Furman & Summers reconsider fiscal policy; Galbraith responds

Jason Furman and Larry Summers recently wrote a paper noting the downward trend in interest rates and arguing for expanded fiscal policy.

"This paper argues that while the future is unknowable and the precise reasons for the decline in real interest rates are not entirely clear, declining real rates reflect structural changes in the economy that require changes in thinking about fiscal policy and macroeconomic policy more generally that are as profound as those that occurred in the wake of the inflation of the 1970s."

They identify three implications for fiscal policy that follow from low interest rates

1. Fiscal policy must play a crucial role in stabilization policy in  a world where monetary policy can counteract financial instability but otherwise is largely "pushing on a string" when it comes to accelerating economic growth.
2. In a world of unused capacity and very low interest rates and costs of capital, concerns about crowding out of desirable private investment have less force. Debt-to-GDP ratios are a misleading metric of fiscal sustainability that don't reflect how the present value of GDP has risen and debt service costs have fallen as interest rates have fallen.
3. Borrowing to finance appropriate categories of expenditure pays for itself.

Jamie Galbraith agrees with the conclusion but calls the underlying economics a mess.

"Their effect, and one may reasonably surmise their purpose, is to make the argument without appearing to question the longstanding "mainstream" theory of interest rates. That [loanable funds] theory, which has been the source of deficit- and debt-hysteria for several centuries, in turn underpins the newly-proposed FS debt-service-to-GDP ratio criterion for fiscal policy. It will be nothing but a source of trouble, unless disposed of...

"[To explain the decrease in rates] Their theory therefore requires one of two things, perhaps in combination: a vast offsetting, autonomous increase in the supply of savings (global or national), and/or a reduction in the private demand for savings, in the form of privately-issued debt ... There are two problems with the argument. The first is that there is no long-term trend in US private savings, nor in the import of savings from overseas - which would show up as an increasing US current account deficit relative to GDP - nor in the ratio of private debt to GDP... 

"The second problem is more theoretical. One way to put it, is to say that "loanable funds" is a theory of the sport market ... the question of maturities is secondary ... so the loanable funds theory has no explanation for the difference between short and long-term interest rates - for the yield curve. But this is precisely what FS are trying to explain...

"FS therefore arrive at a correct conclusion - interest rates will remain low indefinitely - by a route that requires them to argue that the world has changed in some fundamental, relevant ("structural") way, for which no evidence exists."