MIT Press released last week a volume containing the papers and discussions we organised at the Peterson Institute conference 18 months ago agnostically titled, Evolution or Revolution? Rethinking Macroeconomic Policy after the Great Recession (Blanchard and Summers 2019). While matters are far from clear, the events of the last year and a half lead us to regard secular stagnation as a significant threat to advanced countries. From somewhat different perspectives (Blanchard 2019, Rachel and Summers 2019), we have increasingly come to believe that a major rethinking of macroeconomic policy, and in particular of fiscal policy, is in order.
We had written in our overview paper that:
“At a minimum …policies may need to become more aggressive both ex-ante and ex-post with a rebalancing of the roles of monetary, fiscal, and financial policies. While low neutral rates decrease the scope for monetary policy, they increase the scope for fiscal policy. Think of such rebalancing as evolution. If, however, neutral rates become even lower or financial regulation turns out to be insufficient to prevent crises, more dramatic measures including larger fiscal deficits, revised monetary policy targets or sharper restrictions on the financial system may be needed. Think of this as revolution. Time will tell”
We are struck by several changes in economic conditions since the time when we wrote.
First, neutral real rates as judged by markets or financial observers have not increased and have likely declined even as the crisis has receded. The notion that low rates largely reflected the after-effects of the financial crisis and would slowly fade away has simply proven wrong. In the US, 10-year real interest rates have declined significantly in recent months and are about where they were 18 months ago, despite the passage of major tax cuts. In response to concerns about the possible weakening of the economy and the absence of inflation pressure, the Fed chair has signalled that the current tightening cycle may be over, with short rates below 2.5%. The markets regard the next central bank move as considerably more likely to be a rate cut than a rate increase. In Europe, in response to economic weakness, the date at which interest rates will return to positive territory has been pushed back several years and discussion has shifted to restarting quantitative easing. In both Germany and Japan, indexed bonds suggest negative real rates as a feature of economic life for the next generation.
Second, fiscal policy has continued to be expansionary in Japan and has turned strongly expansionary in the US and mildly expansionary in Europe, without leading to anything like overheating. Despite this fiscal stimulus, inflation has barely reached the Fed’s inflation target, and market expectations are for less than 2% inflation even looking out 30 years. In the euro area and in Japan, inflation remains below target, with little indication that the target will be met any time soon. We see it as a strong indication that, despite aggressive macroeconomic policies, output is still below potential, at least in the euro area and in Japan.
To us, these facts lead to the inevitable conclusion that fiscal policy will have to play a much bigger role in the future than it has in the past. Surely, there is not enough space, even in the US, for monetary policy to respond adequately to a standard-sized recession. Recall that the typical US recession has been associated with a 500-basis-point decrease in policy rates – a decrease twice as large as the value of the policy rate today. But the problem may be more recurrent and more fundamental. Aggregate demand may remain chronically low, implying sustained low neutral rates. The zero lower bound may be binding for long periods of time, implying a lasting need for sustained fiscal policy help and a more dramatic redistribution of roles between monetary and fiscal policy. We should be clear here. Higher public debt per se has welfare costs, although, as one of us has shown, the low rates are a signal that these welfare costs of higher debt may be limited. But, in the current environment, to the extent that higher deficits can help reduce or eliminate the output gap, the benefits may well exceed these costs.
The long zero lower bound episode in Japan is highly instructive. Since 1999, the policy rate has remained at or very close to the zero lower bound. The size of the balance sheet of the Bank of Japan has been multiplied by more than five. On the fiscal side, Japan has run an average budget deficit of 6% of GDP, and net debt has increased by nearly 90% of GDP. Yet, the zero policy rate, aggressive QE, and dramatically expansionary fiscal policy have not even succeeded in maintaining output at potential. For a long time, economists looking at Japan pointed to mistakes in policy and excessive reliance on deficits; it is now clear that the Japanese macroeconomic response was, on net, the right one.
One may argue that these issues only arise when a country is at the zero lower bound, and that the US is now away from danger and the need for such extreme policies. This would be wrong. First, even when rates are positive but close to zero, the risk that a slowdown in demand may take the economy back to the zero lower bound will lead households and firms to worry, leading to even lower demand and a higher likelihood of running into the bound. Second, even if the zero lower bound could somehow be avoided – say, by prohibiting cash and paying negative interest on money balances – very low rates appear to be often associated with excessive risk taking, ranging from excessive leverage to an increase in the frequency of bubbles. Third, there are good reasons to believe that the effect of interest rates on aggregate demand is weaker the lower the rate; indeed, the argument has been made that there is a ‘reversal rate’ below which the effect of the rate changes sign, and lower rates actually decrease lending. Fourth, looking at the long run, low rates may allow zombie debtor firms to remain in existence too long, slowing down reallocation and possibly growth. We do not consider the evidence for each of these factors to be overwhelming, but together they provide a case for keeping neutral rates reasonably high, and by implication being willing to run the appropriate expansionary fiscal policy to sustain demand.
This in turn raises the question of how to coordinate fiscal and monetary policy. That they could work in opposite directions was made clear in the US, when the Fed bought long bonds to decrease their yield and the Treasury used the opportunity to lengthen the maturity of government debt. Coordination in this context, however, raises delicate issues. One of the main advances in monetary policy has been to give independence to the central bank, giving it an inflation target and letting it achieve it on its own. Can this remain the case if both fiscal and monetary policy must work together to achieve full employment? The flat slope of the Phillips curve makes it very appealing to go for time-inconsistent policies, to risk overheating at the cost of apparently limited inflation in the short run. Can the danger be avoided?
We now turn to even more exotic questions, triggered by Japanese developments. Net government debt has now reached 150%. So far this has happened with no increase in interest rates, but were investors to worry and require a larger spread, the higher the debt, the higher fiscal adjustment required to avoid a debt explosion. This raises the question of how to reduce that risk. One way is to increase the maturity of the debt, so that the increase in interest rates affects interest payments only over time, giving more time for the government to adjust. Another is to rely more on implicit, non-tradable debt (for example, giving a larger role to pay-as-you-go social security, which is clearly immune to sudden stops). Yet another is to ask the private sector to take on more of the debt. In general, because of its power to tax, the government is best placed to take on debt, but one must wonder whether this remains true at Japanese levels of public debt. One can think of measures – perhaps even distortionary measures – giving incentives to households to save less and to firms to invest more. The distortions may be less costly than the risks of very high public debt.
Evolution or revolution? The choice of label may depend as much on the temperament of the labeller as on an objective reading of economic conditions. We noted in our chapter in the recently published volume (Blanchard and Summers 2019) that both the Depression and the Great Inflation of the 1970s led to dramatic changes in macroeconomic thinking – much more dramatic than have yet occurred in response to the events of the last decade. We think it is increasingly likely that this gap will close in the next few years as a combination of low neutral rates, the re-emergence of fiscal policy as a primary stabilisation tool, difficulties in hitting inflation targets, and the financial ramifications of a low-rate environment lead to important changes in our understanding of the macroeconomy and in policy judgements about how to achieve the best performance.
Blanchard, O (2019), “Public Debt and Low Interest Rates'', American Economic Review 109(4): 1197-1229.
Blanchard, O and L Summers (eds) (2019), Evolution or Revolution? Rethinking Macroeconomic Policy after the Great Recession, MIT Press.
Rachel, L and L Summers (2019), “On Falling Neutral Real Rates, Fiscal Policy, and the Risk of Secular Stagnation”, Brookings Papers on Economic Activity (forthcoming).