Bloomberg is reporting this week that the idea that it is safe for governments to borrow and spend more money – so long as they can get hold of it cheaply, is attracting new attention.
However, the report says that “as a guide to policy, the doctrine has a blind spot.” Because even after arguing the point for a couple of centuries, economists find it hard to pin down what drives long-run interest rates.
“The greatest area of uncertainty in any forecast really concerns interest rates,” Laura Tyson, a senior economic adviser to the Clinton and Obama administrations. “The profession has not been great at timing either the direction or the amount.”
Those are crucial questions as governments try to figure out how much it's safe to spend on pandemic recovery – and for investors wondering if this year's surge in sovereign-bond yields is a blip or the start of an important new trend.
For years, estimates of future borrowing costs have tended to be too high – leading to projections of bigger debts and helping deter public spending. Some worry the opposite could happen now: politicians will grow complacent about low interest rates, borrow and spend too much, then get a nasty surprise when they spike.
But there's a growing school of economic thought that says that governments and central banks play a bigger role in shaping interest rates than the mainstream acknowledges. This could mean that countries can turn their own borrowing costs into “policy choices,” instead of a price that gets discovered in the marketplace.
It's not a new idea, says Paul McCulley, the former chief economist at Pimco. “The central bank has always had more power over long rates than the consensus thought,” he says. “They just weren't exercising it.”
Now, they are – one way or another, Bloomberg says.
The Bank of Japan has been explicitly targeting government borrowing costs for years, under a policy known as yield-curve control. Australia followed suit during the pandemic.
But central bankers, often the main buyers of sovereign debt nowadays, have other ways to steer the yields without officially making them a policy tool. European Central Bank officials, for example, acknowledge off the record that they manage the cost of borrowing for euro-area governments via bond purchases, Bloomberg says.
Sometimes the idea on its own is enough, says McCulley, who now teaches at Georgetown University. Once central banks acknowledge they have that power, “and the market agrees with that, then it becomes a self-fulfilling prophecy.”
The concern about such policies has been that politicians will spend their countries into bankruptcy or hyperinflation without some kind of external discipline.
Once, financial markets were thought to provide it. More recently the task has been assigned to central banks which were walled off from the rest of government so they can focus on nipping any signs of inflation in the bud.
Key parts of that intellectual edifice have crumbled, however. Bigger budget deficits and debts, one of the things that were supposed to push interest rates higher, didn't do so. Politicians pivoted to austerity anyway, without much of a push from the markets--and economies suffered a lackluster recovery as a result.
COVID-19 is now being seen as different. Spending by governments has been the key to recovery – and the frameworks for assessing how far they could safely go didn't seem much use.
Typically based around budget deficits or national debts as a share of the economy, traditional fiscal guidelines didn't have a role for interest rates – as debt has become cheaper to service even as it grew bigger. Even the Euro area, which enforces a strict version of the old-school rulebook, threw it out in the pandemic.
So, economists are now working on new rules, Bloomberg says.
In a November paper, Jason Furman and others argued that the interest payments a government has to make every year are a better benchmark than its total debt or annual deficit.
The idea carries weight in the Biden administration Bloomberg says and notes that Treasury Secretary Janet Yellen agrees with it.
Furman says that the rule of thumb advocated in his paper – keeping real debt-service costs below 2% of GDP – is applicable regardless of who's right in the debate about what drives interest rates.
“Can central banks decide one variable? Yes. Can they simultaneously decide three variables? No,” he says. “You can do financial repression for a while,” but that just makes it harder to meet other targets like keeping inflation under control.
Modern Monetary Theory (MMT) agrees that inflation is the ultimate yardstick for policy. But it has different ideas about how governments pay for their spending – and what determines long-term interest rates.
While some economists favor explanations such as ageing populations, rising inequality and capital-saving technology, the MMTers believe that when central banks persist in keeping short-term borrowing costs low, they shape long rates too.
And MMT economists see the debate increasingly shifting in their favor. Countries that borrow in their own currencies can't go broke, they say, and the real risk of overspending is inflation not bankruptcy. Now the MMTers would like the profession to take another step in their direction by acknowledging that governments can manage their own borrowing costs.
In the mainstream models, even low interest rates face the danger of spiking that threatening economic plans, says Scott Fullwiler, an MMT economist and professor at the University of Missouri-Kansas City. “They haven't put into this framework that the interest rates are a policy variable.”
So, we will see. These ideas continue to be bitterly controversial in some quarters and stakes are high. The debate is far reaching and certainly one producers should watch closely as it intensifies, Washington Insider believes.