Will bystander economies be able to finance their governments?

From Jesús Fernández-Villaverde comes a new paper titled "Saving for the Machines." The paper highlights a troubling risk that artificial intelligence may burden the finances of many modern governments. The key issue is that building AI requires massive investments, which can only be induced through a significant increase in the real interest rate. For instance, in a benchmark scenario, the ten-year real yield could surge from 5.1% to 13.6% under this transformation.

To illustrate this point, the paper compares two hypothetical economies: one that adopts AI (like the United States) and another that does not (such as Spain). The adopting economy, like the U.S., experiences faster growth due to AI and can pay higher interest rates on its debt. In contrast, the non-adopting economy, like Spain, continues to grow at its historical 1.6% trend rate and must pay the same world interest rate.

The results are stark. For the AI adopter, the real interest rate could climb to 42% by 2040, while growth only rises to 22%. This leads to debt doubling by 2038, reaching 296% of GDP in 2040, and soaring to 907% in 2045. To maintain a 100% debt-to-GDP ratio, the government would need a substantial primary surplus, amounting to 10% of GDP by 2035 and 24% from 2045 onward. Even with a lower elasticity of substitution, the debt still reaches alarming levels, requiring a primary surplus of 13% of GDP from 2045 onward.

The grim news for the bystander economy, like Spain, is that it lacks a viable solution. Its capital income is only a third of GDP, growing at a meager 1.6%. To keep its debt-to-GDP ratio at 100%, it would need a primary surplus of 11% of GDP by 2030, 26% by 2035, and 44% forever. Regardless of the tax system employed, this surplus is impossible to achieve, leading to debt doubling by 2033 and tripling by 2035.

Moreover, the long-term impact of AI on the non-adopting economy is dire. Foreign capital flows to machines in other countries, causing its GDP and tax base to fall below trend. While there is a potential relief in the form of wealthy households saving for the benefit of others, the government must tax these returns to some extent. Ultimately, the scenario paints a bleak picture for many Western European countries, suggesting that default, inflation, or financial repression may be the only realistic outcomes.