Perhaps the most underused instrument in the last financial crisis was debt write-downs that target the heart of the problem. Unfortunately, overblown fears of moral hazard make effectively blocked write-downs in the case of US subprime mortgages and periphery-country debt in Europe. One hopes that in the future, policymakers will be better prepared to implement creative ideas to mitigate such concerns (for example, equity sharing in the case of mortgage write-downs, and GDP-indexed debt in the case of sovereigns).
Debt and Denial
A final challenge facing central banks is that they are no longer needed as bulwarks against the temptation to inflate away excessive government debt. In a sense, this is a corollary of the first challenge: that high inflation has been gone for so long that people have come to believe it can never return. Unlike short-term stabilization policies, however, holding down inflation expectations in the face of rising debt is a long-term project. There are really two separate ideas in the mix here. The first is reasonable but debatable; the second should be discarded.
The first idea is that, owing to the steady decline in long-term real interest rates on “safe” government debt, governments can now issue much more debt than they used to. This claim makes perfect sense, provided one has also accounted for nuances such as the maturity structure of the debt. (Short-term debt is usually cheaper than long-term debt, but far more vulnerable to shocks to global real interest rates.) And in the US case, one must consider the dollar’s increasing centrality in the global financial system. Despite America’s falling share of global output, the dominance of the dollar has fueled global demand for dollar-denominated assets and reinforced its “exorbitant privilege.”
A more extreme version of the contention that debt is completely benign was endorsed recently by former IMF chief economist Olivier Blanchard. In an interesting and provocative paper, Blanchard contends that the US economy is currently in an inefficient equilibrium where, for whatever reason (excessive investment is the classic one), interest rates are below growth rates. He expects these conditions to hold “for a long time,” and concludes that any one-time increase in government debt – even a very large one – will have no effect on the long-term debt-to-income ratio, because growth will outstrip the surge.
In the scenario Blanchard describes, public debt is a free lunch, because there is too much investment in the economy anyway – so much so, in fact, that there is no need even to raise taxes to pay for it. And this is doubly true if the funds are spent on high-return investments such as education and infrastructure (never mind that less than 4% of government expenditure in advanced economies is dedicated to infrastructure investment). More to the point, if higher debt places no additional pressure on fiscal policy, there will be no need for central banks to inflate it away, and thus no need for central-bank independence.
Blanchard may be right, but several of his points are debatable. Is the economy really in an inefficient equilibrium, with interest rates set to remain below the growth rate indefinitely, or is this just a temporary situation that might eventually be reversed? The suggestion that the risk of a debt run does not begin to rise as debt becomes very high is even more debatable. Standard models suggest otherwise, and it is certainly no accident that investors in times of crisis are more concerned about high-debt than low-debt countries. As Harvard University’s Emmanuel Farhi and Matteo Maggiori have shown both empirically and theoretically, one also should not underestimate the frequency with which historically “safe” assets have turned out not to be so safe after all.
Yet another iteration of the benign-debt argument is Modern Monetary Theory (MMT), which, as I understand it, would allow the government to pile up debt longer and at lower cost by instructing the central bank to pursue continuous QE, issuing bank reserves to buy up long-term government debt. The effects of such a mandate would depend on whether bank reserves bear market interest rates, as is now the case, or whether they are non-interest-bearing. As we have seen, there is no meaningful difference between the central bank expanding reserves to buy back newly minted long-term government debt and simply issuing very short-term debt in the first place. If bank reserves pay interest, the first-order effect of the MMT prescription is to shorten the maturity structure of government debt without providing any extra tools for the government to run higher deficits. But if the reserves do not pay interest, any increase in interest rates would prompt a rush by banks to withdraw them, and inflation would soar.
As already noted, short-term debt is typically the cheapest way to finance government borrowing, and there is a case to be made that the cost savings from issuing short-term debt have been even greater than usual after the financial crisis. But there is a reason why governments don’t bet the farm on global real interest rates never rising again: historically, interest rates have an inconvenient habit of doing precisely that. MMT’s overreliance on short-term debt is thus highly risky. If global real interest rates were to rise, the government would immediately feel pressure to raise taxes and cut spending. Should it fail to respond quickly, suddenly rising risk premia would exacerbate the problem.
It is tempting to assume that global interest rates for safe assets could not spike, and that any conceivable shock would, if anything, drive them down. Yet if we have learned anything from the past, it is that tomorrow’s shock may not look anything like yesterday’s shock. It is one thing for a hedge fund manager to bet big on what interest rates will do in the next few years, and then retire. It is quite another thing for a government to play that game.
Salvaging the Ship
Is monetary policy destined for irrelevance in an age of low interest rates? Not necessarily. As I have argued elsewhere, with certain institutional changes, central banks could pursue an effective negative-interest-rate policy. I emphasize “effective” because, while some central banks have engaged in very mild forms of this already, none has tackled the most important issue: the risk of wholesale cash hoarding when rates turn too far negative.