Steady Prices, Sustainable Debt
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- Authors: Ricardo Reis
- Published: March 1, 2022
Overview and context
- Public debt has risen steadily since 2000 with sudden spikes after the financial crisis in 2008 and during the beginning of the pandemic in 2020.
- United States federal government debt: "$30 trillion, equivalent to about 130 percent of GDP, the highest since records began in 1791."
- Since 2000, many central banks delivered steady inflation "of about 2 percent," contributing to low and stable interest rates on public debt.
- Recent developments: "annual inflation in the United States accelerates at the fastest pace since the early 1980s" and "the inflation spike of 2021–22" has challenged previous expectations.
The "specialness" of public debt
- Two broad ways to sustain public debt:
- Run future primary surpluses (historical approach across the 19th and 20th centuries).
- Sustain debt by borrowing at rates lower than private discount rates, generating implicit "debt revenue" from the gap between government borrowing rates and private returns.
- Governments that maximize debt revenue (through reputation and institutions) can sustain larger increases in debt.
- Global driver: the global equilibrium interest rate ("r-star") has been falling for at least two decades due to:
- a demographic transition to older populations,
- a productivity slowdown,
- higher inequality and financial risk.
- Monetary policy affects debt sustainability via currency valuation on repayment and through the voluntary nature of sovereign repayment (inflation and sovereign default are the two central risks that reduce debt revenue).
Five sustainability channels through which monetary policy has supported debt revenue
- 1) Inflation temptation and monetization:
- Central bank independence largely removed the option to use inflation or monetization to erode real debt payments over the past two decades.
- Risk: post-emergency shifts where finance ministries may "take over the functions of the central bank."
- 2) Inattention capital / anchored expectations:
- Consistent delivery of low inflation created inattention, anchoring expectations and allowing nominal government borrowing rates to fall with r-star.
- The "inflation spike of 2021–22" and 2021 signs in the United States showed that expectations can shift, raising future borrowing costs.
- 3) Inflation risk premia:
- Price stability removed inflation risk premia, keeping government borrowing costs low and limiting volatility in Treasury interest expenses.
- Without fiscal buffers, volatile interest expenses increase the likelihood of distortionary tax increases.
- 4) Macroprudential effects:
- Post-financial crisis macroprudential policies increased demand for government bonds as safe, liquid collateral and lowered expected fiscal costs of bailouts, raising debt revenue.
- Risk scenario: if fiscal crises become the main risk, using macroprudential or central bank powers to prop up bond demand can morph into financial repression, enabling larger fiscal deficits and eventual market collapse.
- 5) Quantitative easing and maturity transformation:
- QE replaced long-term government bonds in private hands with overnight central bank deposits, shortening the maturity of public liabilities in the private sector.
- If central banks must raise short-term rates sharply above long-term rates, central bank losses arise (paying depositors more than interest collected on long-term bonds).
- Offset options carry costs:
- Print currency and collect seigniorage (which generates high inflation).
- Ask the Treasury to recapitalize the central bank (which adds to the government deficit).
- A required sell-off of public bonds to restore term structure could itself trigger a crisis; thus, "Countries are therefore stuck in a situation where short-term interest rates may have to rise quickly, which means the state as a whole would face tighter budgetary constraints."
The case for price stability
- Price stability preserves the five supportive channels by:
- Protecting public debt from inflation risk.
- Anchoring inflation expectations.
- Eliminating inflation-related risk premia.
- Preserving the macroprudential role and limits on central bank balance-sheet fiscalization.
- Guiding central bank balance-sheet policy and the fiscal relationship with the central bank.
- Argument against deliberate inflation as a debt-reduction tool:
- Benefits of inflation accrue only if inflation is unexpected; once investors expect inflation, the five channels unwind and borrowing costs rise.
- Reliance on surprising bondholders with inflation is "risky and unsound policy."
- Conclusion: "Governments can avoid sovereign debt crises without sharp turns to austerity as long as public debt is seen as special and its associated debt revenues are high. This requires central banks to be more independent, not less so. It requires an even stronger commitment to an inflation target by governments and central banks alike." Sustaining high public debt is "a job for many years to come."
Key statistics and exact figures (as presented)
- "$30 trillion" — United States federal government public debt.
- "about 130 percent of GDP" — United States public debt relative to GDP.
- "1791" — since records began for U.S. public debt.
- "since 2000" — period of steady rise in debt and steady inflation near targets.
- "2008" and "2020" — years with sudden debt spikes (financial crisis and pandemic).
- "about 2 percent" — steady inflation delivered by central banks over recent decades.
- "2021–22" — period of an inflation spike cited as a shock to expectations.
- "2021" — year when U.S. households showed signs of expecting higher future inflation.
Source: Steady Prices, Sustainable Debt — F&D Magazine, Ricardo Reis, March 2022.
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