May 10, 2016
All Things Considered got things badly wrong in talking about the government debt last night. As most folks know, Donald Trump seemed to imply that he would threaten to default on the debt in order to force creditors to take write-downs on their bonds. He then clarified what he meant, saying that if interest rates rise, he would look to buy back government bonds at a discount.
For some reason, this left NPR befuddled:
“It’s not clear how that would work, though, since the cash-strapped government would have to borrow more money at rising interest rates to buy back its old debt. Holtz-Eakin was left scratching his head.”
It’s actually very clear how this would work. The government would borrow money at higher interest rates (it doesn’t matter if interest rates are rising), to buy back bonds whose market value is less than their nominal value. This is a very simple story, when interest rates rise, the market rise of bonds already issued falls. This would allow the government to reduce the nominal value of its outstanding debt, even if it doesn’t reduce its interest burden.
If it seems strange to people that the government would care about reducing the nominal value of its debt, then they haven’t been paying attention to policy debates in Washington over the last decade. There has been a huge amount of energy devoted to keeping down the debt-to-GDP ratio. In fact, there was a widely held view in policy circles that if the debt-to-GDP ratio exceeded 90 percent, then the economy would face a prolonged period of slow growth. This view was first espoused by Carmen Reinhart and Ken Rogoff, two prominent Harvard professors. It was frequently referenced in publications like the New York Times, Washington Post, and undoubtedly mentioned on NPR. It was also a main justification for the budget cuts put in place in 2011.
The numerator in this debt-to-GDP ratio is the nominal debt, the number that could be reduced by exactly the sort of financial engineering that Donald Trump proposed. For this reason it is difficult to understand why Trump’s proposal would have left Douglas Holtz-Eakin (a former head of the Congressional Budget Office and chief economist for George W. Bush) scratching his head.
Of course it is silly to be worried about the ratio of nominal debt to GDP, but that can’t erase the fact that this ratio has been a central concern in policy circles for some time. It doesn’t speak well of our media that they only recognize that the debt-to-GDP ratio doesn’t matter when the point is raised by Donald Trump, but not when it is raised by elite economists and top policy makers. (Erskine Bowles and Alan Simpson frequently made reference to the 90 percent figure when they chaired President Obama’s deficit commission.)
What matters much more than the ratio of debt to GDP is the ratio of interest payments to GDP. If we net out the interest refunded by the Federal Reserve Board, this ratio now stands at 0.8 percent of GDP. By comparison, it was more than 3.0 percent of GDP in the early 1990s. These numbers don’t fit the deficit crisis story widely preached in the media, but if we want to get serious, that would be the number to focus on.
Addendum:
In case you were wondering how anyone could be concerned about the ratio of nominal debt to GDP, here is NPR on the topic back in 2011.
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