In a research note published September 30, Danske Bank wonders whether the worry about public debt levels after COVID-19 is "much ado about nothing."
Danske explains that central banks have the power to cap borrowing costs, effectively keeping interest rates below growth rates. This strategy, which has the unfortunate name "financial repression", can enable countries to gradually grow (or inflate) their way out of debt. However, Danske also argues that "counting on interest rates to stay low forever can be a dangerous strategy and financial repression is not without costs, especially if it leads to an erosion of central bank independence."
Despite risks, Danske views the interest rate-growth differential as "a key variable that distinguishes sustainable debt levels from unsustainable ones." They cite Olivier Blanchard's work on Public Debt and Low Interest Rates and explain that more economists are beginning to see higher debt levels as less of a worry. A persistently negative interest rate-growth differential makes it possible to roll over debt while decreasing it as a share of GDP. As shown in the chart below, countries like the UK have had much higher debt levels in earlier times and been fine. Adam Tooze summed it up: "If you remember WWII, WWI and the Napoleonic wars, the 2008-COVID fiscal shocks are really not such a big deal."
An interesting historical note:
"The US experience with financial repression in the form of yield curve control (YCC) after the Second World War also provides some cautionary lessons. The Fed adopted YCC in April 1942 to support war financing, agreeing to cap the Treasury bill yield at 0.375% and the long-term government bond yield at 2.5%. From March 1942 to August 1945, the Fed bought USD20bn worth of Treasury securities (10% of total issued). When the war was over and the economy rebounded, inflation did as well. This started a conflict between the Fed, which wanted to raise short-term rates to combat high inflation, and the Treasury, which wanted to maintain low Treasury yields. Eventually, the YCC policy was abandoned in February 1951, but the Fed's experience in the 1940s and 50s illustrates the risks fiscal dominance can have to central bank independence."
Two thoughts on this report: First, something that Danske doesn't mention but might be interesting to think about is the counterfactual: what if the US Treasury had raised taxes in the late 1940s instead of not raising taxes and pressuring the Fed to keep rates low. Taking money out of the economy when it was overheating might have reduced inflation, enabling the Fed to keep rates low for longer. Second, the report begins to call into question the purpose of central bank independence. Central bank independence is viewed as an unquestioned good thing, and mostly for very good reason. But I wonder if it prevents useful discussion about the overlap between fiscal and monetary policy, and to what extent the Federal Reserve should support the Treasury. For example, if we had to choose between an independent central bank and high unemployment (Volcker) or a collaborative central bank and low unemployment (Powell), maybe we shouldn't dismiss the collaborative option too quickly.