The interest-rate-growth differential (r – g) has been under close scrutiny in the past few years. This differential is essential to understanding long-term fiscal sustainability. Higher interest rates generate higher interest payments to service government debt and lead to greater debt accumulation. In contrast, higher GDP growth tends to lower the debt-to-GDP ratio because it increases its denominator.
With interest rates persistently low, r – g has turned negative in many countries in the aftermath of the global financial crisis, bolstering arguments for fiscal stimulus to boost economic activity. The evidence for advanced economies hints that a negative r – g may persist over the long term. However, there is no guarantee, given that this differential could quickly turn positive as a result of large adverse shocks, especially if government debt is high.
This debate could not be more timely, in the context of the economic fallout of the COVID-19 pandemic: countries have increased, and will likely continue to increase, government expenditures to deal with the health emergency, mitigate the economic collapse, and accelerate the recovery. Whether fiscal expansions will deliver the intended objectives boils down to the extent to which they are able to boost GDP, the relationship captured by the concept of fiscal multiplier. This multiplier represents a measure of the effect of increases in fiscal spending on a country’s economic output and is defined as the ratio between the change in GDP and the change in government spending.
A recent IMF study using data from 10 euro area countries finds that the level of r – g affects the size of the government spending multiplier. According to textbook macroeconomics, at every point in time, the debt stock will grow by the existing debt stock multiplied by r – g, net of the primary budget balance (with debt and the primary balance expressed as fractions of GDP). Although a negative r – g does not guarantee debt sustainability, government debt will tend to fall when r – g is negative and will tend to grow when r – g is positive. In addition, the higher r – g, the higher the future primary budget balance a government will need to stabilize its debt, a theoretical prediction confirmed by euro area data (Figure 1). Forward-looking private agents will incorporate this mechanism into their expectations and increase their savings.
This behavior affects the size of the government spending multiplier, which is inversely correlated with the level of r – g (Figure 2). Statistical tests reveal that in the negative r – g regime, the multiplier is larger than in the positive r – g regime with high probability. The difference in the multipliers across the two regimes increases at time horizons beyond the first year. Over the medium term (five years), median cumulated multipliers range between 1.22 and 1.77 when r – g is negative and between 0.51 and 1.26 when r – g is positive. To put this in perspective, if euro area governments had spent €100 in the early 2000s, when r – g was positive, this would have generated an average increase in GDP of €86. Spending the same €100 in the late 2010s would have generated an average increase in GDP of €150-almost twice as much.
These findings carry important policy implications, especially in the context of the EU Recovery Plan, which is leading to ambitious government spending programs in member countries. With GDP growth expected to resume, insofar as interest rates remain low, the resulting r – g should promote relatively high government spending multipliers. However, this scenario may be reversed, and multipliers may become significantly more modest, if adverse shocks keep r – g significantly above zero in large member countries. For example, during the global financial crisis, r – g spiked in the euro area and then remained positive for several years. In such circumstances, it is even more important that fiscal spending prioritize what is most productive. This policy has a high chance of maximizing the growth impact directly, but also indirectly by curbing r – g and the expectations of necessary future fiscal adjustments.