How I learned to stop worrying about public debt and inflation

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With British politics returning to normal, we discover what “Trussonomics”, the new British Prime Minister Liz Truss’s approach to economic policy, means. According to my reporting colleagues, it is preparing for a “radical” transformation. My fellow economic commentators, Chris Giles and Martin Wolf, have looked at the tax and spending plans of Truss and her advisor, Kwasi Quarting, and positioned them as gamblers in the British economy and public finance.

They have a point: Truss and Quarting are preparing to throw in a lot of money. The advisor committed to financial relief in his recent article for the Financial Times; The UK will subsidize energy prices more than any other European country; And on Friday we should see the government implement the promised tax cuts. And all this is based on the unfounded belief that their policies will permanently raise the rate of growth in order to pay for their generosity and make everyone better off.

Everything is somewhat reckless. But there is one area where I think the important stance taken by the new overseers of the British economy has something to do with it, and that is their lack of concern about the level of public debt. The Financial Times reports on Truss’ team’s economic plans that “Kwarteng will establish the main fiscal rule that debt should fall as a proportion of national income.” [in the medium term] To make sure it still works for the economy” — which instead seems not to let debt concerns get in the way of the deficits they want to run.

This pits the UK against the European Union, as governments finally prepare to agree on how to update the bloc’s financial rules. While debt rules seem likely to be more flexible, to avoid self-harming demands for debt reduction too quickly, there does not appear to be a prospect of abandoning a framework that sets targets for acceptable ratios of public debt to output.

But what if Truss and Quarting were right about this? To be precise, what if there is no good reason to believe that any given level of debt is too high – and whatever it is, should be treated with benign neglect?

As heretical as this view may sound, there are some strong arguments in its favour. In 2015, an IMF discussion note explicitly concluded that in countries that do not experience exorbitant interest rates, “deliberate debt-repayment policies are normatively undesirable.” The reason is that taxes in excess of the amount required to finance public spending do more harm to the economy than having old debts. Instead, debt inherited from crises should be simply left where they ended up, and allowed to gradually erode due to growth.

Three years ago, Olivier Blanchard gave a prestigious lecture to the American Economic Association in which he said that the fiscal and welfare costs of public debt are likely to be small if not negative. This does not necessarily mean that governments should borrow more, but it also implies that it may not be necessary to tighten the public budget for the purpose of reducing debt. I would underline that Blanchard’s analysis was conservative in that it accepts the hypothesis that public borrowing can crowd out private investment. If public spending boosts private investment – by raising confidence in strong demand or prospects for good infrastructure – that strengthens the case even further.

Given the insights of the IMF and 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 “ideal” level of religion. What these arguments refer to, then, is what is technically called “quietly about public debt levels.”

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

To be clear, there is certainly the issue of financial stability of public debt. New debt must be financed, and old debt must be replenished. The eurozone has learned from its sovereign debt crisis not to take these things for granted. But market financing is a matter of interest rates and refinancing schedules, which are only indirectly related to outstanding debt levels. This relationship is something the government can influence through prudent management of maturity (as Blanchard’s lecture points out). As an illustration, consider extending sovereign bond issues equally over 100 years. Even an indebted government will face no more than two percent of output in refinancing. Interest rates can be fixed for a long time. It is a shame that governments did not significantly extend the maturities of their debt 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 have to worry about managing maturity, cycle deficits, and above all how they tax and spend, it is best to forget about any targets for debt levels. This will not happen in talks on reforms to the EU’s financial system. But the repairs would be better if you did.

Here is an even more provocative idea: there may be kinds of inflation that we must also treat with benign neglect. It is not surprising for readers of the free lunch to think that central banks are mistaken in their enthusiasm to increase borrowing costs in response to the current high inflation. In short, my view is that inflation in rich countries is not driven by excessive demand – which is approaching normal levels thanks to 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 massive sectoral shift in US consumer spending (from services to goods) that meant that production of goods could not keep up, especially with the addition of supply chain disruption. Since late 2021, Russian President Vladimir Putin has been aggressively putting pressure on energy markets (which began to choke off replenishing gas reserves in Europe).

I have argued that there is not much central banks can do to contain these pressures in the short term, and that there is no need to do so in the long term because the shocks will dissipate on their own. Above all, the optimal economic response to shocks that hit production and job growth cannot be to deliberately further stagnate. But what should one do with such inflation?

Perhaps – as with debt levels – there is a case of benign neglect here, too. If I’m right that trying to curb this particular type of inflation will only make things worse, it’s best to leave things as they are. But what if – as the best case for tightening supposes – expectations of higher inflation take hold, causing inflation to rise permanently?

What if really? Well, it depends on the amount of height. Take the United States. Inflation forecasts three years from now are at most 1 to 1.5 percentage points higher than in the five years before the pandemic; At the five-, 10- and 30-year horizon, the increases are much smaller. In other words, the expectation that central bankers worry is that current inflation will fall quickly, but perhaps to slightly higher rates than before. Since forecasts were fairly consistent with less than 2 percent before, if these new forecasts hold firm, we could risk a 3 percent inflation rate. But since the forecast clearly follows current price movements, it is likely to settle lower once inflation slows.

So what if we’ve had 3 percent inflation for a while? The pests of central banks’ supposed error have done little to illustrate the cost, let alone define it. But what we do know is that more supply shocks are likely. And some of them will be positive, which increases growth and reduces inflation. The policy of benign neglect – but we must be clear these Types of shocks, not traditional demand-driven inflation shocks – it amounts to this: allowing inflation expectations to skew a bit when external supply shocks raise prices (and not killing the economy for trying to stop that), then waiting for positive supply shocks to let them drift downwards (again without trying trying to stop it).

I don’t pretend to have made arguments that this would be the wisest policy. This is just a first stab at answering the “what would you do” question. But it shows what the alternative to the current policy would be. Given that current policy involves the loss of millions of jobs and billions of income, advocates of this policy have to explain why they believe the alternative to benign neglect is much worse.

Other readings

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

  • James Plunkett has published the first article in a series on social justice in the digital age, with the goal of enlightening us on what the “evil hand” of platform companies really is.

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

  • FT Alphaville attempted to measure the monetary value of joining The Queue – or of giving up his place in it.

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