Public debt and low interest rates: Japan’s case


This article is heavily based on Olivier Blanchard’s work, more specifically on his articles “Public Debt and Low interest rates” and “Fiscal policy options for Japan” co-written with Takeshi Tashiro.

In January 2019, Olivier Blanchard, ex-chief economist at the International Monetary Fund, wrote an article about the cost of public debt. If the future is like the past, then when the growth rate exceeds the interest rate, public debt has little or no fiscal costs. What does it say about current economic policies and what are the implications of such statements for the future?

The main idea behind Olivier Blanchard’s paper

Olivier Blanchard starts his paper “Public Debt and Low interest rates” by saying that in the history of the US, the interest rate being lower than the growth rate is “more of a historical norm than the exception”. Here, rather than the interest rate, he uses the safe rate, which is the risk-adjusted rate of return on capital. 

Source: NBER working paper series: Public debt and low interest rates, Olivier Blanchard

Furthermore, the 10-year treasury bond nominal rate of the US, which is an estimator of long-term interest rate, is expected to be lower than the expected growth rate with a 1% spread. The same goes for the UK and all the countries of the European Union, except for Italy. 

In this context of interest rates being lower than the growth rate, debt rollovers could have no fiscal costs. Another way of putting it is that a country could contract new loans to refund its debt, and thus not levy taxes, and have a decreasing debt to GDP ratio. If we look at the trend of debt ratio starting from different dates with zero primary balance (no primary surpluses or deficits), it would have decreased, even in the 80’s, in other words, even in the presence of a bad economic shock.


There is still welfare cost attached to a higher debt level, because of its effect on capital accumulation. Debt rollovers may be feasible but not desirable. In this paper, Blanchard shows however that those welfare cost might be smaller than expected. To simplify his analysis, Blanchard uses an overlapping generation model under uncertainty, where he studies the real effect of transfer from young to old.

The benefits of public debt

According to Blanchard, there are four main arguments in favour of deficit finance during a time of recession.

First, during a period of recession, the multipliers may be stronger than assumed. The lower ability for household and firms to borrow from banks incites a stronger effect of current income on spending, and as a result a small increase of public debt (in other words public spending) will increase a given output. 

The second argument comes from a paper by Delong and Summers, where they conclude that the effect of a fiscal expansion during a hysteretic situation (where a bad economic shock would increase durably the natural level of unemployment) would reduce the debt in the long run rather than decreasing it. 

The third argument is quite intuitive. Under austerity policies, investments are cut. However, many argue that public investment has been too low. We should take more into account the marginal product of public capital and their positive effect on welfare. 

The fourth argument relies on the assumption that we have entered a period of secular stagnation. In other words, we have entered a period of global economic slow-down with low economic growth. This could be explained by the ageing population, the slow-down of technological innovation, the post-2008 fiscal austerity policies and deflation that affects the normal economic growth. In this situation, in order for savings to equal investment at full employment, negative interest rates would be needed. However, the policy rate cannot be lowered any further because of the effective lower bound on nominal interest rates. Here not only would budget deficits be needed to boost demand and output growth, but the cost of debt may be absent because of negative safe rates. 

The cost of public debt

Blanchard lists three counterargument to the thesis that debt may have low fiscal and welfare costs. First, safe rate may be artificially low because of financial regulation such as liquidity discount, and may therefore reflect distortion rather than preferences, in which case we would need to use another interest rate. Second, we can argue that the future may not be like the past, and we cannot exclude the possibility that safe rate will be higher than the growth rate and that the cost of debt will be more important, regardless of the statistics and economic data that show an optimistic perspective. Finally, the existence of multiple equilibria in the case where investors believes that debt is risky. They ask for a premium for the risk they take on investing, and therefore increase debt payment, and as a result make the debt riskier. 

Japan: public debt and secular stagnation 

Japan has the highest debt-to-GDP ratio in the world and highest overall public debt. Japan’s debt represents 234% of its GDP (world population review 2019). Even though the rating agency Moody’s downgraded the Japan’s credit rating in 2014, because of the uncertainty of Japan in succeeding to cut deficits, Japan’s situation seems less problematic than that of Italy or Greece. Roughly speaking, investors tend to have more pessimistic expectations regarding the economy of those two countries. Furthermore, in Greece, the difficulty of the state to levy tax revenue increases default risk.  As a result, they have difficulty “selling” their debt. Whereas Japan benefits from a more optimistic economic perspective and a unique situation in which the majority of the debt, about 83%, is held by Japanese economic agents, such as the Bank of Japan, financial institutions and insurers. Moreover, the yield of the public debt is low because of low interest rates; this shows that national investors have a certain faith in their country’s economy. Only 6% of the public debt is held by foreign agents. This limits greatly the risk of capital flight. 

Japan: secular stagnation and fiscal policy options

Japan is a strong example of secular stagnation. It has been 20 years that this country experiences an economic slowdown with a weak domestic demand. Japan’s monetary policies to increase demand, such as using low interest rates, are limited, because of the effective lower bound. Let’s take the budget constraint of a government, which is:

It was once assumed that r>g in traditional analysis. In that case, if debt increases, then we would need an increase in primary surplus (with taxes or cuts on spending) to keep the debt-to-GDP constant. However, with r<g, we could have a primary deficit and have a constant debt-to-GDP ratio. We could also decide not to raise taxes, and the debt to GDP ratio could decrease over time. 

In the case of Japan, decreasing debt would create welfare costs that would exceed the benefits of a lower debt. Furthermore, Japan should not fear too much about a sudden increase in interest rates. Indeed, it is unlikely that interest rates increase suddenly because of a decreasing in savings or a rush in investment. This would come progressively, and the state would have time to adapt. The most likely reason for a big change in interest rates would be the problem mentioned earlier, that investors starts to believe that the debt is risky and ask for a compensation for the risk they take in investing, in other words a risk premium. However, as quoted in “Fiscal policy options for Japan” , “it has been argued that as long as a country borrows in its own currency, the risk can be avoided” and the Bank of Japan plays the role of “a large investor (that) stand ready and (is) able to buy the bonds in unlimited quantities”. 

In what should Japan invest?

The graph below shows that despite primary deficit, public investment has been in decline since 1993. 

Source: Peterson Institute for International Economics: Fiscal Policy Options for Japan, Olivier Blanchard and Takeshi Tashiro

Olivier Blanchard and Takeshi Tashiro argue that “investing in public subsidization of child-rearing costs and provision of benefits and income breaks”, to increase fertility rate in Japan, could have positive impact on the country’s future economic growth. In their research, they show that an increase in public spending for fertility policies of 1,5% of the GDP would then make the GDP  6% higher in 30 years and 17 % higher after 50 years. These types of policies could be finance through debt rather than through an increase in consumption tax from 8% to 10%, as it has been decided in October 2019 in Japan.


Olivier Blanchard’s paper doesn’t say that higher public debt is a good thing, but that it might not be as bad as we thought. If countries like Japan, who probably doesn’t have a risk of bad equilibrium like Italy, need primary deficits to do progressive policies, such as increasing fertility, then they should do it. In that case, the benefice of increasing primary deficits might exceed the cost of higher debt. 


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