MNI INTERVIEW: Secular Stagnation Author Says Debt Raising R*

Massive borrowing since the Covid pandemic is driving up the neutral level of interest rates while increasing the danger that tight monetary policy could amplify the effects of fiscal contraction, a former Bank of England economist and co-author with Larry Summers of the seminal work arguing that advanced economies were stuck in low-rate secular stagnation, told MNI.

In a business-as-usual scenario, real r* is now likely to be 0-1.2%, rather than the negative values of the pre-pandemic years, though still far below historical averages, Lukasz Rachel has argued. A one percentage point increase to the debt-to-GDP ratio would raise r* by between one and two basis points in the medium term, he said in emailed follow-up question to an interview.

However if a central bank responds to an increasing budget deficit with high interest rates, the government will "face a double whammy on debt" which further drives up cyclical r*, he said, as tighter monetary policy drives up government interest payments.

Rachel has based his research on new more sophisticated econometric models which move away from the assumption that all economic agents behave identically in line with Ricardian equivalence, treating fiscal shortfalls as deferred taxation, prompting them to save rather than to consume more. The new heterogeneous agent (HANK) models also cast doubt on the Taylor rule principle that real interest rates must go higher to keep inflation under control, according to the economist.

NEW CENTRAL BANK MODELS

“With these old models, the idea is that the Taylor principle is kind of almost like a free lunch. If I respond to inflation very strongly, then I'm ensuring all these great outcomes in the economy,” Rachel said. “Actually there's a big cost to that, which is your implications on the fiscal side are so severe and they're so hard to deal with, that actually the Taylor principle might bring about fiscal troubles.”

This means that the notion of a passive monetary policy countering the inflationary effects of an active fiscal policy does not work, according to the new HANK models, he said. 

“There's no clean notion of active versus passive policy. The policies … jointly determine inflation and output in equilibrium," he said. "Fiscal policy is an instrument, not a goal, but it is useful to know that when this instrument is used, it has inflationary effects.”

In contrast, in a model with Ricardian equivalence, it is straightforward for the fiscal branch to "mop up" after an inflation-targeting central bank, he said. 

“In any of these models that are now becoming popular without Ricardian equivalence, there is this strong influence from what monetary policy does on government debt and government debt dynamics, and there's no escaping that.”

SECULAR STAGNATION

The assumptions of perfect foresight in the older RANK models had also been employed by Rachel and Summers in their work on secular stagnation. 

While the same demographic pressures that seemed to condemn economies to secular stagnation continue to weigh on r*, the sheer scale of government debt is now driving it higher, according to Rachel. Central bankers have long calculated that r* would remain stable only until indebtedness became excessive, he noted.

"Government debt ratios have tripled in advanced economies over the last 34 years, and that provides an offsetting force" to the demographic pressures that continue to weigh down on r*,” Rachel said.

UK debt-to-GDP is currently about 100%, an increase of about 15 percentage points from the year ending March 2019, according to the ONS. (See MNI INTERVIEW: UK Debt Stabilisation Insufficient - NIESR Head)