A Reconsideration of Fiscal Policy in the Era of Low Interest Rates
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@JasonFurman and @LHSummers argue that traditional debt-to-GDP ratios are inadequate for assessing fiscal sustainability in an era of low interest rates. Nominal or real interest payments as a share of GDP provide a more accurate measure.
Jason Furman and Lawrence Summers, "A Reconsideration of Fiscal Policy in the Era of Low Interest Rates," November 30, 2020, Discussion Draft, https://www.piie.com/system/files/documents/furman-summers2020-12-01paper.pdf
This is their argument in practical/policy terms, “…Specifically, by way of illustration, these estimates assume $2.5 trillion in additional fiscal support over the next there years and an investment program that starts at a net cost of 1 percent of GDP but eventually starts to result in deficit decreases over a longer period of time. Overall, this would mean about $5 trillion of deficit-financed investments over the next decade plus additional investments paid for by added revenue or other spending reductions. The result is that the debt would stabilize at less than 150 percent of GDP which would be the highest the United States has ever experienced but nominal interest payments would still be only 3.8 percent of GDP and real interest payments would be only 1.0 percent of GDP (around the 77th percentile of historical experience)…”
This is their takeaway on guardrails in terms of fiscal space, "... As a new guidepost, we propose that fiscal policy focus on supporting economic growth while preventing real debt service from being projected to rise quickly or to rise above 2 percent of GDP over the forthcoming decade. We also propose three guidelines that would be consistent with achieving this broader objective within the guidelines we recommend: (i) undertaking substantial emergency spending that is not paid for in response to economic downturns; (ii)paying for all long-term commitments with broad exceptions for ones that plausibly pay for themselves in present value;and (iii) improving the composition of government to make it more supportive of demand and also more efficient...."
Note this, "...In that sense the U.S. fiscal situation is by definition sustainable—effectively it has an asset equal to at least several percent of GDP that it could choose to collect if it needs to. Higher tax countries have less room in this regard. France, for example, is closer to the top of its Laffer curve so would have less space to close a fiscal hole with more revenue. Considerations of debt sustainability need to take into account not just the amount of taxation under the law but the capacity for taxation..."
An FYI as this might be useful. Furman and Summers make the case for expanded fiscal policy given persistence low rates, seemingly the same argument works for (growth oriented) tax cuts. They note the implications of sustained lower rates going forward, "...The decline in interest rates has three important implications: (i)as monetary policy is limited in its ability to stabilize the economy and financial system, fiscal policy must play a critical role; (ii) fiscal sustainability cannot be assessed by traditional debt-to-GDP ratios but should instead be understood with measures like nominal or real interest as a share of GDP; and (iii)many public investments pay for themselves, or come close to paying for themselves, and the risk of not undertaking these investments is larger than the risk of doing too little deficit reduction.The remainder of this paper discusses these three implications in turn...."
In turn, "...The main concerns about fiscal expansion in economic downturns is that they will lead to unsustainable debt and may not be affordable in countries that currently have high debt levels. This concern is misplaced. At a minimum, countries can always come back later to raise revenues or reduce spending in order to get debt trajectories back on a desired course. More importantly, this may not even be needed as fiscal support may help fiscal sustainability by increasing output more than it raises debt, thus reducing the debt-to-GDP ratio..."
In terms of debt sustainability this struck me as an argument we will be hearing going forward, Despite debt-to-GDP going up ~ 3x since 2000 the debt relative to the present value of future GDP has been stable/falling (as interest rates fall present value goes up) at the same time real debt service has also fallen relative to GDP. "...We argue that debt-to-GDP ratios are a misleading metric of fiscal sustainability that do not reflect the fact that both the present value of GDP has risen and debt service costs have fallen as interest rates have fallen. Instead we propose that it is more appropriate to compare debt stocks to the present value of GDP or interest rate flows with GDP flows..."
Ed Comment:“Although I still think the langue is hard to understand although the sign is correct—i.e. interest as a percent of GDP is lower.”
Steve Comment: “So for accounting purposes the Fed isn’t currently treated like a Federal entity. They like your note above argue, “…Thus, the Federal government’s consolidated net interest should subtract out remittances to the Federal Reserve which are currently inaccurately classified as a receipt (or revenue item) not as net interest. Figure I.2 shows the gap between net interest and net interest minus Federal Reserve remittances over the recent past…”However they don’t note the Fed’s interest payments as another Federal liability however. Here is their full explanation, “…The Federal budget defines “net interest” largely as the interest paid on Treasury bonds with adjustments for other interest paid and received by other Federal agencies (for example, the equity earnings of the National Railroad Retirement Investment trust partly offset net interest). The data do not count the Federal Reserve as part of the Federal government even though it is clearly a Federal agency and the Treasury’s and Federal Reserve’s balance sheets should be thought of on a consolidated basis for thinking about fiscal sustainability and the macroeconomy. Put another way,fiscal analysis should essentially not count the Treasury debt held by the Federal Reserve but should add the Federal Reserve’s reserves because these are effectively interest-bearing short-term debt. In 2019 the Federal Reserve earned interest of $103 billion largely on its Treasury and mortgage securities while paying $41 billion in interest mostly on reserves. This $62 billion interest spread reflected the higher interest rates it received on its longer-term assets than it paid on its shorter-term debt and $55 billion of this spread was remitted to the Treasury. Thus, the Federal government’s consolidated net interest should subtract out remittances to the Federal Reserve which are currently inaccurately classified as a receipt (or revenue item) not as net interest. Figure I.2 shows the gap between net interest and net interest minus Federal Reserve remittances over the recent past. The gap between these two is likely to grow substantially over the next several years as the Federal Reserve has expanded its balance sheet but the latest CBO projections expect it to come back down to 0.2 percent of GDP in 2030 (CBO 2020a)….”
Ed Comment:“…True if interest rates stay low for a long time. Not true if they don’t. Not great if you need savings/capital for other reasons, to solve global warming for example, or to respond to another crisis.plz clarify their point on adjusting interest expense for the fed. I would say the fed transforms debt form one form to another—from a treasury to an excess reserve. The interest paid on debt help by the fed should not be counted but the interest paid by the fed should be included. If you included all the interest paid, including interest paid to the Fed, you would subtract interest paid to the fed but add interest paid by the fed to banks. Perhaps the difference between those two is what the Fed remits to the treasury, but I’m not sure….”