How I learnt to stop worrying about public debt and inflation


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As UK politics returns to normal, we are finding out what “Trussonomics”, the new British prime minister Liz Truss’s approach to economic policy, means. According to my reporting colleagues, she is preparing a “radical” shift. My fellow economics commentators Chris Giles and Martin Wolf have looked at the tax and spending plans of Truss and her chancellor, Kwasi Kwarteng, and put them both down as gamblers with the UK economy and the public finances.

They have a point: Truss and Kwarteng are preparing to throw a lot of money around. The chancellor committed to a fiscal loosening in his recent op-ed for the FT; the UK will subsidise energy prices more than any other European country; and on Friday we should see the government make good on promised tax cuts. And all this is premised on the unsubstantiated belief that their policies will lift the growth rate permanently so as to pay for their largesse and make everyone better off.

It is all rather reckless. But there is one area where I think the carefree attitude displayed by the new stewards of the UK economy has something going for it, which is their lack of worry about the level of public debt. The FT has reported on the Truss team’s economic plans that “Kwarteng would assess the principal fiscal rule that debt should be falling as a share of national income [in the medium term] to make sure it still worked for the economy” — which rather sounds like not letting concerns about the debt get in the way of the deficits they want to run.

This puts the UK counter-current to the EU, where governments are finally gearing up to agree how to update the bloc’s fiscal rules. While it seems likely the debt rules will be made more flexible, to avoid self-harming demands for too-fast debt reduction, there seems no prospect of abandoning a framework that sets goals for acceptable public debt-to-output ratios.

But what if Truss and Kwarteng are right on this one? To be precise, what if there is no good reason to think that any particular debt level is too high — and whatever it is, it should be treated with benign neglect?

Heretical as that view may sound, there are some powerful arguments in its favour. In 2015, an IMF discussion note, explicitly concluded that in countries not facing prohibitive interest rates, “policies to deliberately pay down debt are normatively undesirable”. The reason is that taxation over and above the amount needed to fund public spending causes more harm to the economy than the existence of legacy debt. Debt inherited from crises should instead simply be left where it has ended up, and allowed to be gradually eroded by growth.

And three years ago Olivier Blanchard gave a prestigious lecture to the American Economic Association in which he argued that the financial and welfare cost of public debt was likely to be small if not negative. That need not mean governments should borrow more, but it also entails that it may not be necessary to tighten the public budget for the purpose of bringing down debt. I would highlight that Blanchard’s analysis was conservative in that it accepts the premise that public borrowing could crowd out private investment. If public spending boosts private investment — by increasing confidence in strong demand or expectations of good infrastructure — that strengthens the case further.

Given the insights of the IMF and of Blanchard, what can we say about what debt levels should be? It seems to me that the answer is “nothing”, because the implication of their analysis is that there is no “optimal” debt level. What these arguments point to, then, is what in technical terms is called to “be chill about public debt levels”.

Which is anathema to the EU’s fiscal rules, where the notion of “fiscal sustainability” is central to both their letter and their spirit. In practice, fiscal sustainability is understood by policymakers as a sense that public debt can be “too high”. But the arguments above should make us rethink whether “sustainability” makes any sense when applied to debt levels rather than budget deficits.

To be clear, there is certainly an issue of the financial stability of public debt. New debt has to be funded, and old debt has to be rolled over. The eurozone learnt from its sovereign debt crisis not to take these for granted. But market funding is a matter of interest rates and refinancing schedules, which only indirectly relate to the levels of debt outstanding. And that relation is something a government can influence through prudent maturity management (as Blanchard’s lecture also points out). As an illustration, consider stretching out sovereign bond issuances evenly over 100 years. Even a highly indebted government would never face more than a couple of per cent of output in refinancing. And interest rates could be locked in for equally long. It is a great shame that governments did not vastly extend their debt maturities when interest rates were at rock bottom. But even today, most rich countries face long-term rates below their long-term nominal growth rate.

The implication is that while governments should worry about maturity management, deficits in relation to the economic cycle, and above all how they tax and spend, they would do well to forget any targets for debt levels. That will not happen in talks on the EU’s fiscal rule reforms. But the reforms would be better if it did.

Here is a yet more provocative thought: there may be types of inflation we should also treat with benign neglect. It is no surprise to Free Lunch readers that I think central banks are mistaken in their zeal to increase borrowing costs in response to current high inflation. In a nutshell, my view is that inflation in rich countries is not driven by excessive demand — which is near normal levels thanks to the strong policies to get us out of the pandemic shutdown of our economies — but by two or three other phenomena. In early 2021, it was the enormous sectoral shift in US consumer spending (from services to goods) that meant goods production could not keep up, especially with supply-chain disruption added in. Since late 2021, it has been Russian president Vladimir Putin’s bellicose squeeze on energy markets (which started by throttling gas reserve replenishments in Europe).

I have argued that there is little central banks can do to contain these pressures in the short run, and that there is no need to do so in the longer run because the shocks will dissipate by themselves. Above all, it cannot be an economically optimal response to shocks hitting output and jobs growth to deliberately depress them even further. But what, then, should one do with such inflation?

Maybe — like with debt levels — there is a case for benign neglect here, too. If I am right that trying to rein in this particular type of inflation will only make things worse, then it’s better to leave things alone. But what if — as the best argument for tightening assumes — expectations of higher inflation get entrenched, and that causes inflation to be permanently higher?

What if, indeed? Well, it depends on how much higher. Take the US. Expectations for inflation three years hence have gone at most 1 to 1.5 percentage points above where they were in the five years before the pandemic; at five-year, 10- and 30-year horizons the increases are much smaller. In other words, the expectations central bankers worry about are for current inflation to come down fast, but perhaps to slightly higher rates than before. Since expectations were consistent with somewhat below 2 per cent before, if these new ones were entrenched, we might be risking a 3 per cent inflation rate. But since expectations visibly follow current price movements, they could likely settle even lower once inflation slows.

So what if we had 3 per cent inflation for a while? The scourges of central banks’ supposed error have not done much to spell out, let alone quantify, what the cost would be. But what we do know is that more supply shocks are likely to happen. And some of those will be positive ones, which increase growth and reduce inflation. A policy of benign neglect — but to be clear, for these types of shocks, not traditional demand-driven inflation shocks — would amount to this: allowing inflation expectations to drift up a bit when external supply shocks raise prices (and not kill the economy to try to stop this), and then waiting for positive supply shocks to let them drift down (again without trying too hard to stop that).

I am not pretending to have offered arguments that this would be the wisest policy. This is merely a first stab at answering the question “what would you do”. But it spells out what an alternative to the current policy would be. And given that current policy involves the loss of millions of jobs and billions in incomes, it rather behoves its advocates to clarify why they think the alternative of benign neglect is so much worse.

Other readables

  • Another reason to treat inflation with benign neglect — or even welcome it — comes courtesy of economist Brad DeLong, who argues that wage and price inflation have to be temporarily high to ease the structural transformation the pandemic forced the economy into.

  • James Plunkett has published the first essay in a series on social justice in the digital age, aiming to enlighten us about what the “invidious hand” of platform companies really does.

  • Norway’s sovereign wealth fund has a new climate action plan, and wants all the companies it invests in to reach net zero emissions by 2050.

  • FT Alphaville has tried to measure the monetary value of joining The Queue — or of giving up one’s place in it.

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