Public debt: don’t target the quantity, target the price

As I’ve mentioned previously, when I started work on Economic Consequences of the Pandemic, I assumed I’d be writing a polemic against austerity, as I did in Zombie Economics. Based on the last crisis, it seemed likely that any stimulus measures would be wound back rapidly, leading to a sluggish and limited recovery. That’s pretty much what is happening in Australia, where I live, but not in the US, where the book will be published. On the contrary, Biden’s policies are pretty much what I would have advocated (certainly if you take into account the razor-thin majorities he is working with). And, with luck, the main elements will be in place by mid-year, long before my book can appear.

So I’m refocusing on the issue of debt and how it can be managed. This was the central issue after the Treaty of Versailles, and also in the return to the gold standard, which prompted The Economic Consequences of Mr Churchill. io o

My central conclusion is a simple one. Rather than aiming for a fixed ratio of public debt to GDP, governments should aim to control the long-term rate of interest on inflation-protected bonds, and set it at a rate of around 1 per cent, about equal to the long-term rate of productivity growth. Since rates are well below that now, there is plenty of room for more public investment.

More over the fold

Instead of targeting the quantity of public debt it is better to focus on the price, which is best measured by the real (inflation-adjusted) rate of interest on long-term government bonds. For the US, this is represented by the interest rates for Treasury Inflation-Protected Securities (TIPS), the principal of which is adjusted in line with inflation. Currently, the rate of return on 10-year TIPS is negative (about -0.5) while the rate on 30-year TIPS is just positive (about 0.1 per cent).

These rates have been declining slowly over recent years. However, the passage of the American Recovery Plan and the announcement of the Biden Infrastructure package, involving around $5 trillion in new expenditure led to an increase of around 0.5 percentage points.

get the right strategy on public debt, it’s worth considering why any limit might be imposed. The answer is that lenders might refuse to buy more bonds and demand the repayment of the existing debt as it falls due. If governments cannot raise the money required, as has happened on many occasions, a crisis will ensue. There are three main concerns here

  • If debt is denonominated in a foreign currency, and the domestic currency depreciates, the burden of repayment can increase rapidly
  • If bond buyers fear future inflation, they will demand higher rates of interest to compensate for this
  • If bond buyers fear that the government will default on its obligations, they will be unwilling to buy bonds and will demand an interest rate premium

The US does not face the first problem, since its debt is denominated in US dollars. The second is not as big a problem as it seems, since government revenue will rise broadly in line with inflation. Nevertheless, to clarify the issue it is best to focus on TIPS

If investors fear a default, the real rate of interest on inflation-protected securities will increase. Unlike exchange rates and expectations about inflation, which can change rapidly, real interest rates typically move very slowly.

As can be seen below, the rate of interest on 10-year TIPS has declined gradually since the turn of the century, falling from a little over 2 per cent to a range between 0 and 1 per cent in the years before the pandemic. Rates spiked briefly by 2 percentage points in the worst of the financial crisis, before returning to the previous trend.

There was also a brief uptick during 2012 and 2013. The rate fell to negative levels between 2011 and 2013, following large scale purchases of government bonds (quantitative easing), followed by a return to just under 1 percent. The reversal, occurring when investors expected a rapid reversal of ‘quantitative easing’ , is sometimes referred to as the ‘taper tantrum’, but what is more striking is how modest these fluctuations have been.

The key implication here is that, if long-term fiscal policy is focused on maintaining a low and stable real rate of interest on government debt, there is little likelihood that it can be derailed by a sudden change in investor sentiment. rate
The stability of rates can be enhanced by a shift to longer term financing. There is a strong case for relying more on 30-year bonds and encouraging retirement income systems that invest in these bonds to provide secure incomes.

The ultimate long term security is a perpetual bond, like the ‘consols’ on which the British government relied in the 19th century. The advantages of perpetual securities have been discussed by both conservative and liberal writers.

Where should the target rate be set? In a world of technological progress, we expect that there should be investment opportunities that yield a positive rate of return, roughly measured by the rate of multifactor productivity growth (the growth in output from a given input of labour and capital). This is about 1 per cent.
Even before the pandemic crisis, the TIPS rate was consistently below 1 per cent. This implies that, with a 1 per cent target, there is substantial room for public investment financed by long-term debt, even after the passage of the infrastructure bill.

On the other hand, there are good arguments for gradually unwinding the expansionary measures adopted specifically in relation to the pandemic emergency. This would provide more room to move in the event of a similar emergency arising as unpredictably as the pandemic and, before that, the GFC [these events weren’t, in fact, unpredictable and were in fact predicted, but even those who feared such events couldn’t say when they would hit]

Last Word on the Golden Age (for now)

Thanks to everyone who has made useful comments on my recent posts. I need to move on to present concerns, so I’m finishing my writing on the post-War Golden Age (or whatever you would like to call this period). Here are some thoughts I still need to organize

Over the period since 1900 as a whole, there hasn’t been any clear trend in the rate of technological progress for the US. However, from 1950 to the early 1970s, the US economy was closer to the ‘frontier’ determined by technological progress and available resources before or since, and the output of the economy was shared more equally than before or since.

We can’t replicate these things exactly, but we can use a revamped version of the mid-C20 institutions as a starting point for a Green New Deal.

The breakdown of the Keynesian-social democratic moment in the late 1960s and early 1970s was largely the result of mistakes which were probably inevitable at the time, but may be avoided if we learn from them.

What went right

The strong growth in aggregate output from the late 1940s to the late 1970s primarily, though not entirely, reflected the fact that the economy moved from operating well below its technological potential to operating at or near the technological ‘frontier’.

The most important implication is that egalitarian economic policies and social institutions are conducive to good economic performance at an aggregate level. Here’s a list of some of the relevant policies (commenter TM at Crooked Timbe suggested most of these, and I’ve added some)

  • Policy commitment to full employment – important for expectations
  • Keynesian fiscal and monetary policy – helped in accelerating recovery from recessions
  • Progressive taxation and New Deal welfare state – reduced inequality, and provided automatic stabilisation (as employment falls, tax revenue falls and spending rises)
  • Strong unions (reduced inequality and constrained employer class from aggressive anti-worker policies)
  • Public investment and expanded public provision of services – reduced dependence on business confidence
  • Broad access to education at low cost, necessary to achieve productive potential of the economy
  • Low capital mobility and financial repression – kept power of financial capital in check, avoided waste of resources in financial sector

What went wrong

The breakdown of the Golden Age can be traced to a combination of

  • Hubris on the part of the technocratic policy elite, reflecting in a belief in their ability to ‘fine tune’ the economy, and to run the War on Poverty and the Vietnam War at the same time
  • Mistaken belief on the left that the US and the world were approaching a revolution and that impossibilist demands (particularly, but not exclusively in relation to wages and conditions) could help to bring this about
  • The rapid but unrecognised growth in the power and global mobility of financial capital arising from the end of international capital controls and domestic financial repression

Around 1970, these factors combined to produce an inflationary outburst which, in a context of capital mobility brought about the end of the Bretton Woods system of fixed exchange rates (the residual role of the gold standard played an important technical role here). This in turn produced more financial deregulation and more volatility leading to an escalating crisis.

Developments in ideas were also important. Friedman and the Chicago school had correctly predicted the inflationary consequences of policies pursued by Keynesian technocrats in the 1960s, and therefore was well positioned to replace them as guides to both macroeconomic and microeconomic policy. Even though the policies did not restore the strong and egalitarian growth of the Golden Age, they were highly beneficial to the financial sector which rapidly achieved sufficient political and economic dominance to ensure that its wishes prevailed.

What didn’t matter

The 1973 oil shock is often seen as central to this story, but it occurred well after the critical events, including the breakdown of Bretton Woods and the failure of wage-price controls. It was a late development in a general upsurge in commodity prices. More broadly, the idea that the pre-1973 period was one of cheap and abundant energy compared to subsequent decades is only true for oil, which became steadily less important in economic terms after 1973, despite being a continuing focus of geopolitics. Prices and production for coal, natural gas and electricity followed different paths.

The Golden Age

In most societies, there is a myth of a ‘golden age’, a time when men and women lived simply and happily, free from the cares and troubles that afflict them today. This myth usually includes an account of how, through foolishness or malice, the golden age was lost. In Western versions, the blame has been placed upon women – Pandora opening the box and Eve taking the apple.

In the economic history of the developed world, there is one historical episode which might reasonably be regarded as a golden age. Between 1945 and 1973, developed countries in Western Europe, North America and Oceania experienced strong economic growth, combined with minimal levels of unemployment and a sharp decline in inequality. In policy terms. the dominant features of this period were the use of Keynesian macroeconomics to stabilize the economy and the development of a fairly comprehensive welfare state, protecting citizens from falling into poverty due to old age, incapacity or unemployment.

Those are the opening paragraphs for Chapter 2 of The Economic Consequences of the Pandemic. Comments and criticism much appreciated.

I adapted some of it, with more of a focus on Australia, for this article in Inside Story, also published in the Canberra Times

The Economic Consequences of Mr Biden

When I agreed to write The Economic Consequences of the Pandemic for Yale UP, with a target date of May 2021 the idea was that it would be a polemic against austerity along the lines of Keynes’ The Economic Consequences of Mr Churchill, and the The Economic Consequences of the Peace [1] . In view of the rapid resurgence of austerity politics after the Global Financial Crisis, about which Henry and I wrote here, it seemed like a safe bet that this would be a hot topic in 2021. Even when Joe Biden won the election, and then the voters of Georgia gave the Dems a wafer-thin Senate majority, it still seemed likely, that we would see, at best, a half-baked “compromise” along the lines of the Republican counter-proposal to the American Recovery Program.

But here we are, a couple of months later. Not only has the ARP passed with the only significant cutback being the exclusion of the $15 minimum wage rise, but the Administration is already talking about an additional $3 trillion in infrastructure expenditure. If that happens, it will be after I’m due to finish my manuscript, but well before the book comes out.

All of this is great news, but it means I need to produce a different book to the one I had planned and have already written a fair bit of.

I could continue in the vein of the oppositional polemic I had planned, and talk about the inadequacies of Biden’s program, but I don’t see any benefit in that.

What I now see as the big danger is not austerian limits on spending, but shying away from the need to raise taxes on the well-off [2]. Roughly speaking that means those in the top 5 per cent of the income distribution, who account for around 25 per cent of all income, more than everyone below the median (estimates vary a lot, here’s one based on 2010 Census)

This needs to happen quite soon if it is to be in effect by the time employment returns to pre-pandemic levels. Before ARP, the Congressional Budget Office estimated that this wouldn’t happen until 2024. But with ARP and another round of stimulus, it’s reasonable to expect a recovery (at the aggregate level, though not for all places and sectors) by 2022. With that timing, the correct option is to include revenue measures as part of the infrastructure packages. That seems to be on the agenda, but will face serious resistance, as increased taxes always do.

The constraints of the pandemic, and the substantial public assistance provided to deal with have left many households flush with cash. That’s particularly true of high-income households who were able to work remotely, didn’t lose their jobs and benefited from rising asset prices. To raise substantial revenue, and avoid hitting capacity constraints, it’s necessary to tax away some of those gains, as well as reversing corporate tax cuts, the benefits of which ultimately flow to the same group.

Apart from the obvious resistance that always faces higher taxes, and the presumption of uniform opposition from the Republicans, the biggest obstacle may come from those influenced by what I’ve called the pop version of Modern Monetary Theory, which suggests that there is no benefit from taxing the well-off other than to make them not so well-off. Bearing in mind that we are talking about millions of people who regard themselves as middle-class

Correctly understood, the core of MMT (namely, the functional finance version of Keynesianism presented by Abba Lerner in the 1940s is entirely supportive of higher taxes once the expansion is well under way. The key to functional finance is that taxes should be used to ensure that aggregate demand is consistent with the productive capacity of the economy, neither too low nor too high. If we want a big increase in public expenditure, its necessary to prevent high-end private consumption and speculative investment from crowding out vital social needs.

fn1. The Economic Consequences of the Peace was not precisely about austerity, but about the same underlying thinking, that massive reparations could be extracted from Germany without worrying about the macroeconomic effects there and in the recipient countries.
fn2. I’m carefully avoiding the term “rich” here, which mostly seems to be applied to a tiny stratum typified by Bill Gates and Jeff Bezos.