Fiscal Policy under Low Interest Rates

Their wordsThe main challenge in discussing fiscal policy is the widely held and nearly religious belief that public debt is very bad.

Their wordsIn other words, central banks are not to blame for low rates: these low rates just reflect underlying fundamental factors.

Their wordsA low r is actually a signal that something is wrong with the economy: In effect, if we think of the safe rate as the risk-adjusted rate of return on capital, the low safe rate is sending the signal that, risk adjusted, the return on capital is low.

Their wordswhile the growth rate may well affect saving and investment, there is no tight relation between growth rates and interest rates, either on theoretical or empirical grounds.

Their wordsReal interest rates have steadily declined in all major economies for more than three decades. This decline was not caused by the Global Financial Crisis or the Covid crisis.

Their wordsSovereign debt markets (and many other markets as well) are subject to sudden stops in which investors either drop out or ask for large spreads even in the absence of large changes in fundamentals.

Their wordsA longer maturity of debt protects the government from a temporary increase in the short run interest rate, and it gives it more time to adjust to a permanent increase.

Their wordsassessing debt sustainability is as much art as it is science.

Their wordsI am skeptical of the use of quantitative rules to ensure debt sustainability.

Their wordsThus, as desirable as public investment is, the proposition that it can be automatically financed by debt is wrong.

Their wordsThe analysis in this chapter has shown that there is no such thing as a universal threshold over which debt becomes unsustainable, and that the relevant debt level depends on many factors, in particular the real interest rate on debt.

Their wordsThis is precisely the role the central bank can play. By announcing that it stands ready to buy the bonds that investors want to sell at the price associated with the low interest rate, and credibly indicating that it has deep enough pockets to buy whatever is needed, it can eliminate the bad equilibrium.

Their wordsGovernments have not been bailed out by their central banks. As I discussed earlier, central bank intervention does not reduce the overall liabilities of the consolidated government, just their composition. And it does not automatically lead to more inflation: It increases the size of the balance sheet of the central bank, but it does not increase the size of the non-interest-paying money stock.

Their wordsThe proposition is that the cancellation of the bonds held by the central bank would decrease the amount of interest payments and thus the debt service of governments. And indeed, it would. But it would have another effect—namely, to decrease the revenues of the central bank and thus the profits that the central bank turns in to the government. This second effect would be exactly of the same size as the first, and the net effect on the government budget constraint would be equal to zero.

Their wordsI have argued that the probability of a bad equilibrium is only marginally influenced by the level of debt, but can be much reduced by a contingent rule making the primary balance react to an increase in debt service.

Their wordsI believe that, except in times of hyperinflation, the price level does not behave as an asset price but as the aggregate of billions of mostly backward-looking decisions, and that expectations of future primary balances have little effect on the price level today.

Their wordsIf a fiscal expansion takes place when output is already at potential, monetary policy is likely to tighten, leading to higher interest rates and thus a smaller effect or even no effect of the fiscal expansion on output.

Their wordsMultipliers are likely to vary a lot over time and space, but the bulk of the evidence is that they are different from zero, positive for spending, negative for taxes, and that they are stronger when monetary policy does not or cannot react to fiscal policy.

Their wordsThe lower the neutral rate, the smaller the fiscal and welfare costs and the larger the welfare benefits of debt and deficits.

Their wordsJapanese macroeconomic policy is often characterized as a failure, with the central bank unable to achieve its inflation target, a low growth rate, and debt ratios steadily rising to reach more than 170% for net debt and 250% for gross debt. I think it should be seen instead as a qualified success, with the use of aggressive fiscal and monetary policies to compensate for very weak private demand: Output has remained close to potential.

Their wordsThe costs of high debt were perceived to be very high—higher than they truly were—and the multipliers were underestimated, leading to an underestimate of the output costs of fiscal consolidation.

Their wordsIn some dimensions, fiscal policy has an advantage over monetary policy in stabilizing output. The main example is indeed the operation of automatic stabilizers, which act faster than monetary policy can.