It’s the NGDP, Not the Interest Rate

Lot’s of news articles on the eurocrisis focus on the sky-high interest rates now being paid by the Spanish and Italian governments, roughly 6%. But I rarely see people pointing out that until a few years ago 6% interest rates on government bonds were completely normal. As was the 70% ratio of public debt to GDP that you see in Spain. So why is this interest rate now such a crushing burden? Simple, in the old days 6% interest rates were accompanied by much more robust NGDP growth rates. The problem today in the periphery is that NGDP growth has collapsed.

If structural problems prevent a return to normal real growth rates, then the living standards in those countries must take a hit. If you continued the normal pre-2008 NGDP growth rates, then the burden would be shared by both debtors and creditors. If you have near zero-NGDP growth and keep paying 6% interest to creditors, then the entire burden falls on debtors. Indeed creditors would be receiving a much greater share of GDP than they anticipated—a windfall.

Of course that assumes no default—the holders of Greek debt obviously took a huge hit. I’m calling for a public policy of no default and faster NGDP growth. Avoid the Greek option, but also avoid the other extreme of never defaulting despite paying a huge interest penalty, accompanied by very low NGDP.

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