Debt and economic growth

What is the impact of higher debt on economic growth? This is not an easy to answer question. Some analysts will have you believe that debt, and here I am referring to government debt, is either bad for growth or good for growth. These thoughts about debt can be summarised under mainly three ideologies:

·         Barro-Ricardian: Indifferent between taxes and government debt; households only care about  present discounted value taxes

·         Keynesian: Debt can be welfare enhancing increasing both current and future consumption

·         Neoclassical: Debt reduction has positive effects on investment through lower interest rates

My personal view is that debt on growth incorporates all three views with some views being stronger under certain conditions. Economists often use a solvency rule for analysing whether government debt is sustainable. This solvency rule inherently assumes that debt cannot be rolled over and that there is a point at which any change in government finance decisions cannot curb the growth in debt. In other words you will perpetually borrow more funds to finance maturing debt or you will simply have to default.

There are good reasons why government debt can be bad. Funds used for financing higher debt service costs could have been used to do something more productive. Higher debt, if perceived unsustainable, can lead to massive capital outflows - thus a reduction in foreign investment. Often higher interest rates are required to attract additional financing which increases debt service costs even more.

But, debt can also be good. Especially if government borrowed funds to be more productive - i.e. there is a future return for the borrowed funds.

We can then see that debt has a direct impact on growth only in the way expectations are formed. Debt itself  does not necessarily add or subtract to growth since debt is only an accumulation of public finances (public finances directly affect growth). These expectations create investor fears and confidence, which leads investors to either to purchase government bonds or to sell them or not to purchase new bonds.

Simple figures or simple statistical tests often inform people's views on debt. Take as an example a simple scatter plot of South African debt and economic growth since 1980 - It shows that the level of debt is associated with positive economic growth (if you plot a trend line through the bubbles). On average it would seem that higher debt is associated with increasing GDP growth. But using such simple figures would be a very misleading representation of the effects of debt on growth. Some authors (just read about the recent Reinhart and Rogoff controversy) suggest that such figures, accounting for many cross countries and a long enough history, show us meaningful results. It must be added that these attacks ignore a lot of the other good research (and more serious research for that matter) that Reinhart and Rogoff have done. The point that I am trying to make is that we cannot simply infer relationships between any two variables without knowing whether other common factors influence debt and GDP while also controlling for possible feedback loops between debt and GDP -  debt, interest rates and economic growth are endogenous - that means that they influence each other: Higher debt accumulated through government investment programs can increase economic growth while higher economic growth makes it easier to finance debt. Higher debt levels are associated with higher debt service costs which are linked to a risk premium (given that debt increases), but at the same time higher interest rates increases debt (this is if monetary policy has interest rates rising). Thus one needs to properly account for the future path of all these variables in a simultaneous setup to determine whether debt is truly sustainable. This is exactly why looking at the aggregate debt level is wrong - one needs to analyse the composition of debt and all its contingent liabilities (as an example if Eskom defaults then government guarantees will finance the default).

Figure 1: Government debt and economic growth

Or you can use more fancy statistical techniques that tell you at which point debt will have a negative impact on growth - smells like a Laffer curve:

Figure 2: Simple growth regression with debt and debt square

If one were to believe the results of Figure 2 it would suggest that a debt to GDP ratio higher than 42% would lead to less economic growth.

Unfortunately the past is not always a good predictor of the future (and these figures and econometric tests all depend on data collected from the past). If that were the case then we would be able to predict recessions! So using simple Figures and statistics are not that useful in determining debt sustainable.

While debt sustainability is certainly part of solvency calculations, it is the role of expectations that are important: Let's say you want to invest your hard earned cash in government bonds - most likely you will look for a good  and safe return (remember you are a risk averse investor) with a degree of certainty that you will get your principal and the interest back when the bond reaches some date (bond maturity). Your views on good returns are informed by the monetary policy interest rate and a certain risk premium (the risk premium is some kind of incentive that the government pays you for purchasing a bond - this is linked to the probability of default). The higher the probability that government will default on its debt obligations, the higher the risk premium (here measured as simply the yield on government bonds). And here is the tricky part - what actually informs the probability of default? 

Rating agencies use various probability models to tell us how safe our debt is...but just what makes one country's debt more sustainable than another? Why can Japan have debt well over 100% to GDP, have very small GDP growth numbers while other emerging market countries run a risk when debt exceeds 60% of GDP. Are the Japanese better at paying back the principle and interest rate than South Africa? Both countries finance the majority of their debt domestically and thus avoids currency risks and sudden stops in capital flows. Both countries print their own money, but South Africa has higher inflation which decreases the real value of debt over time while Japan has long periods of negative inflation which increases the real value of debt over time. Once again it would seem like expectations is the main character  in making debt sustainable or unsustainable. 

While this blog entry does not advocate that any country ramp up debt, it does question the views of the market on debt sustainability. It is obvious that if governments ramp up debt with no expected return tax payers will finance the debt and receive nothing in return...when debt runs away at crazy interest rates that are required to finance debt service costs then people might have to make crazy adjustments by paying higher tax rates up until the point where the country is forced to default. But at which point is debt unsustainable? I don't think rating agencies have this right either. Like any good financial investor, a future bond holder should analyse the reasons for why debt is accumulated - ff it is simply to finance transfers or higher government wages then there is a good possibility that government won't make a return. Unless higher wages translate into higher savings which are used for investment purposes.

In essence, the issue regarding the effect of debt on growth seems to be somewhat stupid since we cannot truly measure expectations - we just see it after the fact (higher credit spreads, capital outflows etc.). And we cannot understand expectations completely because they are even different for countries with similar economic conditions. Perhaps the closest we can get is that people follow sometimes silly rating agencies - and these guys might influence expectations. But you can already see some kind of decoupling of expectations to ratings: after the recent SA bond downgrade yields and credit default spreads hardly increased.

And SA has actually done a good job - a majority of debt has been accumulated to finance investment projects. It is up to the government and us to tell us what the expected returns of these projects are. But for now I would not worry about SA debt being unsustainable or whether it is hurting economic growth ;0)

Why do we feel so lonely and so empty?

We live in a world where technology makes life easier. We live in a world where entertainment takes away the lonely nights. We live in a world that defines a set of rules in order for mankind to succeed. Yet, we live in this world feeling empty. We live in this world in isolation. Hardly anyone questions the design of the world. Have you for one instance thought about the concepts we value so much like money, prestige and importance. All three are illusions that build up the image of the self. We have been living a lie and our souls know it. Our minds have accepted these lies. This is called confirmation bias. The world throws out a theory and the standard reaction of the mind is to accept that theory. As soon as a few accept that theory we are introduced to herd bias. And so we form cultural trends and rules for everyday "successful" living. We earn a living from something that has no value. Money is linked to a statutory input and for some reason we believe that a note carries the power to purchase something that is tangible. We drive "fancy" cars. Just why is a car "fancy"? Is it because it has leather seats? Why do we think leather seats are fancy? Is it because of resource scarcity? And so we can question mainly everything that has wealth, power or status attached to it. Most of us don't do anything valuable with our hands. We simply think about things, make sums, write computer code...but we are not really contributing to making society a better place. Of course a better society can be subjectively interpreted. But here I simply mean that a better society is one that has substance to it, where we care for everyone and put the needs of others before the self, and one strives for the eternal rather than the temporary. The eternal here is harmony with God and man (you don't have to agree with this definition). We have set up an image of what man ought to be. This image has been refined through the ages. And through the ages this image has become more perverted and more hollow. We strive to be like this image and we call him the Super Human. In essence he is god. And so we replace one form of idol worship with another, but this time it is the image of man.

So instead of becoming ourselves, we lose ourselves by trying to become something that we are not. In fact, we would do anything to become that image. We want to become something completely imaginary. Yet by doing this we have become simply empty. There is no joy in that. We worry about the most ridiculous things just because we have not become that image. We fool ourselves by thinking we have control over our future, and because of this we constantly worry about tomorrow. Our pride, our self-importance has betrayed us in the deepest sense.  The Bible has it right, for you to gain life you need to lose your life. You need to become less of yourself and let God take control. I really believe this is the natural order of things. Thus, in order for you to really become yourself you need to let go of yourself.

How does one do this? Through learning and working really hard at it, but most of all relying on God who started good in you to see it to the end.

Once again Kierkegaard points us to the Bible. He tells us to humble ourselves and learn from the lilies in the field and the birds in the sky. They are joyful and are joy themselves. They have joy because they are exactly what they are - lilies and birds. They are completely obedient and this obedience leads to joy. They are completely obedient because they just live like they are suppose to. They do this in everything that they do, whether it is basking in the sun, singing while building a nest or even withering under sever conditions, they do so in a joyous fashion.

We are an unhappy species because we over-complicate matters. We are suppose to be just humans and nothing more. You cannot be God, you cannot be supreme ruler, you cannot be the most important and you are definitely not immortal. Yet we toil and spin to gain an illusory place in this world.  By knowing what we are not we can come get somewhat closer to what we are. But in the affirmative, we are simply God's representatives on earth. We are suppose to create order when disorder appears. We are to make beautiful the things that have become ugly. But, most of all, we ought to glorify God. When God tells us to put our worries and troubles on Him, who then are we to disobey? Have we become something that we are not - have we become our own creators? We can only be human and nothing more. The sooner we accept this the quicker we will let go of silly and empty pursuits. Only then can we become, like the lily and the bird, joyful. Once again, the cure for despair is becoming oneself through God. There is nothing more to it than that. It is rather simple. We have just blurred this process.

So, are we too far down the rabbit hole? Have we reached the point of no return? Have we lost ourselves completely never to be found again? We are definitely bound by the world's rules, but only in flesh. Our souls are still free only if it/we wills/will it. Slowly but surely the fake identity of the world will lie exposed, and then your heart will turn from it because it is just so damn ugly. All of this reminds me of the matrix - the red or the blue pill kind of choice. We have lost ourselves only because we let go of God. Thankfully God calls us to Him no matter how many times we have rejected Him. Kierkegaard yells from the grave: let the lily and the bird be your master and learn from them. Be yourself as the lily is simply a lily and the bird simply a bird. 

Statistics is a strange subject. Its purpose is to provide insights into many subjects. Yet, it provides only confusion. From classical statistics to Bayesian methods, the constant contrasts confuse so many. But, it shows just how beautiful our world is. It illustrates the world as part deterministic and part random. We model our finances, behaviour and simple tasks according to a set of statistical principles. Any event occurs with a probability and this probability is assumed to stem from some distribution. With many years of data the true data distribution reveals itself, but even with less observations we are able to assume this distribution and run many experiments.

But, it is also very frightening. Government policies are often made based on these statistical outcomes. Various surveys inform policy makers how much expenditure should be allocated to various population groups or to various states. Thus, not surprisingly, these surveys should conform to the strictest scientific rigour. This is unfortunately not always the case. The South African Statistics authority (Statistics South Africa or StatsSA) recently fired two of its Census statisticians on the basis of gross incompetence. This is based on results from a post census survey which measure how many people were not surveyed. The original results suggested something like 18% of the population (that is a massive number) which was changed to something like 14% after the Statistician General (SG) contended the original results. He said that he applied his logic and saw that the algebra did not make sense. Yet news papers only published the views of the Statistician General without getting the comments from the fired employees. There is seriously something fishy here:

• Jairo Arrow (the statistician originally in charge of the post census) has received many awards for outstanding service by the SG, but is now suddenly deemed incompetent
• The SG should be embarrassed for making premature statements regarding a single digit under-count
• The SG does not show how he applied his "logic" and "algebra" to the results   
• Experts at UCT also question the survey results, but this is met with laughter and a dismissal from the SG
• A 14% under-count is not very reliable to make informed policy decisions
• The SG handled the matter very poorly by quickly going to the press and blaming others for mistakes

Statistics in the hands of bullies is dangerous. To clear this mess up the Census methods and data should be made available for proper and professional scrutiny. The SG is quick to say that the Census results are good and a true reflection. I have my doubts however given the way things unraveled post Census. 

Perspective found in quiet evenings

We don't stand still. Our minds are beehives that are distracted by functions. The busy toil of everyday living impedes our ability to understand life. As a consequence we become mere drones whose sole purpose is to maximise over a grid of decisions. If only this grid was a vast field of endless possibility, then perhaps we would have expressed our desires in a way that is more soothing to the soul. This two dimensional constraint in which we operate allows us limited movement. We can only maximise over a set of combinations, which for some might seem infinite. It is strange that we cannot construct something truly unique and original. The best that we can do is combine existing elements into a form that serves a particular function. Yet, by being able to move above, or below the two dimensional space we might find something extraordinary.

Life becomes boring. We experience both failure and success in various degrees. And since we seem to enjoy success so much, and are even more averse towards failure, we do everything to succeed. How futile our existence to strive for success when we don't even really benefit from it. If you want to make a success out of work you sacrifice peace and family. If you want to be a great writer you must work hard at writing well and be able to sell a story only to worry whether you are a good writer. We toil and spin and learn nothing from the wise men. We get excellent examples of how to live life. The Bible tells us to observe the lilies in the field and the birds in the air. They neither toil nor spin. They do what comes naturally to them and cannot worry about the future. Yet we continuously define our success, or failure, in terms of human dictates.

What I miss most in life is quiet evenings outdoors where the sky is dark yet filled by little lights. I miss those evenings because it is quiet and my mind finds rest. My prayer becomes silence and all that remains is me waiting upon God. I feel Him walk beside me and I feel His presence calming my soul. Only then do I get perspective about life, only then do I focus on things that really matter.

Seek first the Kingdom of God

Despite our best intentions, we continue to be betrayed by our desires. We preach the gospel, and make ourselves the subject instead of the gospel. By criticising hypocrites we implicate ourselves. How often do we really get a message across that is pure and innocent of hidden motives? You see we work hard to make progress, we argue to win, we earn to own, we cry to feel sorry and we complain because we lack. Nowhere is God the constant object of our everyday lives.

We are to seek first the Kingdom of God. Then only will everything else follow. Adam and Eve's behaviour was only a precursor to that which was to come. In absolute disbelief did they deny God by trying to obtain wisdom and knowledge through their own effort. Unable and unwilling to let God rule their lives, they wished rather to be masters. No one is free from this. Even Abraham who many  see as the symbol of the expression of faith failed by conceiving a child with a woman other than his wife. We want to be masters of our own lives when we take the glory for things that happened by our hands but were given by God. Moses made this mistake when taking the glory for the flowing water from rock. We are to seek first the Kingdom of God, and only then will everything else follow. Kierkegaard puts this phrase into action by pointing out that we have the choice to do this. It is such a delicate decision, one that is not forced upon is, but one that will set in motion the accent to righteousness. In Matthew we learn that the Kingdom of God  is like a man stumbling upon a great treasure. He sells everything to buy the land in which the treasure was found. If man is open to receiving the good news God might have mercy on Him and give him life. In this discovery he is willing to forgo everything to have everything - God. The Kingdom of heaven can also be expressed  as a fisherman searching his whole life for a specific pearl, and upon finding it he is willing to let go of everything, because he has found what his heart desires. Man will find God if he really wants to find God. And finally, the Kingdom of God is like a net cast into the ocean sweeping up all sorts of fish. The fisherman than takes with him the good fish and returns the bad fish to the ocean. Here believers will be separated from unbelievers. Those who are open to God, and those who seek Him will find Him. But those who do not wish to know God will never know Him, since the Holy Spirit does not work in someone who actively denies Him.

While the details of everyday life are important, they add to many unnecessary complexities to living life. Once again, by focusing on the details we subtract from the main objective, which is to seek the Kingdom of God first. We naturally, but wrongly, assume that we exercise control over outcomes. Outcomes are not always proportional to our inputs. If we used this logic we put faith into our own hands, instead of simply relying on God. Adam and Eve failed to see that they had God right there beside them. That the source of everything was walking with them and that any question they might pose be answered in perfect harmony. They had everything, but they lost it to gain everything for themselves. And in doing so they divorced themselves from everything only to gain nothing.

So, the only logical conclusion to make when going through life, is to make God the centre of everything. Everything else loses purpose when we change this equation. 

Along this path you will most likely venture off in a different direction. But that is ok since you know what it is to follow the right path. Hopefully you won't be too stubborn to turn around and continue on the path that is intended for us all.

To live out your salvation means to live like Christ. It means to choose humility over praise, to  sacrifice over being lifted, to be last so that others will be first. It is by lifting Christ that we are lifted up to heaven. If God is the centre of your world, then the world and all its worries are inconsequential. For to gain Christ is to truly gain life.

Should we just close the budget deficit?

I am sure most people are aware of the difficulties faced by the US government regarding their debt ceiling. It has sparked debates from academics and politicians alike on the best way to deal with state debt.

A nice lesson of how fiscal policy works is summarised by Jeffery Frankel. He discusses the mistakes made by US and UK governments in the 1930's and how that time is applicable now. To summarise:

1. Fiscal expansions can be justified when interest rates are low and unemployment high (usually when a country is growing below potential)
2. Fiscal expansions should be countercyclical (save in good times and spend in bad times). Unfortunately this is usually dependent on output gap calculations
3. A 1 dollar increase in government purchases grows the economy by more than 1 dollars. I.e. the fiscal multiplier is larger than one
4. High debt is not always bad, unless markets perceive it as bad. Expectations are more important than the actual number

How does this story apply to South Africa? 

1. The SA government has run countercyclical policy (automatic stabilisers ensured that tax revenue automatically adjusted and expenditure growth increased)
2. Fiscal multipliers are < 1 but can be big SA fiscal multiplier paper
3. Debt is growing but set to stabilise at around 40% to GDP (SA has been downgraded, and might face another downgrade if debt exceeds this ratio)
4. Unemployment has increased by quite a bit (might have been worse if it was not for fiscal stimulus)

SA GDP growth has been low, and the Budget Reviews are revised frequently (under collection in taxes). The output gap is closing, but expenditure growth is not moderating (will have to see when the new Budget Review comes out in February). So how does SA go about consolidating its budget deficit (if it is warranted). For one you need to either increase tax rates (see previous post on this) or cut spending. Cutting spending is not that easy given that government is committed to social objectives such as reducing inequality and unemployment. It would be a very tough sell to cut back on wages and transfers to households (more than 80% of government expenditure is government consumption and transfers). This leaves one with very little room to cut back spending (mainly investment). 

SA's VAT rate has remained constant for quite a while (maybe for good reasons). Maybe government could increase the rate on VAT to finance the current expenditure path. On the other hand, tax collections should increase as the economy recovers...

For the next time I will talk about the impact of debt on the economy (for those skeptics out there who think that debt is not necessarily bad).

Higher tax rates in South Africa

Most countries have increased their sovereign debt levels since the 2008/09 financial crisis to stimulate slowing economies or bail out the greedy bankers who tried to make more money for greedy investors. It is a sad thing really. Now governments are facing probabilities of default (just type in sovereign debt crisis EU in google to understand just how bad things are). To minimise the probability of default governments have to increase tax rates, cut rebates or reduce spending. All these measures have negative consequences for economic growth. The point is that some governments simply don't have a choice as capital to finance expenditure dries up. The Obama administration is letting the Bush tax cuts expire (which effectively means that tax rates increase http://www.thefiscaltimes.com/Columns/2012/12/04/Why-the-GOP-Wont-Admit-Supply-Side-Econ-Has-Failed.aspx#page1). Unfortunately the question about which tools to use to appropriately consolidate the budget deficit is a rather complex one. In economics we learn that fiscal spending and taxes have multiplier effects (i.e. a dollar increase in spending increases economic activity by x dollars). If taxes have a lower multiplier than spending, then increasing taxes will harm the economy less than cutting spending. But calculating the multiplier is a very difficult task and one cannot simply rely on any old estimate. However, there seems to be empirical support that taxes have smaller multipliers than spending.

Let us assume that taxes damage the economy less than spending cuts, what taxes do we change and what rates do we set? This question is also very complex. One has to consider the redistributional preferences of government, the public's aversion towards income inequality, the possibility of tax evasion and tax avoidance and the possibility of immigration. Most undergraduate textbooks show that lump-sum taxes are Pareto efficient (the point where an increase in welfare of one individual cannot take place without decreasing the welfare of another). This tax strategy also assumes that government is efficient in distributing revenue collection efficiently. Unfortunately inequality exists and governments are far from efficient. This is why we have progressive taxes which addresses vertical (people with higher incomes should pay more taxes) and horizontal (people with the same income should pay the same amount of taxes) equity concerns. This unfortunately implies a Pareto-inefficient outcome as the tax liability lies with the minority of the population. This is very true for South Africa!

So, is it at all possible to increase the tax rates of the tax paying population further? Can these people afford a higher tax rate? Most probably yes. It is important to know that there is a difference between the effective tax rate an individual pays and the statutory rate. If person A earns R600 200 per annum he would fall in the top tax bracket. Assume that the cut-off point is R600 000 with a lump sum tax of R100 000 and 40% tax of anything in excess of R600 000. His total tax liability would then be (R100 000+(R600 200-R600 000)*40%) R100 080. Assume that the tax rate would increase to 50%, then his liability would be R100 100 which is only a R20 increase. His effective tax rate before the change is ((R100 000+R80)/R620 000) 16.141%. His effective tax rate after the change is 16.145%. That is why you always need to look at the change in rebates, tax rates and lump-sum taxes when the Budget is revised.

We know from theoretical and empirical (see Mirrlees (1971) and Saes (2012)) work that tax setting depends on:

1. The ability of labourers to shift their productive labour hours when taxes changes. Their preference for hard work diminishes as higher taxes are implemented (Frisch elasticities and labour-supply elasticities)

2. The distribution of tax payers (wealth is usually Pareto distributed)

3. Income and substitution effects. One's income is directly affected by taxes but substitution effects depend on labour-supply decisions. Elastic labour supply means that people can change their labour decisions (either choose more leisure or work harder to maintain a similar income as before the tax change). If the elasticity is larger than one, then increasing the tax rate could result in less revenue collection as more people decide to work less (either by reducing the amount of hours worked or by simply not being as productive while working the same amount of hours). When the elasticity is smaller than one then increasing the tax rate could result in higher revenue collection as people work at the same levels as before (same amount of hours and at the same productivity level).

In South Africa one would, a priori, expect labour supply to be very inelastic (smaller than 1) across income earners. Using StatsSA's Labour Force Surveys (LFS) suggests that the labour supply elasticity is close to zero (even while controlling for other costs such as transport or grants received). That means that one could increase tax rates and collect more revenue. But South Africa's top income earners also have access to other income types, which means that they can shift their labour income to capital which has a lower tax rate. I.e. some top income earners have a lower effective tax rate than middle and low income earners which violates the vertical equity principle. A business owner might not get his benefits in terms of a salary (which is subject to labour income tax), but gets his benefits in the form of higher dividends or company profits (which are subject to much lower rates than labour income tax). Thus raising taxes at the top end of the income distribution might only result in tax shifting. One possible policy remedy would be to increase tax rates on capital. Now this comes close to Lump-sum taxation (which implies Pareto-efficiency). Obviously there are different trade-offs involved in taxing capital such as a decrease in investment incentive.

Setting tax rates are notoriously difficult. Just looking at South African data would suggest that it is possible to increase the top tax bracket, or even introduce a new top income bracket. This would not necessarily result in a significant increase in tax burden as the effective rates are still low. This is definitely one way to close the budget deficit without incurring much harm on the economy overall. The only problem is that South African's do not necessarily get a return on their taxes as spending on education and health in the past has yielded little to be happy about (more on this later).