In a series of speeches since 2013, former Treasury Secretary Lawrence H. Summers advocated that “secular stagnation – a prolonged period in which satisfactory growth can only be achieved by unsustainable financial conditions – may be the defining macro-economic challenge of our times”. This hypothesis rests, inter alia, on the observed trend decline in inflation and the equilibrium interest rate, combined with the policy rate at the effective lower bound (ELB). Indeed, a broad range of estimates shows a declining trend in the equilibrium interest rate in advanced economies starting in the 1980s, driven by lower trend growth as well as demographic factors. Risk aversion and flight to safety have contributed to a further decline in the wake of the Global Crisis.
Along the lines of Summers and Rachel (2019), it can be argued that the COVID-19 crisis will halt the fall in the equilibrium interest rate, as huge government spending and borrowing will reduce the surplus in savings and, thereby, lead to a rise in interest rates. This idea bears parallels to the 1930s, when the secular stagnation hypothesis was buried after war spending and the Marshall plan stirred economic growth. In this column, we discuss to what extent the sizeable fiscal policy measures announced by governments can reverse the downward trend in the equilibrium interest rate via various channels and, thereby, reduce the severity of the effective lower bound constraint.
Savings and spending
The COVID-19 crisis started as a supply side shock that morphed into a demand shock. High uncertainty and strict lockdown measures are increasingly weighing on the economy, leading to a rise in private savings in the short run. The fall in aggregate demand is, at least partly, compensated by higher government spending, as governments announced substantial fiscal policy measures. While changes in public savings can be seen as a mirror image of private savings in the short run, the effects of the COVID-19 outbreak on aggregate savings are less clear going forward.
Assuming that the COVID-19 crisis is a temporary shock that does not affect savings preferences in the long run, the pent-up demand will give rise to a higher interest rate once the crisis has been solved (given that the equilibrium interest rate is the relative price of future goods over today’s goods). Yet, given the budgetary restrictions in the euro area, budgetary positions will need to be improved at some point, so that the provided fiscal stimulus will be temporary. This reduces the room for a permanent reduction in public savings.
If multiple waves of the COVID-19 virus would demand the lockdowns to continue for longer, the recession might become more prolonged, as opposed to a V-shaped recovery. In this case, the marginal propensity to consume may fall, as higher unemployment risk may further increase preferences for precautionary savings. In this context, Jordà et al. (2020) find suggestive evidence that a shift to precautionary savings is a typical feature of pandemic periods. Such an increase in risk aversion – similar to the one observed after the Global Crisis – will further depress the equilibrium interest rate. As a result, the economy moves towards a new equilibrium (or balanced growth path) with higher uncertainty and lower economic growth.
The lockdown of economies creates conditions in which private sector demand may fall unboundedly. The fiscal measures taken by governments aim to prevent this, by stabilising incomes of households and providing support to firms in the short run. By mitigating the contraction in output, the fiscal policy measures can also affect the equilibrium interest rate to the extent to which they prevent hysteresis, i.e. the transition to the aforementioned new equilibrium with lower potential growth. This argument is akin to the one made by Summers and Rachel (2019), yet note that the fiscal measures will only prevent a further decline in the equilibrium rate, but not raise potential growth above levels seen before the outbreak of COVID-19.
The reason is that the current fiscal expansion will be unlikely to revert the downward trend in investment demand, if it aims at supporting existing economic activities rather than stimulating new investments, R&D or structural reforms. Yet another side effect of higher public spending and borrowing in the longer term might be potential crowding out effects of private investments, which will ultimately also weight on the equilibrium interest rate. Hence to bolster potential growth, it is important that public spending supports private investments and productivity by creating growth enhancing conditions, e.g. by spending on infrastructural projects that would elicit private activities. Along these lines, Krugman (2020) recently called for a permanent deficit financed increase in public investment, arguing that debt sustainability is not an issue as long as interest rates remain below the nominal growth rate.
Public debt developments
The additional public spending due to the COVID-19 crisis will – by and large – be financed by increasing public debt. Germany, for instance, announced to increase debt issuance by an additional €156 billion this year (roughly 4% of its GDP), while for the Netherlands the range is between €45 and €65 billion. This outward-shift of the supply curve in the government bond market leads to an increase in bond yields (Figure 1) – a phenomenon already observed for some countries in anticipation of the announced fiscal measures.
If the increased supply of government bonds persists, it will have a positive effect on the equilibrium interest rate, to the extent that these bonds are considered safe (see e.g. Del Negro et al. 2017 and Caballero and Fahri 2019). The reason is that safe assets hold a convenience yield, which lowers the bond yield. The greater the supply of safe assets, the lower the convenience yield and hence the higher the equilibrium interest rate (conditional on the demand for safe assets).
Against the backdrop of a sharp drop in aggregate demand and the potentially increased precautionary savings, safe governments bonds provide a vehicle for the private sector to hold its increased savings. As a result, increased debt issuance prevents the equilibrium interest rate from falling unboundedly. In the current crisis, a coordinated European debt issuance (either corona bonds or ESM issuance) could contribute to meet the private sector preference for safe assets.
Figure 1 Supply and demand in sovereign bond markets
Source: extension by the authors of the stylized model of Summers and Rachel (2019)
Summers and Rachel (2019) already argued before the COVID-19 crisis that a rise in public debt will lift the equilibrium interest rate. According to their estimates, the increase in public debt-to-GDP ratio by 50 percentage points to 68% GDP in advanced economies since the 1980s has raised the natural rate by 1.5-2 percentage points, ceteris paribus.
Central bank asset purchases
Looking ahead, the accommodative monetary policy, and the recently extended central bank asset purchases in particular, will keep both short and long-term interest rates low for the coming years (with asset purchases shifting the demand curve – temporarily – to the right). This has been foreshadowed by a drop of bond yields following the announcement of the Pandemic Emergency Purchase Programme (PEPP) by the ECB. According to the standard new Keynesian theory, monetary policy has no long-term effects on the real economy and hence does not affect the equilibrium real interest rate. The fact that PEPP is a temporary programme supports this assumption. Following this logic, persistently higher public debt leads to a rise in the equilibrium interest rate and – given the monetary policy stance – will translate into lower real rate gaps, thereby supporting economic recovery.
However, the COVID-19 crisis may give rise to higher demand for safe bonds and permanently higher risk premia on less safe assets. This will worsen financial conditions for private investments and thereby depress aggregate demand. Via this channel, the equilibrium interest rate may decrease, moving the economy to a new equilibrium with lower investment demand. Finally, note that if the central bank continues to hold a large share of government bonds, bond yields themselves will becomes less sensitive to changes in the supply of bonds. Ultimately, this implies a flattening of the demand curve for government bonds, which might lead to a new equilibrium in bond markets.
The COVID-19 crisis leads to a large-scale fiscal expansion, which affects aggregate savings. Excess savings were seen as an important factor in driving down the equilibrium real interest rate in the past decades. The lockdown of economies creates conditions in which private sector demand may fall unboundedly. Government support measures try to prevent this. If the increased supply of government bonds persists, there will be an upward effect on the equilibrium interest rate, to the extent that the bonds are safe and thereby provide a vehicle for the private sector to hold its increased savings. However, the crisis also has a downward effect on the equilibrium rate if potential growth falls and risk premia remain elevated due to increased risk aversion.
Bloom, N (2009), “The impact of uncertainty shocks”, Econometrica 77(3): 623-685.
Caballero, R J and E Farhi (2018), “The Safety Trap”, The Review of Economic Studies 85(1).
Del Negro, M, D Giannone, M P Giannoni and A Tambalotti (2017), “Safety, liquidity, and the natural rate of interest”, Brookings Papers on Economic Activity 2017(1): 235-316.
Jordà, O, S R Singh and A M Taylor (2020), “Longer-run economic consequences of pandemics?”, mimeo.
Krugman, P (2020), “The case for permanent stimulus”, in R Baldwin and B Weder di Mauro (eds) Mitigating the COVID Economic Crisis: Act Fast and Do Whatever It Takes, a VoxEU.org, CEPR Press.
Summers, L H and L Rachel (2019), “On Falling Neutral Real Rates, Fiscal Policy, and the Risk of Secular Stagnation”, Brookings Papers on Economic Activity.