Of Debt, Growth, Interest Rates and History

The blog of New York Times columnist Paul Krugman recently featured a chart plotting the U.K.’s ratio of government debt to gross domestic product against the nominal yield on long-term government bonds from about 1700 to the present. See Figure 1.

The chart appeared with this comment:

“You might think that these data, and the relationship they show -- or, actually, don’t show -- should have some impact on our current debate, especially given the tendency of many players to reject modeling and appeal to what they claim are the lessons of history. Or are they claiming that this time is different?”

It’s hard to be sure, but Krugman appears to be saying -- again -- that there’s no reason to fear that high levels of public debt might inhibit growth. The chart shows that the U.K., in the 19th century, had both high levels of debt and low-and-stable nominal interest rates. So, the message seems to be, why worry about debt? Why bother to dig any deeper?

Because the chart, interesting though it is, doesn’t get you far in understanding this issue.

To begin with, in judging the connection between debt and growth, it’s real interest rates (nominal interest rates minus inflation) that matter. If low nominal interest rates were the ticket to economic prosperity, then the Great Depression of the 1930s was a boom. Nominal interest rates in the U.S. hovered around zero during much of that decade -- while severe deflation yielded some of the highest real interest rates in U.S. history.

Debt Burden

Indisputably, high real interest rates place an added burden on debtors, whether they are households, companies or governments. So it’s important to know whether very high levels of debt are associated with high real interest rates. This is one of the questions that Vincent Reinhart, Kenneth Rogoff and I addressed in a study we published in 2012.

We examined 26 high-debt episodes between 1800 and 2011, looking both at growth rates and at levels of real interest rates. We found that in 23 of the 26 high-debt cases, growth was low as compared with the relevant country’s performance in periods when debt was less. Table 1 from that paper sets out this result. You’ll notice it makes clear that the U.K.’s high-debt episode of 1830-1868 is one of the three exceptions.

The table also makes clear that, more often than not, real interest rates were higher during the high-debt episodes. This was true in 15 cases out of the 26. The sharp rise in interest rates and public debt in the European Union’s periphery since 2008 follows this historical pattern. In four of the cases we studied (including the U.K. between 1917 and 1964), real interest rates were about the same as when debts weren’t elevated; and in another four, we found that real interest rates were actually lower during the high-debt episodes.

We noted that there was ‘‘little to suggest a systematic mapping between the largest increases in average interest rates and the largest (negative) differences in growth during the individual debt overhang episodes.” And we drew attention to the variety of circumstances that might affect the association between debt on one side and real interest rates and growth on the other. Emphasizing the salience of wartime as opposed to peacetime debt, we said this:

“More germane to the current situation are the longer peacetime debt overhangs -- for example, Belgium, Canada, Greece, Ireland, and Italy in the 1980s and 1990s, and Greece, Italy, the Netherlands, and New Zealand in an earlier era. With the exception of the United Kingdom at the height of its colonial powers in the nineteenth century, these long peacetime debt overhangs are consistently associated with lower growth (in varying degrees), irrespective of whether real interest rates rose, declined, or remained about the same.”

U.K. Experience

Much of the discussion on debt and history has focused on the U.K. experience, so a further word is in order.

First, in the post-1700 era covered in the chart, U.K. inflation ranged from a high of 37 percent a year to deflation of 25 percent. Ignoring this volatility in inflation and real interest rates suggests a financial El Dorado that would be the envy of modern-day central banks. Nominal long-term interest rates in those days were more stable precisely because inflation was more volatile and the price level tended to revert to the mean (in any given year, 10 percent inflation was about as likely as 10 percent deflation). Today it is hard to imagine that kind of volatility in real rates of return, recent crises notwithstanding.

Second, the numbers need to be handled with caution. U.K. fiscal and debt data go back to 1692, but the nominal (or real) GDP data before 1830 is tentative. Debt ratios before 1830 are therefore tentative as well.

After 1830, U.K. debt remained above 100 percent of GDP through the 1850s, as the chart shows. Far higher debt levels were recorded for the Netherlands in this period, with less benign outcomes through most of the 1800s. How were these two countries able to support such high debt loads for decades? Both played a prominent role as international financial centers; and in both cases, high public debt coexisted with high private saving. The two nations, in effect, were creditors to the rest of the world -- unlike the U.S. today.

The U.K. and the Netherlands enjoyed a substantial and well-documented transfer of resources from their colonies that no modern economy can count on. Other structural forces were in play, too: Peacetime reductions in military spending helped to reduce their debts. Today, structural forces -- notably, the fiscal demands of aging populations -- are mostly pushing the other way.

Could it be that “this time is different”? The underlying phenomenon Rogoff and I characterized in our book of that title has little to do with demographics or public debt, and more to do with human folly. People like to believe that crises happen to other people in other countries at other times. Because we are now so smart, what happened again and again in history won’t happen to us -- or so we suppose.

(Carmen M. Reinhart is Minos A. Zombanakis professor of the international financial system at Harvard University’s Kennedy School of Government. She is co-author, with Kenneth S. Rogoff, of “This Time is Different: Eight Centuries of Financial Folly.”)

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