High levels of public debt are here to stay
Arslanalp and Eichengreen argue that public debts, which have reached unprecedented levels for a peacetime, are not going to decline significantly for the foreseeable future. They state four reasons why this is true:
- Current uncertain economic conditions and polarized politics bode ill for any effort by governments to run a primary surplus.
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[I]t is difficult to imagine more favorable interest-rate-growth-rate differentials (favorable interest-rate-growth-rate differentials reducing debt ratios in an accounting sense). Real interest rates have trended downward to very low levels. It is hard to foresee them falling still lower. Faster global growth is pleasant to imagine but difficult to engineer. History suggests that the reorganization required of firms to capitalize on Generative Artificial Intelligence and other new general-purpose technologies, in ways that translate into faster aggregate growth will take a decade and more.
- Using statutory ceilings on interest rates and related measures of financial repression to stabilize public debt, is less feasible than in the past.
- Inflation is not a sustainable route to reducing high public debts.
Living with High Public Debt
Authors: Serkan Arslanalp, Barry Eichengreen
From: International Monetary Fund, University of California, Berkeley
The fiscal-monetary policy interaction
Further exploring Arslanalp and Eichengreen’s last point on whether inflation could reduce public debt, De Grauwe and Foresti examine how fiscal dominance affects both the outcome and the institutional design of the fiscal-monetary policy mix. They use a behavioral New Keynesian model with heterogeneous expectations formation for output, inflation, and government spending and where agents can be either fundamentalists or extrapolators when forming their expectations. In addition, agents are allowed to revise their forecasting rules, a feature of the model that generates endogenous waves of optimism and pessimism. The authors show that under a regime of fiscal dominance:
- The government forces the central bank to contribute to public debt stabilization in order to avoid the policy trade-off between the stabilization of output and public debt.
- The central bank’s ability to stabilize output and inflation is therefore reduced, causing higher inflation volatility around the central bank’s target.
- In terms of agents’ beliefs, waves of optimism and pessimism become more persistent, as a result, under fiscal dominance the central bank’s credibility is undermined.
Interactions of fiscal and monetary policies under waves of optimism and pessimism
Authors: Paul De Grauwe, Pasquale Foresti
From: London School of Economics, University of Roehampton
