistent deficits could offset that dynamic.

John Hartley Behavioral Macreconomics
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The “Blanchard effect” suggests economies can grow out of debt, but this effect diminishes at 50-100% of GDP. The US, with its reserve currency status, may be an exception.

Can economies grow out of debt when growth exceeds interest rates?

Core argument: The "Blanchard effect," in which real GDP growth exceeds real interest rates and allows economies to grow out of debt, tends to diminish once public debt reaches 50–100% of GDP.

The "Blanchard effect," where real GDP growth (g) exceeds real interest rates (r), suggests that economies can grow out of debt, but this effect tends to diminish when debt reaches 50-100% of GDP. The U.S., with its reserve currency status, may be an exception, potentially sustaining higher debt levels. Historically, the U.S. managed post-WW2 debt (near 100% of GDP) through economic growth rather than fiscal austerity, as r-g remained negative. However, persistent deficits exceeding r-g could challenge this dynamic. While real interest rates have been stable over centuries, the sustainability of r-g at high debt levels remains uncertain. The focus should be on economic growth as a means to manage public debt, as highlighted by Blanchard, who argues that debt is "less bad" if g consistently outpaces r.

Takeaways by Macro Roundup® AI

  1. The "Blanchard effect," in which real GDP growth exceeds real interest rates and allows economies to grow out of debt, tends to diminish once public debt reaches 50–100% of GDP.
  2. The U.S. reduced its post-WW2 debt burden of near 100% of GDP through economic growth rather than fiscal austerity, with r-g remaining negative over that period.
  3. Persistent deficits exceeding r-g could challenge debt sustainability, and while real interest rates have been stable over centuries, the durability of a negative r-g at high debt levels remains uncertain.

John Hartley, “Public Debt In A Time Of Growth (And Low Interest Rates,” Behavioral Macreconomics, January 20, 2019, http://behavioralmacroeconomics.blogspot.com/2019/01/public-debt-in-time-of-growth-and-low.htmlPublic Debt In A Time of Growth (And Low Interest Rates)

Jon

Thanks,

That's not to say, that higher levels of debt-to-GDP couldn't be sustainable (or that there wouldn't be good reasons like increased investments in public education), just that this offsetting "Blanchard" effect which is a feature of the "specialness" of government debt that disappears at a certain point (between 50 and 100% of GDP) and shouldn't be a point of justification for additional debt increases.

Absent any shocks to default expectations, the “Blanchard effect” predicated on r-g seems like a real phenomenon to be taken seriously in lower. There could be other reasons behind the historical post-war r-g < 0 phenomenon such as the high productivity of the 20thcentury which may not continue into the 21stcentury indefinitely perBob Gordon’s arguments.

Of course, if some event suddenly shifts expectations negatively toward an increased likelihood toward non-repayment of public debt, this sends r skyrocketing (the G7 examples exclude default cases like Greece and Argentina of the world, which hit default at very different levels of Debt-to-GDP).

The real interest rate however is largely invariant to Debt-to-GDP (historicallyreal interest rates haven't changed much over the past 700 years):

What is causing the Blanchard effect to be? More or less, it's the same story of Reinhart-Rogoff's "Growth In A Time of Debt" observation that growth begins declines non-linearly with GDP hitting a flashpoint somewhere around 100%:

It appears the "Blanchard effect" (where r < g and grow out debt) ends somewhere between 50 to 100% of GDP (depending on the country). The US, which has the world's reserve currency, appears to be something of an exception which might be at the higher end of that range.

Here is what the r-g differential looks like for the G7 countries at higher levels of debt-to-GDP:

We can certainly grow our way out of the existing stock of debt no problem as Blanchard observes, but what if deficits (G-T) persistently grow at rates higher than r-g? In other words, is r-g scalable at higher levels of debt-to-GDP? r-g aren't exogenous and r and g both depend a lot on the growth rate of G-T.

Paul Krugmanover at the NYTcorrectly observes and makes the related point that we didn't pay back the debt accumulated from WW2 (when debt-to-GDP was close to levels today around 100%) through taxes or spending cuts. Instead, the U.S. grew its way out through g, something that we we’re able to do in part because r-g < 0 for most of the 20thcentury (I’ll add while debt-to-GDP levels remained below 100% with a clear path to paying our way out.

It is true that there are only three ways to reduce public debt (other than default): 1) lowering fiscal deficits (G-T), 2) higher economic growth (g), and 3) seignorage (the latter of which we can and should ignore for inflationary reasons). While we often talk about #1 in fiscal policy/public debt discussions while #2 is either ignored or poorly quantified. Blanchard finally gives #2 the proper attention that it deserves.

If you attended the annual ASSA meetings this year, you may havewatchedorreadOlivier Blanchard's American Economic Association presidential address entitled "Public Debt and Low Interest Rates".

Blanchard observes that for most of the post-war period, real GDP growth (g) has been higher than real interest rates (r). He further makes the point that if real growth is higher than real interest rates (r-g < 0), we can grow our way out of an existing debt stock with relative ease. Blanchard argues this is reason for us to be "less worried" about public debt and that debt is "less bad" than we think. There’s also some nice modelling using a Diamond OLG framework if you have the time to read all the way through.

Before our lunch, wanted to send you mylatest blog postwhich is a rebuttal of the Blanchard argument that since r - g < 0 (real interest rate being less than real GDP growth implying we can grow our way out of debt), we can add more federal debt (Larry Summers and Jason Furman now have a Foreign Affairs piece out titled "Who's Afraid of Budget Deficits"echoingthis). Looking forward to lunch and would be great to hear your thoughts!:

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