Alright, dumb question. I understand why higher interest rates, all else being equal, increase our total debt burden. But higher interest rates are ordinarily a function of high nominal gdp growth, and lower interest rates the opposite. So why is it that a high nominal gdp growth, high interest rate equilibrium would lead to a lower debt:gdp ratio than a low interest rate low growth equilibrium?
Thank you for your question! Let me know if this clarifies things:
When the interest rate is higher than the GDP growth rate, then the debt-to-GDP ratio will increase over time, unless there is a surplus large enough to offset the interest payments. This is because debt will grow faster than GDP, which makes the debt to GDP ratio larger.
Conversely, if the interest rate is lower than the GDP growth rate, then the debt-to-GDP ratio will decrease over time, unless there is an offsetting deficit. If GDP grows faster than the debt, the debt to GDP ratio will decline.
Thanks! I’m tracking this bit. I think what I was curious about is why a long term “no-landing” type scenario (where nominal gdp growth rates are like 5-7% and interest rates ~5%) is a long term problem in a way the 2010s equilibrium (3-5% nominal growth with much lower interest rates) is not. In both scenarios growth runs higher than interest rates. Is there some expectation the fed would eventually bring the hammer in scenario 1? Or is there some weird dynamic with the way debt gets rolled over in a high interest rate environment that I’m not understanding?
There should be some expectation that the fed will eventually “bring the hammer down” in scenario 1. At some point, something is likely to disturb the equilibrium. That applies to both scenarios.
There are also some debt-rollover dynamics that make the high growth/interest rate environment dangerous. As older bonds mature and need to be refinanced at higher rates, the government may face increased pressure on its budget to cover interest payments, potentially exacerbating the debt burden over time.
Brian Riedl gives a cautionary analogy in his 2021 paper, How Higher Interest Rates Could Push Washington Toward a Federal Debt Crisis, on a related idea: “An analogy would be a football team that managed to improve its overall win–loss record over several seasons—despite a rapidly worsening defense—because its offense kept improving enough to barely outscore its opponents. Claiming that the wins prove that defense no longer matters, or should be allowed to continue declining on the assumption that the offense will simply continue to improve even faster, is obviously unwise.”
Alright, dumb question. I understand why higher interest rates, all else being equal, increase our total debt burden. But higher interest rates are ordinarily a function of high nominal gdp growth, and lower interest rates the opposite. So why is it that a high nominal gdp growth, high interest rate equilibrium would lead to a lower debt:gdp ratio than a low interest rate low growth equilibrium?
Thank you for your question! Let me know if this clarifies things:
When the interest rate is higher than the GDP growth rate, then the debt-to-GDP ratio will increase over time, unless there is a surplus large enough to offset the interest payments. This is because debt will grow faster than GDP, which makes the debt to GDP ratio larger.
Conversely, if the interest rate is lower than the GDP growth rate, then the debt-to-GDP ratio will decrease over time, unless there is an offsetting deficit. If GDP grows faster than the debt, the debt to GDP ratio will decline.
Thanks! I’m tracking this bit. I think what I was curious about is why a long term “no-landing” type scenario (where nominal gdp growth rates are like 5-7% and interest rates ~5%) is a long term problem in a way the 2010s equilibrium (3-5% nominal growth with much lower interest rates) is not. In both scenarios growth runs higher than interest rates. Is there some expectation the fed would eventually bring the hammer in scenario 1? Or is there some weird dynamic with the way debt gets rolled over in a high interest rate environment that I’m not understanding?
Thanks for taking the time to respond!
There should be some expectation that the fed will eventually “bring the hammer down” in scenario 1. At some point, something is likely to disturb the equilibrium. That applies to both scenarios.
There are also some debt-rollover dynamics that make the high growth/interest rate environment dangerous. As older bonds mature and need to be refinanced at higher rates, the government may face increased pressure on its budget to cover interest payments, potentially exacerbating the debt burden over time.
Brian Riedl gives a cautionary analogy in his 2021 paper, How Higher Interest Rates Could Push Washington Toward a Federal Debt Crisis, on a related idea: “An analogy would be a football team that managed to improve its overall win–loss record over several seasons—despite a rapidly worsening defense—because its offense kept improving enough to barely outscore its opponents. Claiming that the wins prove that defense no longer matters, or should be allowed to continue declining on the assumption that the offense will simply continue to improve even faster, is obviously unwise.”
Thanks for the response. Appreciate it guys. Love the Substack.
Dammit. Typo. My question is why would it lead to a *higher (not lower) debt:gdp ratio.