Fiscal Expansion: Spend as if You Have to Pay It Back

BOCCONI STUDENTS ON THE SEMINARS ORGANIZED BY IGIER. IN THE LATEST ARTICLE OF THE SERIES, SVIATOSLAV TIUPIN REPORTS ON THE WORK OF OLIVIER BLANCHARD AND JOHN COCHRANE

Leading international scholars present their cutting-edge research at Bocconi every year, in front of faculty and students. In order to make this work accessible to a larger audience, Bocconi Knowledge publishes the summaries of the scientific and policy seminars organized by the IGIER research center, written by the students participating in the IGIER-BIDSA Visiting Students Initiative
 
The low interest rates of the last two decades have created challenges for monetary policy, but have also opened opportunities for major fiscal expansions in the US and EU, with levels of debt-to-GDP ratios now projected to approach wartime levels by the end of pandemic. Should we expand government spending even more, or there is tangible risk of significant rise in interest rates?
 
At the IGIER Seminar of 11 January, Olivier Blanchard from the Peterson Institute for International Economics and John Cochrane from Stanford University and Hoover Institution offered their perspective on these issues in a debate moderated by Alberto Martin from CREi.
 
Blanchard stressed that, given the zero lower bound on interest rates, monetary policy is currently ineffective. As a result, fiscal expansions could prove not only valuable but also “cheap” to finance. Indeed, when the interest rate r is lower than GDP growth g, r < g, the government can roll over its debt, issuing new claims to repay for the maturing ones, and render the debt path sustainable or declining without raising taxes or cutting spending. Eventually, the economy could grow out of debt, as post-war US did. The trick is that when r<g current and future investors pay for the debt, not the taxpayers. So, why not to spend more?
 
To assess the merits of an expansion we must ask: will r be above or below g in the future? Indeed, if r becomes higher than g, troubles arise: government debt must be repaid with higher taxes or lower expenditures in the future. In this scenario, then, future generations will have to pay for current debt, rendering current fiscal expansions much less attractive.  In his AEA 2019 lecture Blanchard points out that we should not worry too much about the r>g case.  For most of the 20^th century the US was in fact in the r < g zone
 
 But are there structural explanations for why interest rates should stay so low also in the future? Cochrane argued that there are three potential explanations for why current rates are low. The simplest one is: low GDP growth itself. Average real GDP growth in the US has been under 2% in the last decade (and is projected to remain under 2% in the upcoming one) compared to the average of 3.5% in the 80s and 4.5% in the 60s. This should reduce households’ incentive to borrow, keeping the interest rate low. A second explanation is a growing demand for safe assets: government bonds since the 80s have performed well during recessions, offering valuable insurance. This has also contributed to reduce the interest rate. A third reason is demography: rising life expectancy increases demand for savings and safe assets, which also drives the interest rate down. Cochrane however argued that none of these accounts is fully convincing, which creates substantial uncertainty over the future prospects of r-g.
 
Furthermore, he warned against two problems that could arise with large public debts even in an r<g environment. The first is instability in investor confidence. If investors suddenly come to perceive that the government may not be able to repay its debt, interest rates may suddenly rise. This would make it very costly for the government to service its debt, in turn fueling investors’ fears.  A “doom loop” like this can either results in a sharp inflation or a default.  The second problem is that if the current debt-to-GDP ratio is increased, then, for a given r-g<0, smaller future deficits can be run. This strongly reduces the room for a current fiscal expansion. For instance, the current value of r-g allows for only 1% perpetual deficit under 100% debt-to-GDP or for only a 2% deficit under 50% debt-to-GDP. Current US deficits are much larger than that, and the debt-to-GDP is approaching 100%.
 
In sum, low interest rates have enabled fiscal authorities to spend at a relatively low cost in recent years. Continuing low interest rates may create room for even larger fiscal expansions, which may be desirable, as Blanchard says.  However, there are two problems. First, even if rates stay low the space for additional expansions seems small, given the already high debt. Second, interest rates may suddenly increase in the future, creating large risks. This suggests caution. As Cochrane put it, “Spend as if you have to pay it back. Because you do."

by Sviatoslav Tiupin