Sunday, August 25, 2013

Can You Solve A Debt Problem With More Debt?

It is often said — particularly in Austerian circles, and most recently by British Prime Minister David Cameron — that “you can’t solve a debt problem with more debt”. 

This is, I think, an entirely tautological definition. It is definitional that you can’t solve a drowning problem with more water. You can’t solve a burning problem with more fire. But what exactly is a debt problem? What does that even mean? Austerians seem to think that it means rising levels of debt, and those that charge that we have a debt problem often use scary-looking non-inflation adjusted charts that show soaring levels of nominal debt as an illustration that debt levels are out of control:


But that is not the same as a debt problem. As Frances Coppola notes, unless the level of debt is shown as a proportion of total economic activity, a nominal debt figure is totally meaningless. And as a proportion of GDP, British government debt levels are very low relative to the historical norm:



That tiny blip upward toward the end is what David Cameron calls a “debt problem”? Seriously? Yes, debt levels have reached new nominal highs, but those nominal highs are supported by a proportionately larger level of nominal economic activity. Using the current British situation as an example of a “debt problem” is intellectually dishonest — and using this totally arbitrary definition of a “debt problem” as a justification for austerity doubly so.

Yet even debt as a percentage of economic activity is not flexible enough to really define a “debt problem”. Reinhart & Rogoff's 90% threshold for lowered growth is dead; every country and situation is different. The truest kind of "debt problem" is a solvency crisis, where a debtor can no longer service its debts and thus forced deleveraging. Of course, before hitting a solvency crisis there are warning signs. The best measure of a growing “debt problem” is interest rates. Rising interest rates — like we see in Greece, and to a lesser extent Italy, Spain and Portugal would indicate falling confidence in the government’s ability to repay its debts in a timely and non-inflationary fashion. Yet that is not what we see today in Britain. 

Quite the opposite:


Interest rates on government debt are still close to all-time lows. So, the notion that the British government has a debt problem is not just wrong, but absurd. Cameron is just repeating unrealistic assumptions in the face of massive evidence to the contrary. The relevant aphorism here is not “you can’t solve a debt problem with more debt”, but “you can’t solve a derp problem with more derp”.


In the private sector, we see something much more like the aftermath of a debt problem —  mass deleveraging. In 2008 private sector debt in many Western nations including the USA and the UK hit all-time highs as a percentage of GDP, and since then both nations’ private sectors have been deleveraging. This has depressed private investment and consumption. In this context, the UK does have an unemployment problem, with over 8% unemployment for most of the last five years and currently over 2.51 million individuals looking for work. This is a serious market failure, and evidence shows that the long-term effects of mass unemployment are deleterious and lingering.That problem could easily be solved with more borrowing and job creation, using debt-financed fiscal policy to bring down unemployment until the private sector begins expanding again. This would kill multiple birds with one stone, as evidence shows both the US and the UK are chronically under-invested in infrastructure

58 comments:

  1. Yea this is nothing new, or at least outside of the doom & gloom blogosphere where bond-based hyperinflation is just around the corner. This is the only thing which I agree with Krugman in that America is not Greece and the bank bailouts & QE was a success despite all the criticism. The debt binge is here to stay and isn't going to sink the economy.

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    1. Assuming of course the borrower determines the interest rate, which they cannot. Blissfully pretending the market will not eventually demand higher interest rates is a game for fools. The FRED chart correlates exactly with any chart showing interest rates. Coincidence? It doesn't take a rocket scientist (or economist) to figure out what the charts will look like when rates rise, (particularly given the ballooning principle borrowed.)

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  2. Sharkbite4:34 AM

    Excellent article, learned something new today especially about debt-to-GDP as being the key indicator.

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    1. Why use only debt to GDP? Why not use debt to revenues? Both are current budget pay-as-you-go items.
      And, whatever happened to principal? We act as if this is a low interest loan, with no principal?
      Don Levit

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    2. Anonymous8:39 AM

      Nah, even the debt to GDP ratio is flawed (its used all the time by the austerity crowd) since it doesn't actually tell stuff about interest rates as John mentioned in fact once adjusted for inflation they are negative (I.E IT IS CHEAPER FOR THE UK GOVERNMENT TO BORROW THAN TO TAX

      Don's also right about principal, wealth is key, Britain's private debt is huge well over 100% of GDP, except its mostly mortgages to buy its inanely expensive housing stock which also well over 100% of GDP.

      Maturity the fact that Britain's average bond payment time is over ten years is a huge factor in why we are not Greece or Italy which have far shorter maturities. Think ten years to grow and inflate debt away before it has to be paid or rolled over.

      income/gdp growth and inflation, thanks to these its actually really to pay down debt quickly as they make nominal debt contracts (most of the UK bonds are not inflation protect and those that are have negative interest rates).

      We need a better measure of debt burden than this, something that thinks about the actual pressure on our resources/incomes a debt stock. If huge debts meant penury, then Britain in the 1800's should have been a basket case not the first industrialised nation in the history of man and the 1950-60's should have never been an era that a prime minister could remark "you've never had it so good".

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  3. This is a good rebuttal to that annoying pro-austerity meme. While this was addressed back in the '09 transatlantic fiscal stimulus debate, I'm glad to see that it's coming up again. I take it as a sign that soon we'll be talking fiscal stimulus options again :)

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  4. The Bank of England has been buying UK government "Gilts" in recent years, thus manipulating the interest rate to a lower value than the market value. This means interest rates are not a valid indicator of anything anymore.

    http://en.wikipedia.org/wiki/Goodhart%27s_law

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    1. The chart shows that gilt yields have been on a continual downwards trend since the early 1980s. Recent gilt purchases appear if anything to have pushed yields up slightly.

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    2. The UK buying gilts is a market operation, not market rigging. The demand for gilts is changed by intervention, but you still get an actual curve, not just a blank picture with a caption saying "government operating in this market, market doesn't indicate anything".

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    3. And if the UK decided to buy up all the milk in the country to 50 pounds per gallon, that would be a market operation aswell. This indicates a lot about the market force of government, but little about expectations and efficient pricing.

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  5. John S6:00 AM

    Isn't the relevant measure debt-to-govt income, rather than debt-to-GDP?

    http://econlog.econlib.org/archives/2013/01/how_i_was_wrong.html

    http://www.businessinsider.com/dept-to-gdp-revenue-2010-8

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    1. John S6:09 AM

      Back of the envelope for US:

      $16.8 trillion debt / $2.5 trillion tax revenue = 672%

      http://en.wikipedia.org/wiki/National_debt_of_the_United_States

      http://en.wikipedia.org/wiki/File:U.S._Federal_Receipts_-_FY_2007.png

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    2. Government income is adaptable based on the tax rate, and is very sensitive to business cycles. We don't know precisely what the Laffer curve will look like for any given country, but ultimately GDP is the better indicator because it gives the clearest indication of the present potential tax base.

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    3. John S6:24 AM

      What's your take on Japan and stimulus spending? In my view, it doesn't seem to be a home run solution.

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    4. Anonymous7:23 AM

      John,

      "Isn't the relevant measure debt-to-govt income, rather than debt-to-GDP?"
      --- How about debt-to-private wealth. As far as I can recall, Italians' private wealth is about 7 times her GDP. Germans' wealth is just 4 times GDP.
      The fiscal constrains for a nation issuing her own currency are real (e.g., inflation, productivity...) not financial.

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    5. John — Japan has massive other problems, namely demographics and a rigid and inflexible economy. No amount of fiscal or monetary stimulus can make this disappear.

      Anonymous — Private wealth isn't what I'd consider a taxable base, at least not under normal circumstances...

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    6. John S8:24 AM

      A good point. But when looking at private wealth, I think we need to distinguish btw non-financial and financial assets (i.e. housing). I'm not quite sure why Italy has such a large portion of non-financial assets, but its net financial wealth comes to 2.6 times disposable income while net total wealth is 8.5 times disposable income.

      http://www.oecd-ilibrary.org/docserver/download/190200151e1t006.pdf?expires=1377432907&id=id&accname=freeContent&checksum=3E6931A48C35EF9091EE8E861F2290B1

      This seems to explain some of the discrepancy:

      "A large part of the huge difference can be explained by the fact that only 44.2% of Germans live in their own home, compared to 82.7% of Spaniards and 68.4% of Italians."

      http://research.nordeamarkets.com/en/2013/03/22/wealthy-germany-and-even-more-wealthy-italy-and-spain/

      But you're certainly right that wealth matters, too.

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    7. John S8:43 AM

      Aziz,

      Right, private wealth isn't directly taxable (not yet, anyway). But the issue of private wealth does seem to matter w.r.t. questions of fairness over who should bear the burden of Eurozone public debt and bailouts--creditor nations (Germany) or the relatively wealthier debtor nations (Spain, Italy)?

      Also, I wonder what you make of an old post of yours about European int rates (I don't mean this as a "gotcha"; one's thinking can certainly evolve, and currently I'm in the midst of reconsidering Austrian business cycle theory myself).

      However, it at least seems plausible to me that the "artificial" harmonization of long-term rates in Europe following the introduction of the Euro led to credit expansion getting out of whack with actual economic conditions and could have led to an Austrian-style credit/housing boom in the PIIGS which led to a bust when the "true fiscal pictures" were revealed.

      http://azizonomics.com/2011/12/14/artificially-low-interest-rates-in-europe/

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    8. I hardly find it calming that the government having the ace in its sleeve to confiscate all private property and enslave the entire population through high taxation to be your argument. We have a major problem far far before those become constraints.

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    9. John —

      Also, I wonder what you make of an old post of yours about European int rates (I don't mean this as a "gotcha"; one's thinking can certainly evolve, and currently I'm in the midst of reconsidering Austrian business cycle theory myself).

      I remember that post, and while I reject the terminology I use — specifically, the term "artificially low interest rates", because I see interest rates as always determined by economic agencies and not the legal framework, I stand by the ideas expressed in it. The Euro currency area made investors and governments blind to the risks of the Euro system — namely, monetary union without fiscal union, and the lack of a lender of last resort without any force. This is a similar phenomenon to South Americans borrowing in dollars, while their actual economy is in their domestic currency. Both examples market participants deluded themselves into a false sense of security.

      Curt — It would be highly silly for government to start confiscating wealth as opposed to taxing activity as a means to staying solvent. It would totally undermine any notion of protection for property rights. That could be a very damaging political externality to incentives and activity.

      On the other hand, a tax on economic activity is almost certainly ceteris paribus a disincentive toward economic activity. So it is a good idea to try and look at alternatives to taxes on income (maybe replacing income taxes with land taxes or even carbon taxes, or something). But wealth taxes are not the right alternative, in my view.

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    10. Anonymous3:59 AM

      "... the term "artificially low interest rates", because I see interest rates as always determined by economic agencies and not the legal framework, I stand by the ideas expressed in it. The Euro currency area made investors and governments blind to the risks of the Euro system — namely, monetary union without fiscal union, and the lack of a lender of last resort without any force."
      I am afraid that you are playing with words. The "artificially low interest rates" is an accurate expression, if you mean what is usual to mean, i.e: artificially low RISK-FREE interest rates.
      And, in the final paragraph: Isn't a land tax a wealth tax?
      @Curt: there are a lot of ways of enslaving population currently in motion in these countries (plunging wages, bankruptcies,...). We are not afraid of a new one through high wealth taxation.

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    11. John S
      I really need to bang people on the head with this more often. "Housing" booms are not "housing" booms. They are LAND PRICE booms. It makes the world of difference, particularly when "Austrians" start going on about it. In the US for instance, based on historical averages there is now a SHORTAGE of housing in the US.

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    12. John Aziz
      "On the other hand, a tax on economic activity is almost certainly ceteris paribus a disincentive toward economic activity."

      I don't think this is at all clear. Income and substitution effects operate in opposite directions.

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    13. Anonymous4:39 AM

      @John
      I don't see why a wealth taxes should be any worse wrt incentives/activities than activity taxes. Framing them as "confiscating wealth" seems to me as silly as framing labour taxes as "forced partial slavery".

      A number of wealthy countries already have explicit net wealth taxes in place: http://en.wikipedia.org/wiki/Wealth_tax#Existing_net_wealth.2Fworth_taxes and don't seem much worse for it. And of course the specialized form of property taxes is extremely widespread world wide.

      The main problems with wealth taxes are practical, rather than principle: apart from property, most wealth is very flighty (much more so than labour or consumption), so raising significant amount of revenues through this channel is hard.

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    14. And ceterus is almost never paribas - particularly in macro-economics.

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    15. Anonymous - yes, and taxes and wealth definitely and unambiguously increase the incentive to use the wealth productively (e.g. Henry George on ULV taxes), but as you say stopping the wealth from fleeing the country can sometimes be a problem. Wealth is also more difficult to define, because the value is very volatile, and not always knowable (illiquid markets, unique items).

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    16. John S6:46 AM

      reason,

      A Georgist land tax may or may not be a good idea--I haven't looked into it much.

      What I do know is that "I really need to bang people on the head with this" isn't the best phrase to start off with when trying to persuade someone of your ideas. At least not with me.

      Anonymous--agree that wealth taxes shouldn't be ruled out a priori in favor of income or consumption taxes. It's a complicated issue, though. It was a topic-of-the-day in the blogosphere a while ago.

      http://blog.supplysideliberal.com/post/26413855704/is-taxing-capital-ok

      http://esoltas.blogspot.kr/2013/03/why-we-dont-tax-wealth.html

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    17. John S
      Well it seems you at least didn't ignore the post. And convincing you is not necessarily my primary aim.

      I'm not the only one pointing this out by the way - Karl Smith made a point of it several times.

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  6. If you want to attack the Austerian metaphors:

    "It is definitional that you can’t solve a drowning problem with more water."

    If you are drowning in a pit you can't climb out of, more water can float you out the top.

    "You can’t solve a burning problem with more fire."

    Combatting forest fires is often done with back fires.

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    1. >> Combatting forest fires is often done with back fires.

      Yeah, that one jumped out at me as well. And it's a particularly nice example: The solution is counter-intuitive, so people resist it because it "doesn't make sense". But experience and evidence is overwhelming that this can be an impressive part of fire containment and control.

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  7. Anonymous7:38 AM

    Not a very convincing article.

    Obviously the debt peaks in the UK were caused by WWI and WWII.

    Has the author not noticed the impact of those two wars, and their associated debt, on the UK? It resulted in the total collapse of British power.

    The British debt pile is currently growing at around £100 billion a year, GDP at maybe £30 or £40 billion a year. That is not sustainable.

    And as for low gilt yields, I would imagine that people in Greece a few years ago, when Greece had to pay only a few basis points more than Germany to borrow, were also telling others not to worry about the Greek debt problem.

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    1. This comment has been removed by the author.

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    2. Total collapse of British power?

      Which is why the UK is still in the top 10 countries in the world by GDP with a first-world standard of living, and a full welfare state even though it is a relatively small island? Why it still has a UN security council seat, and nuclear weapons?

      No, there was no total collapse of British power, and the relative decline of British is not attributable to high levels of debt. You're getting the causality backward. It's attributable to reversion to the mean. Britain was always a small country, and for it to be a superpower was a historical accident resulting from the industrial revolution. It is no surprise that a larger power took over the role. So the high levels of debt were a result of a small country like Britain trying to punch above its weight on the world stage. The fact that they were sustainable and reducible under a gold standard even in the context of Britain's relative decline from power illustrates that fearmongering over current debt levels is nonsensical.

      Moreover, the reference to Greece is silly because Greece is not a monetary sovereign — it gave up its currency and ability to lubricate its debts away with inflation, which Britain still has.

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    3. "Greece.....gave up its currency and ability to lubricate its debts away with inflation, which Britain still has."

      Not really. While I did not agree with much of what Mrs Thatcher claimed to stand for, one thing she got right was "you can't buck the market". While probably not the same individuals, British borrowers paid for the inflationary reduction of their debts in the form of higher interest rates for years afterwards. In the short-term, inflation transfers wealth from the holders of money claims to shorts in money claims; in the long run, it transfers wealth from tomorrow's borrowers to today's. That is why David Cameron is right that Britain has a debt problem, but I doubt whether he will be contemplating taxing his supporters to fix it!

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    4. You can't buck the market runs both ways. If you have a depressed economy, with investors and savers both reaching for yield and desperate for anything which can provide a higher yield than cash, then rates are going to stay low and the debt sustainable no matter how much David Cameron prattles about a debt problem.

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    5. True, but the average maturity of UK gilts is about 15 years, and the effective maturity of UK state debt is even less if you allow for the fact that some gilts have been swapped for floating rate (reserves) debt by the BoE. So the debt is not going away but its sustainability might. Ideally, the UK should be issuing new undated debt, but then the cost would not be so low.

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    6. Anonymous12:49 AM

      @John Aziz

      Nice set of rationalizations for the collapse of the British Empire post-WWII, total surrender to the US, 50 years of "austerity" to pay off WWII debt, repeated sterling crises, and so on.

      But the UK has nukes. Must be thanks to all the debt.

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  8. Now that we have learned "That problem could easily be solved with more borrowing and job creation, using debt-financed fiscal policy", please suggest the method of accomplishing this.

    We could simply give higher wages to government employees. That would give a result. We could also sponsor additional government paid programs which would give a different result.

    Even higher rates of money supply creation will change the ratio of average-individual-money-ownership to supply-limited-assets at a higher rate, which some people will call inflation. The relative effects between population segments will be unequal, with different results.

    Yes, we need a change of government policy, but to only criticize the language describing the problem does nothing to suggest practical solutions and anticipated future wealth distributions.

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    1. Anonymous12:37 PM

      The "easy" solution is to inflate away the debt that can't make us poorer because we owe it to ourselves anyway. Wait, what?

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  9. Money is gold. Debt is sin. Austerity is penance. Penance can work the remission of temporal punishment, and act as a channel of grace.

    And you can't refute a theology.

    The problem isn't the Austrians per se. The problem is the macroeconomic intuition of the typical leader of an OECD country, and even more so of its average citizen, is still pretty much that of a 14th c. Burgundian peasant.

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    1. 1) That's not a tautology.
      2) Money is not gold. Money is 1) A unit of account, 2) A store of value, and 3) a medium of exchange.


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    2. Austerity is when people live a life of minimal luxury, avoid excessive consumption, maintain self discipline, eschew ornamentation and abstain from indulgence.

      I know this because I consulted the dictionary.

      Government spending is an unrelated concept.

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    3. Tel - very good. I might also add that what is normally meant as government austerity seems to be very selective in its impact. It also IMPLIES that SOME people must do the opposite of austerity, if the economy is to improve as a result.

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  10. Anonymous12:20 PM

    The linked chart from the economist shows that U.K. debt (counting both public and private debt) rose steadily from 200% of GDP in 1990 to 500% of GDP in 2008.

    Since 2008, this growth in debt/gdp has flatlined, and so has the U.K. economy. Your post argues that the problem with the U.K. economy is that this metric stopped growing, and government should borrow to make it grow again.

    But surely there must be a limit somewhere? Debt as a percentage of GDP can't rise forever, can it? Surely the U.K. can reduce debt and have strong economic growth at the same time?

    I wonder if you created this misleading post simply because you were confused, or because the alternative to ever increasing debt ratios is printing (non interest bearing) money and this is always treated as a monster under the bed that must be ignored rather than treated as an obvious solution to the combined woes of too much debt and a weak economy.

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    1. U.K. debt (counting both public and private debt) rose steadily from 200% of GDP in 1990 to 500% of GDP in 2008.

      Part of that increase is almost certainly the result of structural changes in the debt markets with the introduction of intermediaries having the result that debt gets double or triple counted. For example: if I deposited $100,000 to a bank in 1990 and the bank lent that money to my neighbor on a mortgage that would have been $200,000 in debt. If I deposit the money in 2008 and my bank goes out and buys an MBS from a bank that lends the money to my neighbor, now we have $300,000 in total debt.

      Every hedge fund which borrowed to invest in debt instruments, every money market fund would serve to artificially inflate the total debt.

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    2. Your post argues that the problem with the U.K. economy is that this metric stopped growing, and government should borrow to make it grow again.

      My post argues no such thing. I would prefer the total debt/GDP (TCMDO) ratio to be flat or falling. I'm much more concerned about the denominator, which hasn't been growing.

      But surely there must be a limit somewhere? Debt as a percentage of GDP can't rise forever, can it? Surely the U.K. can reduce debt and have strong economic growth at the same time?

      The key is the ratio, not the absolute figure. Nominally, debt can rise forever sustainably. In real terms — denominated in terms of GDP — it needs to be made sustainable. The best way to do this is to grow the denominator.

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  11. Surely the U.K. can reduce debt and have strong economic growth at the same time?

    Yes, if you have full employment and strong gains in TFP (technology shocks?) the GDP will soar, and the debt will take care of itself. This is what occurred in Britain from the '50s to the '70s.

    We can't nurse TFP, but we can have full-employment policies...

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    1. We can't nurse TFP

      Sure you can. Education, infrastructure, scientific research, regulatory reform can all boost TFP. You can spend money in ways you hope will increase TFP or you can helicopter drop the same money for make work projects hoping that the mere injection of money will revive the economy. I think targeting TFP is the better way to go - at worst it turns into a helicopter drop.

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    2. We can target TFP with the policies you mentioned, but there's no definitional way to increase it as there is with, say, employment.

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  12. Anonymous2:40 PM

    EXCELLENT post - you're the "troll slayer" for a reason. You very succinctly decimated the entire stupidity of that argument in a very concise, easy-to-understand format. POST MORE!

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  13. Anonymous7:53 PM

    Note to Aziz: Most of us come here for the cool pics! Bad Aziz!!

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  14. Anonymous12:52 AM

    UK councils could hire the unemployed to spy on and generally supervise the employed. Snap--prosperity! It worked for the Soviets.

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  15. Rothosen1:07 AM

    So if the government forgave all student loans and took them on as additional debt, then all those late twenty year olds could move out of their parents basements, buy houses, frigerators, washers and dyers, stimulating the economy to greater heights.
    I think you're on to something.

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  16. You don't distinguish clearly enough between public and private debt. This difference is important and just treating them as interchangeable is a large part of the problem. If you graph private debt versus private wealth excluding private debt (i.e mostly land and house values and equity) you get are more interesting picture.

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  17. Christian Mannhood6:25 AM

    Don't they set back fires to fight forest fires?

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    1. Anonymous2:57 PM

      Don't they pour gasoline on forest fires from helicopters?

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  18. Anonymous1:13 PM

    Also oil well fires, if you make a big explosion you can use up all the oxygen and starve the fire.

    Right wingers were all about "growing our way out of debt" when the money was getting spent on stuff they wanted...

    There's a sincerity problem here as to the extent to which leaders actually think that the things they say are correct, which seems more problematic than their positions on any single issue.

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