Fiscal Discipline: the Age of benign neglect

Neither a blind austerity policy nor a bening neglect of fiscal discipline satisfy the demands of sustainable budgets. A commenary by Charles Wyplosz.

«After years of blind austerity the pendulum swings back.»

A decade ago, budget deficits and public indebtedness were seen as the absolute villain. The Greek crisis was about to start and the collective wisdom, a.k.a. as the latest fashion, led to the widespread adoption of austerity policies no matter what. It did not make sense and, among others, caused the infamous double dip in the Eurozone, a second recession in 2012 following the first one in 2009. Blind austerity subsequently went out of fashion. A new fashion is now building up. It argues that deficits and debts are not a problem. It is as misguided as the previous one. The question is whether it will cause trouble.

Benign neglect of fiscal discipline comes in two strands. The first one is the Modern Monetary Theory (MMT). Championed by US economists, hitherto perfectly unknown and now stars of the media, it states that governments can freely run deficits with needing to borrow if they use the printing press. It is neither modern, nor a theory. It harks back to the 1960s, when simplistic presentations of Keynesian principles indeed suggested that monetary financing of continuous budget deficits would promote growth. This vulgar Keynesianism was not a respectable theory by any stretch of the mind.

Short memory

It was tried in many countries – mostly in South America – with the same predictable results: runaway inflation and collapse of the exchange rate. It gave Keynesian principles a bad reputation, which remains alive up to this day among people who have not noticed that, over the last fifty years, this view has been destroyed and repudiated by mainstream economists. That it now comes back under the MMT label is mystifying, a testimony to short memory or ignorance, both in facts. It is also driven by a swing of the pendulum after years of blind austerity.

The second strand of benign neglect of fiscal discipline is much more elaborate. It has become influential since early this year, when a highly reputed economist (and good friend of mine), Olivier Blanchard, gave the most prestigious Presidential Lecture at the annual gathering of the American Economic Association. The reasoning starts by looking at what drives public indebtedness, measured as the ratio between debt and GDP. This is standard measure of debt, simply because the US debt can safely be much larger than that of, say, Malta, since its economy, from which resources need to be raised to honor the debt, is also much larger.

The ratio grows in the presence of primary deficits, which exclude debt service, and it declines when GDP rises. Debt service, in turn, increases when the interest rate rises. Obviously but crucially, the higher the debt accumulated so far, the larger the debt service is. Two observations follow. First, indebtedness is a vicious circle: the higher the debt, the higher the debt service and therefore the deficit, and the more the debt tends to grow. Second, looking at the debt to GDP ratio, the speed at which this vicious circle unfolds is driven by the difference between the interest rate and the economy’s growth rate.

This has been known for a long time and is not controversial at all, it is mechanical. The innovation in Blanchard’s lecture is the assertion that, in the case of the US, the interest rate has been lower than the growth rate for most years since 1950. When this is the case, again a well-known observation, the vicious circle is broken: the debt to GDP ratio tends to decline, the faster the higher it is, a sort of magic virtuous circle. This does not mean that the ratio always declines. A large enough deficit can offset the tendency offered by the low interest rate or the high growth rate. It is a subtle conclusion, not a blank check for budget deficits.

While Blanchard is fully aware of this subtlety, many of his readers are not. His presentation is sometimes interpreted in simplistic terms: if, as some predict, we have entered an era of ultra-low interest rates, concerns about fiscal deficits is unjustified. In addition, it is argued that governments that can borrow at zero or even negative interest rates would be foolish not to do so to finance productive investments in infrastructure, education, research, possibly health. This is the time to loosen the purse and do good things. Along with MTM, this line of reasoning is shifting the media and political conventional wisdom.

The problem with this view is that it does not quite match reality. If we look at the developed countries since 1961, the interest rate has been lower than the growth rate about half of the time (56% in the US). This means that the virtuous circle in place in a given year can turn into a vicious circle the next year, a useful reminder that betting on miracles can be dangerous. In addition, it is not the case that the debt systematically declines when the interest rate is lower than the growth rate, it happens again half of the time.

The reason is that many governments see a decline in the debt service as an opportunity to increase spending or reduce taxes, a move that pleased a lot of voters. However, when the situation turns around, the government should block the vicious circle and cut spending or raise taxes, which voters hate. Unsurprisingly, the debt then increases 60% of the time. If the past in any guide, on average year to year, the debt increases.

Complex perspectives

A couple of recent examples illustrate the situation when the interest rate is lower than the growth rate. Soon after he took office, President Trump cut taxes. The deficit has grown and the debt has risen. In France, President Macron promised to cut public spending and to bring the debt down. After the Gillets jaunes episode, he has given up on these promises, explicitly noting that a low debt service makes it unnecessary to cut spending. When and if the interest rises above the growth rate, these two countries will face a difficult situation.

This is where another fashionable view comes in. The secular stagnation hypothesis, as it is called, states that we have entered a long era of low interest rates. One reason is that ageing societies save more, another reason is that less people will man more equipment which will cut into firms’ profitability. Maybe, no one really knows. But the hypothesis also predicts lower growth, for the same reasons and more. What will be the net effect on the difference between the interest rate and the growth rate? Piling up assumptions is not the best way to plan for the future. Benign neglect of fiscal discipline may come to haunt us if these hypotheses turn out to have been unwarranted.

By the way, in Switzerland, the interest rate has been lower than the growth rate 68% of the time since 1961, the federal debt is one of the lowest in the world and the debt brake keeps pushing it down towards zero. This sounds like excessive concern, especially since financial markets need safe assets like the federal debt. Simplicity can be counterproductive in all directions.