I have been dinking around thinking about minor points in Olivier Blanchard's excellent AEA presidential address, which focused on whether and when it is the relationship of the economy's growth rate to the safe government-bond interest or to the risky average profit rate that defines whether more government debt is good or bad. Blanchard's is an important and valid question. But that discussion is predicated on the assumption that the spread between the safe government-bond interest and the risky average profit rate makes sense as a risk premium. And whether or not it does—and if it does, how it works—are the big and important questions in this literature.
Study and learn from Blanchard, by all means—you can learn a lot. But keep in mind that you are ignoring the elephant in the room Olivier Blanchard: Public Debt and Low Interest Rates: "The lecture focuses on the costs of public debt when safe interest rates are low.... The current U.S. situation in which safe interest rates are expected to remain below growth rates for a long time, is more the historical norm than the exception.... Put bluntly, public debt may have no fiscal cost.... Even in the absence of fiscal costs, public debt reduces capital accumulation... [but] welfare costs may be smaller than typically assumed... [because] the safe rate is the risk-adjusted rate of return on capital. If it is lower than the growth rate, it indicates that the risk-adjusted rate of return to capital is in fact low...
...I look at the evidence on the average risky rate, i.e. the average marginal product of capital. While the measured rate of earnings has been and is still quite high, the evidence from asset markets suggests that the marginal product of capital may be lower, with the difference reflecting either mismeasurement of capital or rents. This matters for debt: The lower the marginal product, the lower the welfare cost of debt.
I discuss a number of arguments against high public debt, and in particular the existence of multiple equilibria where investors believe debt to be risky and, by requiring a risk premium, increase the fiscal burden and make debt effectively more risky. This is a very relevant argument, but it does not have straightforward implications for the appropriate level of debt. My purpose in the lecture is not to argue for more public debt, especially in the current political environment. It is to have a richer discussion of the costs of debt and of fiscal policy than is currently the case...
#noted
