Fiscal Policy - How much space do we really have?
Fiscal policy advice for Joe Biden and Congress - A co-hosted event by the Hutchins Centre on Fiscal & Monetary Policy and the Peterson Institute for International Economics.
This event which aired in early December 2020 featured a panel discussion comprised of participants that read like a who’s who when it comes to influencing the economic policy discussion. The panel was made up of Ben Bernanke, Jason Furman, Larry Summers, Ken Rogoff, and Olivier Blanchard. I won’t list their CVs here, but readers can quickly get the sense that these are some of the most powerful voices when it comes to economic policy choices presented to elected leaders. What struck me most about the discussion was the absolute unanimity of opinion that there is no other option of, and no immediate risks attached to, government deficit spending.
The event, which lasted for two hours, included a presentation by Furman and Summers title “A Reconsideration of Fiscal Policy in the Era of Low Interest Rates”. The main thrust of their argument was that by focusing on debt/GDP, governments are massively underestimating the amount of fiscal space they have to stimulate the economy.
They highlight that in an era of low interest rates by comparing a “stock” item (debt) to a “flow” item (GDP) we get a false impression of the level of debt that an economy can or indeed should be running.
To address these perceived problems with the traditional measure they ask us to consider indebtedness both in stock/stock and flow/flow framework. In the stock/stock framework, they convert GDP into what they term “Infinite Horizon GDP” which is an estimate of the present value of all future US GDP and come up with $3.9 quadrillion. How they come up with this number isn’t clear, but the point remains the stock value of all future GDP is a very big number.
In the chart above, they show that while debt/GDP has gone from 30% to 100% since 2004, debt as a percentage of infinite horizon GDP hasn’t risen at all, presumably as a result of a falling discount rate. What is perhaps even more enlightening for listeners, is that they also point out that this $3.9 quadrillion might be a gross underestimate because as long as r (the interest rate on the debt) is below g (the growth rate of the economy) then the value of infinite horizon GDP is infinity. The corollary is that as long as the interest rate on the debt is below the rate of growth of nominal GDP, the amount of debt the economy can sustain is also infinite.
They then move to consider the debt situation using a flow/flow framework (which they say is their preferred method) by looking at real net interest payments as a percentage of GDP. The chart above shows that this measure of indebtedness has been falling for 20 years, even as Debt/GDP has exploded higher. The presenters then put forward an arbitrary limit on real interest payments/GDP of 2% and again conclude that there is a huge amount of scope for further deficit spending.
It is worth emphasising the point that all participants in the discussion are not fringe economists but pillars of the establishment. The gushing approval by all, tells us that this is the message policy makers will be getting loud and clear. Political cover doesn’t come much better than this. The point that they tried to hammer home is that the world is “catastrophically short aggregate demand at zero real rates and balanced budgets”. The conclusion we must draw as investors, is that for a very long time to come, real interest rates will be below zero and government deficits will be through the roof.