Another extract from my book-in-progress, Economic Consequences of the Pandemic
Over the course of the Covid-19 pandemic, governments around the world have issued huge amounts of public debt, much of which has been purchased by central banks. In the US, for example, Federal public debt increased by $3 trillion over the course of 2020 (this is about 15 per cent of US national income)
while the monetary base (money created directly by the Federal Reserve) increased by around $1.6 trillion. This money was used to buy government bonds along with corporate securities in open market operations (what is now called Quantitative Easing)
Update Important but complicated: the Treasury has been overfunding its spending needs by issuing securities, and then depositing the excess proceeds at the Fed. To accommodate this, the Fed has increased its secondary market purchases of Treasurys. Netting out the Treasury account, the Fed’s balance sheet is $5.6 trillion rather than $7.2 trillion. Moreover, the post-COVID balance sheet expansion was $1.7 trillion, not $3.0 trillion. (moneyandbanking.com/commentary/202…) Presumably, the latest stimulus package ($900 billion) will draw down much of the Treasury account. If I have it right, this has been accommodated in advance by Fed purchases. End update
These policies represent a complete repudiation of assumptions which were considered unquestionable by the political class until relatively recently: that budgets should be balanced, and that public debt is always undesirable.
Even the most widely-accepted modifications of these assumptions are now problematic. A standard view is that budget balances should be stable over the course of the economic cycle. If measured appropriately, this entails a stable ratio of public debt to national income.
But where should this ratio be set?
Back in the 1990s, the European union set a target rate of 60 per cent of national income. At the time, with bond interest rates around 5 per cent, that implied annual interest payments equal to 3 per cent of national income. Taking account of inflation at 2 per cent, the value of payments required to hold debt constant in real terms was about 2 per cent of national income. That’s easily manageable, but still a significant component of government budgets (it’s more than most spend on defence, for example).
Repeating the same calculation today causes some problems. The real rate of interest on high grade sovereign bonds is now negative [That’s true even distressed borrowers like Greece. That is, bondholders are paying governments for the privilege. So, the more debt governments issue, the more they receive.
And there is, it appears, no real limit. Japanese government debt is equal to more than 200 per cent of national income. But 5-year government bonds yield negative returns, just as they do in Germany. Even bonds with a term of 30 years offer interest rates below 1 per cent, below the current rate of inflation.
The bigger question is: in the absence of any apparent constraint on our ability to finance current spending with long-term debt, what policy approach should replace the now-discredited goals of balanced budgets and zero debt. The answer is to consider fiscal policy in terms of the need to match aggregate demand (public and private) with the productive capacity of the economy, taking account of the appropriate balance between consumption and investment.
This way of thinking about things comes naturally to old-school Keynesians,
This suggests a policy of matching the maturity of financing public spending with the effective duration of that spending. Current expenditure, such as transfer payments, should, under normal conditions, be financed by taxation. Long-term investments in physical, human or social capital should be financed by bonds with a maturity similar to that of the investment’s lifetime. This approach is broadly consistent with the accrual accounting framework introduced in the 1990s, but left to languish as governments returned to a focus on misleading, but seemingly more comprehensible cash-based measures.
If this approach is adopted consistently, the long-term equilibrium will be one in which the ratio of public debt to GDP will be determined by the stock of public investments in physical and human capital.