Interest-Growth Differentials and Debt Limits in Advanced Economies

Abstract

Do persistently low nominal interest rates mean that governments can safely borrow more? To addresses this question, I extend the model of Ghosh et al. [2013] to allow for persistent stochastic changes in nominal interest and growth rates. The key model parameter is the long-run difference between nominal interest and growth rates; if negative, maximum sustainable debts (debt limits) are unbounded. I show how both VAR-and spectral-based methods produce negative point estimates of this long-run differential, but cannot reject positive values at standard significance levels. I calibrate the model to the UK using positive but statistically plausible average interest-growth differentials. This produces debt limits which increase by only around 5% GDP as interest rates fall after 2008. In contrast, only a tiny change in the long-run average interest-growth differential -from the 95 th to the 97.5 th percentile of the distribution -is required to move average debt limits by the same amount.

Debt Is Not Free

“…However, LICs-the group for which debt stocks usually refers to the narrower perimeter of government-typically report the interest bill for the same level of government so this is less of a problem. Consistent with other studies (see, Mauro et al 2015;Barrett 2018;Escolano, Shabunina, and Woo 2017), our data suggests that, on average, the interest-growth differential has been close to zero or negative since the 1980s across all income groups (Figure 7). However, there is a wide dispersion within each group and positive interestgrowth differentials are not an anomaly.…”

Public Debt and Low Interest Rates

“…Real interest rates are however often computed using CPI inflation rather than the GDP deflator 6. Using Shiller's numbers for interest rates and historical BEA series for GDP, over the longer period 1871 to 2018, the 1-year rate has averaged 4.6%, the 10-year rate 4.6% and nominal GDP growth 5.3% 7. A more detailed construction of the maturity of the debt held by both private domestic and foreign investors is given in Hilscher et al (2018).…”

Public Wealth in the United States

“…Our assessment of fiscal sustainability rests on the assumption of positive future interest-growth differentials. While this assumption is in line with assumptions made by other policy institutions, including the US authorities, it is worth pointing out that, when interest rates remain below GDP growth rates in the long run, concerns about a sovereign's solvency are no longer warranted -a point made in Barrett (2018) and Blanchard (2019). However, given the uncertainty surrounding the future path of interest and growth rates and given the immense potential cost of underestimating future interest rates, we take a cautious approach to the issue.…”