Public debt: don’t target the quantity, target the price

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John Quiggin
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As I’ve mentioned previously, when I started work on Economic Consequences of the Pandemic, I assumed I’d be writing a polemic against austerity, as I did in Zombie Economics. Based on the last crisis, it seemed likely that any stimulus measures would be wound back rapidly, leading to a sluggish and limited recovery. That’s pretty much what is happening in Australia, where I live, but not in the US, where the book will be published. On the contrary, Biden’s policies are pretty much what I would have advocated (certainly if you take into account the razor-thin majorities he is working with). And, with luck, the main elements will be in place by mid-year, long before my book can appear.

So I’m refocusing on the issue of debt and how it can be managed. This was the central issue after the Treaty of Versailles, and also in the return to the gold standard, which prompted The Economic Consequences of Mr Churchill. io o

My central conclusion is a simple one. Rather than aiming for a fixed ratio of public debt to GDP, governments should aim to control the long-term rate of interest on inflation-protected bonds, and set it at a rate of around 1 per cent, about equal to the long-term rate of productivity growth. Since rates are well below that now, there is plenty of room for more public investment.

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Instead of targeting the quantity of public debt it is better to focus on the price, which is best measured by the real (inflation-adjusted) rate of interest on long-term government bonds. For the US, this is represented by the interest rates for Treasury Inflation-Protected Securities (TIPS), the principal of which is adjusted in line with inflation. Currently, the rate of return on 10-year TIPS is negative (about -0.5) while the rate on 30-year TIPS is just positive (about 0.1 per cent).

These rates have been declining slowly over recent years. However, the passage of the American Recovery Plan and the announcement of the Biden Infrastructure package, involving around $5 trillion in new expenditure led to an increase of around 0.5 percentage points.

get the right strategy on public debt, it’s worth considering why any limit might be imposed. The answer is that lenders might refuse to buy more bonds and demand the repayment of the existing debt as it falls due. If governments cannot raise the money required, as has happened on many occasions, a crisis will ensue. There are three main concerns here

• If debt is denonominated in a foreign currency, and the domestic currency depreciates, the burden of repayment can increase rapidly
• If bond buyers fear future inflation, they will demand higher rates of interest to compensate for this
• If bond buyers fear that the government will default on its obligations, they will be unwilling to buy bonds and will demand an interest rate premium

The US does not face the first problem, since its debt is denominated in US dollars. The second is not as big a problem as it seems, since government revenue will rise broadly in line with inflation. Nevertheless, to clarify the issue it is best to focus on TIPS

If investors fear a default, the real rate of interest on inflation-protected securities will increase. Unlike exchange rates and expectations about inflation, which can change rapidly, real interest rates typically move very slowly.

As can be seen below, the rate of interest on 10-year TIPS has declined gradually since the turn of the century, falling from a little over 2 per cent to a range between 0 and 1 per cent in the years before the pandemic. Rates spiked briefly by 2 percentage points in the worst of the financial crisis, before returning to the previous trend.

There was also a brief uptick during 2012 and 2013. The rate fell to negative levels between 2011 and 2013, following large scale purchases of government bonds (quantitative easing), followed by a return to just under 1 percent. The reversal, occurring when investors expected a rapid reversal of ‘quantitative easing’ , is sometimes referred to as the ‘taper tantrum’, but what is more striking is how modest these fluctuations have been.

The key implication here is that, if long-term fiscal policy is focused on maintaining a low and stable real rate of interest on government debt, there is little likelihood that it can be derailed by a sudden change in investor sentiment.

https://www.dropbox.com/s/1rmd6o5hb8f6oib/TIPP.jpg?dl=0
The stability of rates can be enhanced by a shift to longer term financing. There is a strong case for relying more on 30-year bonds and encouraging retirement income systems that invest in these bonds to provide secure incomes.

The ultimate long term security is a perpetual bond, like the ‘consols’ on which the British government relied in the 19th century. The advantages of perpetual securities have been discussed by both conservative and liberal writers.

Where should the target rate be set? In a world of technological progress, we expect that there should be investment opportunities that yield a positive rate of return, roughly measured by the rate of multifactor productivity growth (the growth in output from a given input of labour and capital). This is about 1 per cent.
Even before the pandemic crisis, the TIPS rate was consistently below 1 per cent. This implies that, with a 1 per cent target, there is substantial room for public investment financed by long-term debt, even after the passage of the infrastructure bill.

On the other hand, there are good arguments for gradually unwinding the expansionary measures adopted specifically in relation to the pandemic emergency. This would provide more room to move in the event of a similar emergency arising as unpredictably as the pandemic and, before that, the GFC [these events weren’t, in fact, unpredictable and were in fact predicted, but even those who feared such events couldn’t say when they would hit]