Governments across the developed world are seemingly competing to borrow the most to use for fiscal stimuli, here's why that makes sure interest rates will stay low.
I wrote about public debt last week, specifically about how increasing public debt can lead to decreasing private investment and I want to follow up on that post with a discussion of how public debt interacts with monetary policy. With government spending and borrowing on the rise across the developed world it seems an appropriate time to tackle the issues of public debt and what the long-term consequences of large-scale fiscal stimulus packages could be. I want to preface this discussion with the caveat that I’m not against fiscal stimulus packages financed by public debt, I think such programmes are necessary to reduce the suffering that the current pandemic has wrought. That being said, I am worried about the long-term damage resulting from high levels of public debt in a low interest rate environment.
Last week’s post was mainly about the crowding out effect and how it can create an environment which can cause investors to seek more risky assets as safe assets’ real yields approach zero, or in some cases go below zero. If you haven’t read that post you can read it here, it could be useful as it explains some of the concepts which will feature in this post. The current environment in financial markets where safe assets offer little to no returns should in theory sort itself out as soon as interest rates start rising which make safe assets more enticing to investors who want some return on their investments and thus the general level of risk-taking in financial markets should decline.
The problem is that high and rapidly increasing levels of public debt offers strong incentives for states to keep interest rates low as that eases the debt-burden. Central banks are supposed to be independent from governments and thus should be more concerned with their mandates which are typically to keep inflation to a modest level, the standard goal being 2 % inflation per year, but there are some central banks with other mandates such as the Federal Reserve which has a dual mandate of stable prices and maximum sustainable employment. Whether or not central banks are disciplined enough to pursue their mandates of stable prices no matter the harm such a policy could cause the rest of the economy remains to be seen, and it wouldn’t surprise me if central banks were to find it difficult to justify raising rates if that would be likely to cause other problems.
Let's discuss this in more concrete terms by using the example of Japan, according to Commodity.com Japan’s debt-to-GDP ratio is 257,44 % at the time of writing. Of course, the size of the national debt is far from the only factor which determines how much of a burden a state’s public debt is, other very important factors are the cost of servicing the debt, which currency the debt is denominated in, and who holds the public debt. Still, any increase in Japan’s interest rate would have a big impact on the cost of servicing the Japanese public debt and thus it would be very inconvenient if interest rates were to rise. If having artificially low interest rates is damaging to the economy, as I suspect, then the Japanese are stuck between a rock and a hard place. Interest rates can’t increase until the debt burden is reduced which can be done in two ways, either by running a fiscal surplus and use the surplus to pay down the debt or to increase inflation to inflate away the debt. Both of these options are problematic; paying down the debt by running a surplus would probably take a very long time, likely one or more decades, given the sheer size of the public debt but inflating away the debt is against the Bank of Japan’s mandate of maintaining price stability and would also cause serious damage to the economy.
The rather dramatic Japanese example is meant to make a point, the point still stand for less indebted societies but Japan's unique situation is a great illustration of how difficult dealing with public debt can be. I think the best option is to borrow during difficult times to help the economy through fiscal stimuli, but I think it’s important to recognise that there are no free lunches and that debt will always have to be paid back in one way or another; be it through a default, inflation, or painstakingly paying it down over many years. As much as I dislike it, low interest rates and quantitative easing are here to stay. If rising inequality between classes and between age groups, and violent drops in financial markets are at least in part amplified by the current monetary policy environment, as I find to be likely, let’s hope that our governments act responsibly to decrease public debt to a level where we can return to a more sustainable interest rate.
If you liked this post you might be interested in my other posts about monetary policy, which you can find here. I'd be very grateful if you shared this post with a friend or coworker who might find it interesting, and if you return next week for a new post!
Written by Karl Johansson
Sources:
1. https://commodity.com/debt-clock/japan/ Commodity.com, 2020 [Accessed 24/5 2020]
2.https://www.chicagofed.org/research/dual-mandate/dual-mandate Federal Reserve Bank of Chicago, 2020 [Accessed 24/5 2020]
3. https://www.boj.or.jp/en/mopo/outline/index.htm/ Bank of Japan, [Accessed 24/5 2020]
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