With the recent strength of long-term bond prices, nominal GDP growth currently exceeds 10-year borrowing rates in most developed countries. The gap between the two has become especially pronounced in places like Germany, whose sovereign debt carries a negative yield.
This theoretical support for loosening fiscal policy dovetails with rising popular backlash against austerity. Europe, in particular, has struggled to find the right formula to generate additional economic growth; budget rules within the eurozone severely constrain the ability of governments to spend. When the IMF provides support for struggling economies, it typically requires strict budget control in return. This damages economic growth.
Opening government purse strings would also take pressure off central banks. Monetary policy continues to stretch and strain, but inflation remains below targets in most markets. Rates are low (or negative), quantitative easing programs are reaching their limits, and forward guidance is losing effect. And the low-interest-rate environment is leading some investors to become more aggressive, creating a risk to financial stability.
But there are potential problems with opening the fiscal floodgates. Firstly, the additional budget room may not always be used wisely; it could be dangerous to assume incremental outlays will produce enough incremental growth. Making additional investments in infrastructure might chin the bar, but increasing public pension benefits may not. The selection process for government projects may be driven more by politics than economics.
Secondly, as mentioned earlier, any investment done by governments has the potential to crowd out private investment. Blanchard suggests this risk is modest; business investment around the world has been soft lately, despite very low rates on corporate debt. But the merits of direct spending by the public sector vis-à-vis providing investment incentives to the private sector are worthy of careful discussion.
Finally, the notion that borrowing comes without consequences still sits uneasily with some of us. Economic growth has exceeded borrowing rates for most of the past decade, but debt-to-GDP ratios have continued to increase. Interest rates may not always be as low as they are today; the greater the debt, the greater the potential that investors will demand a premium for holding it. The more governments try to exploit interest rates that are below growth rates, the sooner this favorable borrowing window will close.
Proponents of modern monetary theory will probably accuse me of being stuck in the past. But anyone forced to eat three-week-old spaghetti will have an aversion to repeating the experience. Taking on too much debt is a similarly unappetizing prospect.
Third Time’s The Charm
This week, the Federal Open Market Committee (FOMC) cut the federal funds rate by another 25 basis points to a range of 1.50-1.75%. This marks three consecutive meetings with cuts, and we believe it will be the last reduction for some time.