Rethinking fiscal rules

Public debt ratios have risen since the Covid shock as governments sought to cushion the impact of the shock. Global debt to gdp averaged 96 per cent in 2021. The average for advanced economies was 120 per cent. In 2008, after the Global Financial Crisis, the numbers were 64 per cent and 79 per cent.

The general view, articulated by the IMF, is that the rise in public debt was inevitable and desirable. But… it needs to be brought down quickly. That is, of course, the received wisdom taught in all Macroeconomics courses, namely, the lower the public debt, the better.

It is refreshing to hear a different view from Andy Haldane, former Chief Economist of the Bank of England. Haldane makes two interesting points. One, over centuries, global debt to gdp has tended to rise as governments respond to the need to create more and more public goods. Two- and this is very interesting- even as public debt has risen, the interest costs have fallen. Not quite what you the Macro course would tell you.

How do you explain these? Well, public debt is used often to create assets. These assets generate streams of income over time that can service the debt. So lenders to government look, not just at the debt, but at the assets that the debt creates. What matters thus is not public debt per se but net worth of government, that is, assets minus debt.

Recognising those assets would give us a measure of the true net worth of the government. Just as a company or household would look at their net worth when making investment choices, so too should government. Countries with high net assets have been found to have lower borrowing costs. Bond market vigilantes target poor ancestors, not borrowers.

Moral of the story? The need to create important public goods remains, perhaps, including those relate to climate change. No need to panic over rising debt levels- focus on debt sustainability. As long as debt creates productive assets, physical or human, chances are debt will be sustainable.

 

More on the IMF's recanting austerity

In a recent post, I wrote about the IMF discarding its austerity mantra in its latest World Economic Outlook Report. The FT has a detailed article on the about-turn. The author writes:

Carmen Reinhart, the eminent economic historian who is now chief economist at the World Bank, recommended countries should borrow heavily during the pandemic. “While the disease is raging, what else are you going to do?” she asks. “First you worry about fighting the war, then you figure out how to pay for it.” Ms Reinhart was a leading advocate of austerity a decade ago after publishing a research paper which concluded that at a similar stage in the 2008-09 financial crisis — to where we are now — high levels of public debt undermined economic performance. It concluded that, “traditional debt management issues should be at the forefront of public policy concerns”.

The author mentions three reasons for the change in the IMF stance. One, the experience post the global financial crisis when fiscal policies  remained relatively restrained while monetary policy was assigned the task of restoring normalcy. It didn't quite work. Now, central bankers urge that monetary policy must work in tandem with fiscal stimulus.

Two, interest rates have fallen steeply over the years and this makes a higher level of borrowing feasible. One wonders whether the fiscal deficit target of 3 per cent  of GDP under the Maastricht Treaty and the notion that debt to GDP in the advanced economies should be under 90 per cent hold water any more. We need to consider alternative indicators: say, the interest to GDP ratio or the ratio of interest to total government income. Better still we have to take a view on (r-g), the differential between the interest rate and  the GDP growth rate. If the interest rate has fallen more than the GDP rate of, say, two decades ago, then the old rules for fiscal policy no longer apply. There is, of course, the interesting question of why interest rates have fallen in the advanced world despite rising public debt and a huge expansion in liquidity- on that, more in a future post.

Three, there is little public appetite for austerity now after the havoc visited on jobs post the global financial crisis. The article notes that even conservative Germany takes pride in the fiscal stimulus it provided post the pandemic.

Carmen Reinhart's prescription, however, may not enthuse Kenneth Rogoff, Reinhart's co-author of the famous book on debt crises, This time is different. In an article in the Guardian written last December, Rogoff gives three reasons, not all of them persuasive. why one must be wary of assuming higher debt given low interest rates.

First, governments may be able to service higher market debt but they may be jeopardising their obligations under social security systems. Well, I guess the measurement issue can be addressed by including contingent liabilities, such as pensions, in government's debt obligations. Let’s monitor the total, public debt plus pension liabilities.

Secondly, the next crisis may be very different in character, say, global climate change or a cyber war, with unpredictable implications for growth and interest rates. This strikes one as something of a bogey. One is not saying the interest burden on government should rise. Let the interest burden in normal times remain the same as before after adjusting for lower interest rates. That means we are at the same level of risk as before in confronting unpredictable crises of the sort Rogoff talks about. Again, the debt level is the wrong indicator to target.

Thirdly, Rogoff argues that "aggressive experimentation with much higher debt might cause a corresponding shift in market sentiment – an example of the Nobel laureate economist Robert Lucas’s critique that big shifts in policy can backfire owing to big shifts in expectations." Well, such a shift has not happened  for well over a decade post the crisis. Markets are not factoring in higher inflation and interest rates consequent to the shift in policy. If it does, policy makers have room to adjust. 

No, we don't need austerity, says IMF!

 The IMF does not prescribe austerity any more- at least not for the advanced economies.

The advanced economies have resorted to a large fiscal stimulus in response to the pandemic. The IMF World Economic Outlook, October 2020, estimates that discretionary stimulus amounts to 9 per cent of GDP in advanced economies (compared to 3.5 per cent of GDP in emerging economies). 

Public debt in advanced economies is poised to rise by a full 20 percentage points to 125 per cent of GDP by the end of 2021 (in emerging economies, the figure will be 65 per cent of GDP). Yet, the IMF thinks the rise in debt will not be a big deal for the advanced economies.

Why? Because interest rates have fallen to close to zero in the advanced world, so more debt does not translate into an unsustainable interest burden. There's more debt but it's cheaper now. As a result, by 2025, overall deficits will be back to pre-pandemic levels without any cuts in public spending, according to a report in the FT:

Most advanced economies that can borrow freely will not need to plan for austerity to restore the health of their public finances after the coronavirus pandemic, the IMF has said in a reversal of its advice a decade ago. Countries that have the choice to keep borrowing are likely to be able to stabilise their public debt by the middle of the decade, Vitor Gaspar, head of fiscal policy at the fund, told the Financial Times. That would mean they would not have to raise taxes or cut public spending plans.

As the report notes, this is a change in the IMF's position with respect to what it had advocated after the global financial crisis.

The IMF is now urging advanced economies to spend their way out of trouble. Growth will take care of debt sustainability because the growth factor 'g' will outweigh the interest rate factor 'r'. 

But the point is that this - the positive gap between growth and interest rate- is not happening by accident. It is happening because central banks are intervening in the debt markets to make it happen. Central banks first allowed the policy rate to drop to close to zero at the lower end of the yield curve. Then, they resorted to Quantitative Easing which is the purchase of a defined amount of government bonds from investors. They have followed this up with Yield Curve Control, which is defining the interest rate they want to see at the higher end of the yield curve.

If central banks elsewhere can make it easier for governments to borrow, why is it a problem if the RBI does the same here? Why is the management of interest rates to facilitate more government borrowing and spending such an issue here? Why the criticism that fiscal dominance dictates monetary policy?

There is merit in what the proponents of Modern Monetary Theory are saying. They say that it's not true that government borrowing drives up interest rates because there is a limited pool of savings to finance it. When the government spends, the interest rate falls, it does not rise. There is an accretion to bank reserves at the central bank. This causes the inter-bank rate, which is the anchor rate in advanced economies, to fall, thereby facilitating more government borrowing and spending.

There is only one constraint in central banks allowing interest rates to fall: the fall in interest rates must not spell higher inflation. This is a constraint in India at the moment, given that inflation has been at over 6 per cent in recent months, that is, beyond the upper bound of the the inflation target framework. However, once the inflation rate falls, there is nothing that stands in the way of a cut in the policy rate. And until then, managing yields at the higher end of the curve is par for the course.