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Chapter 1| Introduction

A guided tour of the book and its major conclusions

Published onMar 30, 2022
Chapter 1| Introduction

It is an understatement to say that policy makers in advanced economies face an unusual fiscal environment. The basic numbers are given in Table 1.1 for seven major countries (as of the time of writing, January 2022). Net debt ratios are historically high, in most countries above 100%; except for Germany, they are substantially higher than they were in 2007, the year before the Global Financial Crisis. Deficit ratios are also extremely high; they largely reflect the lasting effects of the Covid crisis, but they were already fairly large in 2019, before Covid, in particular in the United States and in Japan. At the same time, nominal interest rates are extremely low; 3-month rates on government bonds are often negative and 10-year rates are very low. In all cases, 10-year nominal rates are below expected inflation, implying negative real rates.

Table 1.1: Debt, deficits, and interest rates

Net Debt
(% GDP)

Overall Balance
(% GDP)

Interest Ratea

























































This has led policy makers and academics to often reach drastically different conclusions about what fiscal policy should do at this juncture. Some, focused on the very high levels of debt have argued for a need for urgent fiscal consolidation and a steady decrease in debt. Some have argued that it is enough to stabilize the debt, and accept these higher levels. Some, focused on the very low rates, have argued that this is a great time for governments to borrow, especially if this is done to finance public investment. Yet others have argued for more radical solutions, for example, the cancellation of the debt held by central banks. 1

What policy makers conclude and do will soon matter a lot. Many believe that in the wake of the Global Financial Crisis, the desire to decrease debt and the resulting fiscal consolidation were too strong, leading to a slower recovery. Policy makers in Europe now face a very concrete issue: In the face of the Covid crisis, current EU fiscal rules have been suspended. The old rules are largely seen as in need of serious reforms. European Union policy makers have to redesign them in the right way.

The rest of the introduction offers a guided tour of the book and its major conclusions. It is simply a compendium of the introductions to each chapter.2 Thus, think of it as Cliffs notes for the hurried reader. If you are really in a hurry, the basic theme of the book is summarized in the very last chapter. If you actually intend to read the whole book, you may want to go directly to the chapters themselves.

Chapter 2 introduces five notions related to interest rates, which will be useful throughout the book:

Section 1 defines the neutral interest rate, rr^*.3 It can be defined in two equivalent ways. The first is that it is the safe real interest rate such that saving is equal to investment, assuming output is equal to potential output. The second is that it is the safe real interest rate such that aggregate demand is equal to potential output. The two definitions are indeed equivalent but suggest different ways of thinking about the factors which determine the neutral rate, ways which will turn out to be useful later.

Section 2 introduces the distinction between safe rates and risky rates such as the rate of return on stocks. It shows how an increase in perceived risk or in risk aversion leads to both a higher risky rate and a lower safe rate. When looking at data in the next chapter and thinking about the factors behind low safe rates, the distinction will turn out to be empirically important. Are current low safe rates due to shifts in saving or investment, or instead to higher risk or risk aversion?

Section 3 looks at the role of central banks. One can think of the effective mandate of central banks as setting the actual safe real interest rate, rr, as close as they can to the neutral interest rate, rr^*, and in so doing, keep output close to potential output. The important conclusion is that, while central banks are sometimes blamed for the current low rates, the rates set by central banks reflect mostly low neutral rates, which themselves reflect the factors behind the movements in rr^*, saving, investment, risk, and risk aversion. In other words, central banks are not to blame for low rates: these just reflect underlying fundamental factors.

Section 4 discusses the importance of the inequality (rg)<0(r-g)<0, where rr is the real safe interest rate and gg is the real growth rate of the economy. When rr is less than gg, debt, if not repaid, accumulates at rate rr, while output grows at rate gg. Thus, if no new debt is issued, the ratio of debt to output will decrease over time, making for more favorable debt dynamics. As rr is forecast to be less than gg with high probability for some (long) time, this will play a major role in our discussion of fiscal policy later.

Section 5 discusses the nature and implications of the effective lower bound (ELB). Because people can hold cash, which has a nominal interest rate of zero, central banks cannot decrease the nominal policy rate much below zero. This implies that they cannot achieve real policy rates much lower than the negative of inflation; call that rate the ELB rate, and denote it by rminr_{min}. This potentially reduces their ability to decrease rr in line with rr^* when rr^* is very low, leading to situations where r>rr>r^*. In other words, it potentially reduces or even eliminates the room for monetary policy to maintain output equal to potential output. This is the situation in which many central banks find themselves today, and again has major implications for our discussion of fiscal policy later.

Section 6 concludes. As the neutral rate rr^* has declined over time, it has crossed from above two important thresholds. First, rr^*, and by implication, rr has become smaller than gg, with important implications for debt dynamics and welfare effects of fiscal policy. Second, in some cases, rr^* has become so low as to be lower than the ELB rate, rminr_{min}, limiting the room for monetary policy to maintain output at potential, and by implication, increasing the need to use fiscal policy.

Chapter 3 looks at the evolution of interest rates. It is organized in five sections.

Section 1 looks at the evolution of safe real rates over time. It shows that, even ignoring the high real rates of the mid-1980s which were largely due to disinflationary policies followed by central banks, safe real rates have steadily declined across advanced economies, the United States, the euro zone, and Japan, over the last 30 years. Their decline is due neither to the Global Financial Crisis of the late 2000s, nor to the current Covid crisis, but to more persistent factors.

Section 2 shows that this decrease has led to an increasing gap between growth rates and safe rates, an increasingly negative value of (rg)(r-g). While potential growth has slightly declined, the decrease in interest rates has been much sharper. While there have been periods of negative (rg)(r-g) in the past, this one looks different, neither due to wars, nor to bursts of inflation under low nominal rates, nor to financial repression.

Section 3 looks at the potential factors behind the decline in safe rates. Different factors have different effects on saving/investment, and on riskless/risky rates. Saving/investment factors affect all rates roughly in the same way. Risk/liquidity factors lead to lower safe rates and higher risky rates. The evidence is that both sets of factors have been at play. Within each set, the list of suspects is long, but their specific role is hard to pin down.

The last two sections look more closely at two of the potential factors, where I have found the discussion to be misleading in the first case and confused in the second case.

Section 4 looks at the relation between growth rates and interest rates. There is a wide belief that the two are tightly linked. Indeed, some of the research has been based on a relation known as the “Euler equation,” a relation between individual consumption growth and the interest rate derived from utility maximization, which implies a close link between the two. I argue that this relation however has no implication for the relation between aggregate consumption growth (or output growth) and the interest rate. Indeed, and perhaps surprisingly, the empirical relation between the two is typically weak, and often nonexistent. Lower potential growth is not the main cause of lower rates.

Section 5 looks at the role of changing demographics. Three major demographic evolutions have been at work in advanced economies, namely: a decrease in fertility, an increase in life expectancy, and the passing effect of the baby boom. Some researchers have made the argument that these evolutions are partly behind low rates but will reverse as we look forward, leading to higher rates in the future. I argue that the future is likely to be dominated by the increase in life expectancy, and this is likely to further decrease interest rates rather than increase them.

Section 6 concludes. The overall evidence suggests that the long decline in safe interest rates is due to deep underlying factors, which do not appear likely to reverse any time soon. Investors in bond markets share this conclusion. The conclusion must however be qualified in two ways. The first is that we do not have a precise enough sense of the factors behind the decline to be sure, and that fiscal policy must therefore be designed under the assumption of a small but positive probability of a reversal. The second is that the future path of interest rates is not exogenous and depends very much on fiscal policy itself. For example, the 2021 Biden stimulus may well increase aggregate demand, and by implication, lead to higher rr^* and rr for some time. As I shall discuss in later chapters, fiscal policy should indeed be designed so as to achieve a value of rr^* which allows central banks no longer to be tightly constrained by the ELB. If such a fiscal policy were to be implemented, it would imply a floor on future values of rr^*, and by implication on future values of rr itself.

With the ground having been prepared, the remaining three chapters turn to the implications of low interest rates for fiscal policy. There are two separate questions to be answered, which are sometimes mixed up:

  • How much “fiscal space” does a country have? Or more precisely, how much room does the country have to increase its debt until this raises issues of debt sustainability?

  • How should this fiscal space be used? The fact that there is space does not mean that it should be used. Fiscal policy is about whether, when, and how to use that space.

Chapter 4 is about the first question. It has seven sections.

Section 1 starts with the arithmetic of debt dynamics under certainty, focusing on the role of (rg)(r-g). It shows the respective roles of (rg)(r-g), debt, and primary balances. It shows some of the dramatic implications of (rg<0)(r-g<0): Governments can run primary deficits and keep their debt ratios stable. Formally, there is no issue of debt sustainability: Whatever primary deficits governments run, debt may increase but it will not explode. Put another way, governments appear to have infinite fiscal space...

Section 2 shows however that this conclusion is too strong, for two reasons. First, fiscal policy, in the form of higher debt or deficits, increases aggregate demand, and thus increases the neutral rate rr^*. To the extent that the monetary authority adjusts the actual rate rr in response to rr^*, this increases (rg)(r-g) and thus reduces fiscal space. Second, uncertainty is of the essence. Debt sustainability is fundamentally a probabilistic concept: A tentative operational definition might go as follows: Debt is sustainable if the probability of a debt explosion is small (one still must define “explosion”, and “small”; but this can be done). With this in mind, the section discusses the various sources of uncertainty and their potential effects on debt sustainability. It shows the respective roles of the debt ratio, the maturity of the debt, the distribution of current and future primary balances, the distribution of current and future (rg)(r-g). It shows how “stochastic debt sustainability analysis” (SDSA) can be used by governments, investors and rating agencies. It shows how realistic reductions in debt from current levels have little effect on the probability that debt is sustainable; in contrast, it shows the importance of contingent plans in case (rg)(r-g) increases and reverses sign.

Section 3 looks at the case for fiscal rules to ensure debt sustainability. SDSAs can only be done in situ, for each year, for each country. The assumptions they require, for example about the future evolution of (rg)(r-g), leave room for disagreement. Can one design second best, more mechanistic, rules as guard rails, and still leave enough room for fiscal policy to perform its macroeconomic role? This is the question for example currently under discussion in the European Union. I express skepticism that any mechanistic rule can work well, but, if a rule is nevertheless going to be adopted, I suggest the direction it should explore. I argue that the analysis in Section 2 suggests a rule that adjusts the primary balance in response to debt service––rather than debt—over time.

Section 4 discusses the relation between public investment, for example green investment, and debt sustainability. For political reasons, fiscal austerity has often led to a decrease in public investment rather than in other forms of spending. The transparency case for separating the current account and the capital account (known as “capital budgeting’’) is a strong one. The case for full debt financing of public investment, which is sometimes made, is however weaker: To the extent that public investment generates direct financial returns to the government, it can indeed be at least partially financed by debt without affecting debt sustainability. One may also argue that, by increasing growth, it increases future fiscal revenues. But much of public investment, even if it increases social welfare, does not generate financial returns for the state, and has uncertain effects on growth. Thus, it can affect debt sustainability, and this must be taken into account in the way it is financed. The section shows how this can be integrated in an analysis of debt sustainability.

Section 5 looks at the risk of sudden stops, and the potential role of central banks in that context. Sovereign debt markets (and many other markets as well) are subject to sudden stops in which investors either drop out or ask for large spreads even in the absence of correspondingly large changes in fundamentals. This has been more of an issue in emerging economies’ markets, but, as the Euro crisis has shown, is also relevant for advanced economies. Even if fundamentals suggest little debt sustainability risk and justify low rates, another equilibrium may arise where investors worry, ask for a spread over safe rates, increasing debt service and increasing the probability that debt is unsustainable, justifying their worries in the first place. Given their nature, these equilibria are often referred to as “sunspot equilibria.” I argue that the issue is relevant, but that it would take extremely low levels of debt to eliminate the scope for multiple equilibria, levels far below current debt levels. Realistic reductions of debt over the next decades will not eliminate this risk.

I then look at whether central banks can reduce or even eliminate this risk. I distinguish between two sources for the increase in spreads, sunspots or deteriorations in fundamentals. I argue that central banks, by being large stable investors, can prevent multiple equilibria and eliminate spreads when those are due to sunspots, but that the conclusion is less obvious when spreads are due, at least in part, to deteriorated fundamentals. The reason in short, is that central banks are parts of the consolidated government, and their interventions change the composition but neither the size of the overall consolidated government liabilities nor the overall risk. I discuss why this may be different in the case of the European Central Bank, for example in its ability to decrease Italian spreads during the Covid crisis.

Section 6 takes up two issues which have come up about the relation of central banks to debt sustainability. Some observers have argued that, through quantitative easing (QE) and the large scale purchases of government bonds, central banks are monetizing the deficits and bailing out governments. I argue that this is not the case. Others have argued that, to alleviate the debt burden, central banks should simply write off the government bonds they hold on their balance sheet. I argue that it is not needed, and if it were to be done, it would do nothing to improve the budget constraint of the government.

Section 7 concludes. Negative (rg)(r-g) makes the dynamics of debt much more benign. This does not make however the issue of debt sustainability disappear, both because of endogeneity, i.e. the effect of fiscal policy back on the neutral interest rate, and because of uncertainty, in particular with respect to rr.

The best way to assess debt sustainability is through the use of a stochastic debt sustainability analysis, or SDSA, an approach which allows to take into account the specificities of each country and each year. Given the complexity of the assessment, I am skeptical that one can rely on quantitative rules. If however, such rules are used, they should be based on requiring the primary surplus to adjust to debt service, defined as ((rg)/(1+g))b(1)((r-g)/(1+g)) b(-1), rather to debt itself. It cannot avoid including exceptions however, such as the need to allow for larger primary deficits when the central bank is constrained by the ELB.

Chapter 5 looks at the welfare costs and benefits of debt and deficits and draws implications for fiscal policy.

The chapter is organized in four sections.

Sections 1 and 2 discuss what may feel like an abstract and slightly esoteric topic, but, it turns out, a topic which is central to the discussion of fiscal policy, namely the effects of debt on welfare under certainty and then under uncertainty.

Section 1 looks at the welfare costs of debt under certainty. Public debt is widely thought of as bad, as “mortgaging the future”. The notion that higher public debt might actually be good, increase welfare (on its own, i.e. ignoring what it is used to finance) feels counterintuitive. The section reviews what we know about the answer under the assumption of certainty. The answer is that debt might indeed be good, and that the condition, under certainty, is precisely (rg)<0(r-g)<0. The section puts together the two celebrated steps of the answer. The “Golden Rule” result, due to Phelps 1961 [3], that, if (rg)<0(r-g)<0, less capital accumulation increases welfare; and the demonstration by Diamond 1965 [4] in an overlapping generation model, that, if (rg)<0(r-g)<0, issuing debt does, by decreasing capital accumulation, increase the welfare of both current and future generations. These are clearly important and intriguing results. They are however just a starting point.

A major issue is again uncertainty, the issue taken in Section 2. Under the assumption of certainty, there is only one interest rate, so the comparison between rr and gg is straightforward. But, in reality, there are many rates, reflecting their different risk characteristics. The safe rate is indeed less than the growth rate today. But the average marginal product of capital, as best as we can measure it, is substantially higher than the growth rate. Which rate matters? This is very much research in progress but, thanks to a number of recent papers, we have a better understanding of the issue. In the Diamond model for example, which focuses on finite lives as the potential source of high saving and excess capital accumulation, the relevant rate is typically a combination of the two, although with a major role for the safe rate. Going to the data suggests that the relevant rate and the growth rate are very close, making it difficult to decide empirically which side of the golden rule we actually are. In other models where, for example, the lack of insurance leads people to have high precautionary saving, potentially leading to excess capital accumulation, the answer is again that the safe rate plays a major role; in that case however, while debt is likely to help, the provision of social insurance, by getting at the source of the low rr, may dominate debt as a way of eliminating capital overaccumulation. Overall, a prudent conclusion, given what we know, is that, in the current context, public debt may not be good, but is unlikely to be very bad—that is, to have large welfare costs; the more negative (rg)(r-g), the lower the welfare costs.

Section 3 turns to the welfare benefits of debt and deficits. It focuses on the role of fiscal policy in macro stabilization, a central issue if for example monetary policy is constrained by the effective lower bound. It reviews what we know about the role of debt, spending, and taxes (and, by implication, deficits) in affecting aggregate demand: Higher debt affects wealth and thus consumption demand. Higher government spending affects aggregate demand directly, lower taxes do so by affecting consumption and investment. Multipliers, that is the effect of spending and taxes on output, have been the subject of strong controversies and a lot of recent empirical research. The section discusses what we have learned. The basic conclusion is that multipliers have the expected sign, and fiscal policy can indeed be used to affect aggregate demand.

Section 4 puts the conclusions about welfare costs and benefits of debt and deficits together, and draw their implications for fiscal policy. One can think of two extreme approaches to fiscal policy. The first, call it pure public finance, focuses on the role of debt and deficits, ignoring the effects of fiscal policy on demand and output, for example by implicitly assuming that monetary policy can maintain output at potential in response to a change in fiscal policy. If, for example, this approach leads to the conclusion that debt is too high, then fiscal policy should focus on debt reduction. The second approach, call it pure functional finance (in reference to the name given to it by Abba Lerner 1943 [5], focuses instead on the potential role of fiscal policy in maintaining output at potential, as might be the case if monetary policy is constrained by the effective lower bound. I argue that the right fiscal policy is a mix of these two approaches, with the weight on each one depending on the level of the neutral rate. The lower the neutral rate, the lower the fiscal and welfare costs of debt on the one hand, the smaller the room of maneuver of the central bank on the other, and thus the more the focus should be on the pure functional finance approach, on the use of deficits to sustain demand even if these lead to an increase in debt. The higher the neutral rate, the higher the fiscal and welfare costs of debt on the one hand, the larger the room of maneuver of the central bank on the other, and thus the more the focus should be on the pure public finance approach, and, if indeed debt is perceived as too high, on a decrease in debt. The section ends by discussing a number of related issues, such as the role of the inflation target, and alternatives to deficits to increase demand if secular stagnation becomes worse.

Chapter 6 looks, in light of the previous discussion, at three episodes of fiscal policy in action.

The chapter looks at three recent episodes where, for better or for worse, fiscal policy played or is playing a major role. The purpose is not to review them in full, which would take another book, but to show and discuss fiscal policy choices in the light of the analysis so far.

To caricature just a bit, the three episodes can be thought of “too little’’, “just right?’’, “too much?’’

Too little? The first section looks at the period of “fiscal austerity’’ that took place in the wake of the Global Financial Crisis. After the large initial increase in debt due to the crisis, the focus quickly turned to debt reduction. This was particularly true in the European Union, which embarked on a strong fiscal consolidation. Today, there is fairly wide agreement that, at least in Europe, the fiscal consolidation was too strong, too much based on the traditional view of debt, both by markets and by policy makers, and came at a substantial output cost.

Just right? The second section looks at the Japanese economy over the last three decades. Japan experienced the ELB constraint starting in the mid-1990s, earlier than either the United States or Europe, and has remained close to it ever since. Japanese macroeconomic policy is often characterized as a failure, with the central bank unable to achieve its inflation target, a low growth rate, and debt ratios steadily rising to reach more than 170% for net debt and 250% for gross debt. I think it should be seen instead as a qualified success, with the use of aggressive fiscal and monetary policies to compensate for very weak private demand: Output has remained close to potential. Growth is low, but because of demographics, not because of low productivity growth or high debt. Inflation is low, lower than the target, but this is not a major failure. Looking forward however, there are reasons to worry: The debt ratios are very high. So far, investors do not mind, and 10-year nominal rates are close to zero. But can the build-up of debt continue? What happens if interest rates increase? Are there alternatives?

Too much? The third section looks at the effects of the American Rescue Plan, the stimulus program put in place by the Biden administration in early 2021. In 2020, the focus of fiscal policy had been protection, of both households and firms. In early 2021, the goal partially shifted from protection to sustaining the recovery. The size of the program was extremely large relative to the apparent output gap. The strategy (intentional or not) was in effect twofold: For the Treasury, to strongly increase aggregate demand, and thus increase the neutral rate so as to relax the ELB constraint. And for the Federal Reserve, delay adjustment of the policy rate to the neutral rate, allow for some overheating and generate slightly higher inflation in the process. To a number of observers, the size of the program appeared too large, leading to worries about overheating and excessive inflation. The section takes stock of where things are at the time of writing.

Chapter 7 concludes, by summarizing the basic argument of the book, and discussing what I see as the many issues that remain to be explored.

Orkun Baysal:


Francesco Franco:

I like the term neutral. But maybe a footnote on the more mainstream name, natural (which I do not like, but…)

Egor G:

Not 100% sure, but you may want to double check the references:

Ramón Boj:

Just a typo here: rates instead of ratea.