Both of us have recently developed arguments for a more relaxed attitude toward public debt and deficits (for example, this address by Blanchard at the European Central Bank Policy Forum, this joint discussion at PIIE, and this essay by Ubide on Vox). Not surprisingly, several counterarguments have arisen, some of which we accept, some of which we don’t. This blog addresses two arguments that we reject.
Our contention has been that lower interest rates decrease the fiscal and the economic costs of public debt. In addition, lower interest rates and the effective lower bound on nominal interest rates limit policymakers’ ability to use monetary policy, requiring them to rely more on fiscal policy to sustain demand and activity. We have made a careful case for the use of primary deficits to sustain demand where needed, and for the use of these deficits to finance growth-friendly measures, such as the fight against global warming, or the financing of transition costs of reforms, or other types of public investment. We have argued that, by increasing investment, a well-designed fiscal policy can contribute to increased neutral rates, in turn making monetary policy more effective.
The first counterargument is that governments are naturally spendthrift, and we are giving them arguments to misbehave. We are indeed giving governments arguments to be more relaxed about debt, and, yes, we might encourage some to go too far, which would be bad.
The right attitude, however, is not to pretend that debt is catastrophic if it is not. Sooner or later, a government will test that proposition and discover that it is false. The right approach is to tailor the advice to the situation of each country and point to the limits of our arguments, something we have tried to do. For example, while we believe that both Japan and the euro area should be ready to maintain primary deficits in order to sustain demand, we believe that in the United States the current trajectory of anticipated deficits and debt is far from optimal. Because the Federal Reserve has some limited room to provide stimulus, primary deficits should be reduced, but slowly, and measures should be taken to reduce deficits in the long run.
The second objection, which, interestingly, is often held by the same people who raise the first, is that, although interest rates are low now, this will not last, and there is therefore little reason to revisit the old canons of fiscal policy that aim for a smaller deficit and lower debt. This argument again strikes us as being wrong.
The decrease in real interest rates is not something that started with the financial crisis and that will go away when its effects fully dissipate. The decrease started much earlier, in the mid-1980s, and has taken place steadily since then, driven in large part by structural factors, such as demographics. For a while, there was a belief that, after the financial crisis, interest rates would return to their historical levels. They have not.
Indeed, as time has passed, expectations of future interest rates have been steadily revised downwards. Policymakers have sharply revised their estimates of neutral rates—for example, the median estimate of the long-run Fed funds rate in the Federal Open Market Committee’s (FOMC) Summary of Economic Projections has declined from 4 percent in 2012 to 2.5 percent in June 2019. Market expectations are that interest rates will remain very low for a long time to come. In the United States, 10-year Treasury rates, at 2.1 percent, are below 3-month rates (the yield curve is inverted) and are not expected to increase much: 10-year Treasury rates, 5 years in the future, are expected to be just 2.7 percent. In Europe, 3-month Euro Overnight Index Average (Eonia) rates are expected to be negative for the next 5 years, and the German yield curve is negative up to 15 years. There are some extreme cases: For example, in early July, the Swiss yield curve was negative up to 40 years.
Even more relevant to the issue at hand, option prices indicate that investors do not see much risk of an upward jump. The table below shows implied risk-neutral probabilities that short-term rates will be less than some threshold over the next 5 and 10 years.
|Probabilities that short-term rates will be less than some threshold over the next 5 and 10 years|
|Currency||Expiry||Probability that 3-month Libor rates will be:|
|US dollar||5 years||12%||27%||52%||78%||92%|
|British pound||5 years||26%||56%||80%||92%||97%|
|US dollar||10 years||15%||25%||43%||65%||82%|
|British pound||10 years||32%||51%||69%||82%||90%|
|Note: These probabilities are calculated by estimating a stochastic volatility SABR model using Bloomberg data on interest rate caps and floors (option contracts where the premium depends on interest rates staying below or above a predefined level, respectively) for each of the currencies.|
For the United States for example, markets give only an 8 percent probability to rates exceeding 4 percent in 5 years, and an 18 percent probability that they will exceed 4 percent in 10 years. To put these numbers in context, most forecasts of nominal growth rates over the next 5 or 10 years are around 4 percent (2 percent inflation, 2 percent real growth). The numbers for the euro area are even more dramatic, with markets giving only a 6 percent probability to rates exceeding 2 percent in 5 years, and a 12 percent probability to rates exceeding 3 percent in 10 years, again numbers far below forecast nominal growth rates over the same period. The numbers for Great Britain are in between, closer to those for the euro area.
Can markets be wrong? Obviously yes, although these rates allow governments to lock in low interest payments now for a long time, protecting them against the risk of an unexpected increase. Furthermore, the commitment by central banks to keep rates low for a long time, through forward guidance, decreases the risk of a sudden monetary policy shift and a sharp increase in interest rates.
Nevertheless, a risk exists. Should the existence of such a risk lead governments to actively reduce debt, even if it is at the cost of lower output and higher unemployment? Surely not. By necessity, nearly all policy decisions imply risks. Take the familiar example of required capital ratios. One way to eliminate risks in the banking system would be to require capital ratios of 100 percent. But this is not done, and for good reasons.
In fact, rather than worrying about an increase in interest rates, governments should consider the scenarios that could lead to such an increase. We can see three main potential triggers for an increase in interest rates, all of which are likely to be benign:
- a sustained acceleration of productivity growth—but this would also imply growth and an increase in government revenues, thus offsetting the potential impact of higher interest rates on the fiscal outlook;
- a decline in the equity risk premium that reduces the demand for safe assets (government bonds)—but this would imply an increase in equity prices that would very likely be associated with higher investment and growth, thus offsetting the effect of higher interest rates; and
- a persistent increase in inflation leading to higher nominal interest rates but also to higher nominal growth rates, thus with no strong implications for debt dynamics.
Bottom line: We believe the trade-off between debt consolidation and activity has dramatically changed, and that taking all the risks into consideration, it should tilt fiscal policy in a more expansionary direction. In this new environment, being too fiscally conservative and not supporting demand is in fact a risky strategy. It does increase the risk of permanently depressing activity with potentially adverse political implications, as we have already seen in some countries. If we turn out to be wrong and interest rates sharply increase without a simultaneous increase in growth, then the strategy should, of course, be reassessed again, just as we argue for a reassessment today.
* Ángel Ubide is head of economic research in global fixed income at Citadel LLC and a former senior fellow at PIIE. This article reflects his analysis and views. No recipient should interpret this article to represent the general views of Citadel or its personnel. Facts, analysis, and views presented in this presentation have not been reviewed by, and may not reflect information known to, other Citadel professionals. Assumptions, opinions, views, and estimates constitute Mr. Ubide’s judgment as of the date given and are subject to change without notice and without any duty to update. Citadel is not responsible for any errors or omissions contained in this presentation and accepts no liability whatsoever for any direct or consequential loss arising from use of this article or its contents.