Deficits & interest rates

I fear that the argument between Robert Peston on the one hand and Simon, Paul and Alex on the other about the relationship between government borrowing and interest rates is understating something important.

I agree with Robert's critics that interest rates are not determined by bond vigilantes or confidence fairies - at least for the UK at current debt levels. But there is a different reason to think that a looser fiscal policy would lead to higher rates.

Quite simply, looser fiscal policy would lead to higher aggregate demand and hence to a smaller output gap. If you believe - as the Bank of England does - that a smaller output gap leads to more inflation (or at least the risk thereof) then this means higher interest rates will be needed to hit the inflation target. And because gilt yields should be equal to the expected path of future short rates, it follows that a looser deficit should mean higher yields.

Paradoxically, the more Keynesian you are, the more you should accept this. If you think fiscal multipliers are very big, then looser fiscal policy means much bigger aggregate demand and hence - given the Bank's remit* and view of the inflation process - significantly higher rates.

In this sense, the choice is not just about fiscal policy but about the fiscal-monetary mix. Labour is offering looser fiscal and tighter money than the Tories.

In this context, David Cameron said something yesterday that's misleading. It's this:

By 2018 we will be putting money aside so that if any crash or shock happens to our economy, we will be better prepared.

Now, it might be that a tighter fiscal policy now would give us more room for fiscal manoeuvre when the next recession hits. But the counterpart of a tighter fiscal policy is that interest rates will stay close to the zero bound - which will give us less room for monetary manoeuvre in future. It's not obvious which is best.

One could easily argue - though I'll save this for another day - that a looser fiscal/tighter money policy is preferable. It's entirely coherent to say: "Interest rates would be higher under a Labour government - and a damned good thing too."

Herein, though, lies a puzzle. If Labour's policy implies higher interest rates, why aren't we seeing more volatility in gilts as market opinion about the election outcome varies?

One possibility is that there won't in reality be much difference between the two parties' fiscal policies simply because the Tories' stated plans are nonsense: four-fifths of macroeconomists agree with Rick that their spending plans are in la-la land.

Another possibility is that interest rates won't rise much whoever controls fiscal policy, as they'll be held down by some combination of secular stagnation, deflation and stagnation in the euro area and (very arguably) falling oil prices.

These two possibilities hint at something else - that perhaps the debate about the impact of the deficit upon interest rates isn't very important for practical purposes.

* Those who argue for a serious reflationary policy should be calling not just for looser fiscal policy but for a change to the inflation target too (and of course many are).

Another thing: Robert's "fey anthropomorphism" of the market is mistaken. The "Mr Market" metaphor can sometimes be horribly misleading. 

Comments

[Felipe]

The first part of the post (that looser fiscal policy should lead to higher rates through more demand) is I believe spot on. Which is why interest rates are a terrible signaling tool: central banks actually want higher rates! Its just that they need to lower them now to get there.

The second part, not so much. It presents us with a false problem, because higher interest rates do not mean tighter money (and vice versa). Otherwise you would say that money is tight in any country with hyperinflation.

Tightness of money should be measured against the policy target. Otherwise all you have to measure yourself against are unobservables like potential output (via some taylor-type-rule) or the wicksellian interest rate.

[Ralph Musgrave]

In contrast to Filipe just above, I don’t think the first half of Chris’s article is particularly “spot on”. Obviously if fiscal policy is far too loose in the eyes of the central bank, then the CB will raise interest rates. But all that proves is that if you have a car with two steering wheels, the two drivers may counteract each other’s efforts, which is a daft way to control a car or an economy.

In contrast to that, Positive Money and others advocate merging monetary and fiscal, i.e. having just one steering wheel.

Chris then asks how tight fiscal and monetary policies should be. Milton Friedman in a paper in 1948 and Warren Mosler more recently argued that government should never pay any interest on its liabilities. I.e. government should issue base money, but no interest yielding debt. I supported that argument (with a few minor reservations) in a post on my own blog today:

http://ralphanomics.blogspot.co.uk/2014/12/a-deficit-should-never-increase-debt.html

[Andreas Paterson]

Sounds pretty spot on, only thing that might be worth adding is the time element, it's not just about how high rates go but also about how soon rates would need to rise.

Under Labour it would be sooner, although it may still be a way off even under Labour's looser fiscal policy. Personally I think it's the fact that under either fiscal scenario a rate rise is some way off and this explains the lack of volatility in gilts.

[Felipe]

Ralph,

If some day the central bank is merged into the treasury dept, your criticism of the first part might hold. However, currently the central bank is independent in most countries and they have a more or less explicit target. So you are currently advocating that the central bank actively refuse to achieve the target. I at least want more CB accountability, not less.

[gastro george]

You mean the central bank that's owned by the state and whose senior officers are appointed by the state?

[James]

I too was puzzled what Cameron meant by austerity making us better prepared in the case of adverse shocks.

Paying down debt certainly does give you more freedom to tackle demand shocks using fiscal policy by running a deficit. The economics says we have this freedom anyway if we have our own currency, but it certainly makes it easier to sell politically if you start with a low debt.

Presumably during the next large demand shock Cameron will be first to argue that the UK can afford a huge Keynsian stimulus thanks to his austerity program giving the government of the day more room to manoeuvre when borrowing to fund deficit spending, because it's much easier to convince idiots like him to run a deficit when the initial debt burden is lower.

It's not clear whether (or what mix of) fiscal or monetary action is best suited to deal with a demand shock, but what is clear is that fiscal tightening now makes monetary policy weak and if you combine that with an ideological refusal to engage in fiscal stimulus in the future then that particular mix is potentially disastrous when it comes to potential future shocks!

Interest rates were at 5% and we had a government open to deficit spending going into the last crisis; they'll be 0.5% with government refusal to engage in deficit spending if another one comes around.

Cameron has made clear the case for labour's policy of looser fiscal and tighter monetary policy better than Ed Balls ever could.

[Ralph Musgrave]

James,

I flatly disagree with the idea (popular with the elite world-wide) that a low debt gives a country “more freedom to tackle demand shocks”.

If a country has a high debt and pays little interest on that debt (e.g. Japan), what’s to stop it dealing with low demand by standard fiscal stimulus (borrow and spend) or by “print and spend”. As Keynes pointed out, either “borrow and spend” or “print and spend” will do.

Alternatively, if the country is paying significantly above zero interest on its debt, it can do some QE and/or do some “print and spend”. No problem.

In short, incurring austerity (in the form of having unemployment higher than it need be, i.e. above NAIRU) just so as to get the debt down is totally pointless.

[James]

Ralph, I agree that the economics doesn't care about the debt level in a low demand economy. Unfortunately the politics does matter and it's easier to sell a short term deficit funded stimulus to the public and conservative MPs if you start with a low debt; even if that position doesn't make sense, it's the political reality.

I do not advocate austerity now to reduce debt because a) it doesn't work b) it causes disproportionate misery even if it did. My point was that Cameron was claiming we need austerity now to give us more freedom to borrow in the next shock... and that this is clearly an absurd position because he'd be the last person arguing for fiscal stimulus if that shock did happen and the only reason that logic holds is because of people like him arguing against fiscal intervention!

The debt level in the longer term is a more interesting question. Unless we're in a really quite stagnant age (which we might be) then at some point we will hopefully not be demand constrained, rates on government debt will rise (simply to reflect better investment opportunities in the wider economy) and paying down debt is absolutely the right thing to do for many reasons: to be counter-cyclical in the boom years, remove market distortions, reduce payment of interest etc. But this is in the *long* term and a totally different argument.

[James Oswald]

It took me a bit to wrap my head around the reasoning, but I think you are right. If you increase AD using deficit spending, the interest rates will be higher at the end than if you did the same thing through OMOs. You are increasing the supply of gov't debt and inflation simultaneously, which would result in less willingness to buy the debt, which in turn results in higher interest rates.

[Simon Reynolds]

Robert Peston asks his "pals in the bond market":

Q1) Why can the UK borrow cheaply?

and the bond market pals answer:

A1) Because George Osborne has earned his "austerity proficiency badge."

Q2) Why can the Eurozone can also borrow cheaply -- France's 10-year bonds are now at half the rate of the UK, while Italy's 10-year bonds are at the same rate as the UK despite public debt at 130% and rising?

the bondmarket pals answer:

A2) " Mr Market may be capricious..."

What sort of analysis is this? The line taken by Peston's pals is that "the markets" are able to determine interest rates on public debt. The pals can assume the role of bond vigilantes, punishing governments when they feel like it, but they are capricious so they might not.

Osborne played on this fear of the markets in 2010, and continues to do so today-- for political reasons.

A reasonable answer to Q1 could have been something like:

Countries that borrow in their own currencies need not be vulnerable to "the markets". Central banks control interest rates not the markets.

As Paul Krugman said in November 2013:

"Fear of a Greek-style fiscal and financial crisis has loomed over much of our policy discourse over the past four years, and has played a significant role in shaping actual policy, constituting the principal argument for austerity in countries that don’t face any current difficulties in borrowing. However despite repeated warnings that crises of confidence are imminent in floating-rate debtors – mainly the United States, the UK, and Japan – these crises keep not happening."

http://www.imf.org/external/np/res/seminars/2013/arc/pdf/Krugman.pdf

A reasonable answer to Q2 could have been:

For countries that can't borrow in their own currency it might be different. The Eurozone countries, for example -- were vulnerable to market-led higher interest rates *until* the ECB introduced the long-term refinancing operations program in 2011 and outright monetary transactions in 2012. Since then the Eurozone countries have been effectively in a similar position to countries borrowing in their own currency. One consequence, for example, is Italy's 10-year bond rate has fallen from 6% to 2%.

Peston should forget his pals in the financial marketrs -- they clearly don't understand how rates are set.

He should interview people who know what they are talking about: Chris or Krugman. Or Paul de Grauwe. Or Simon Wren-Lewis.