Friday 14 October 2022
Monetary vs fiscal: the return game
During the 2010s, questions about the sustainability of public debt were often dismissed due to low interest rates, which sometimes led to the belief that there was no limit to public debt. But the question will quickly arise, due to the sharp rise in interest rates in the context of high public debt. The recent example of the United Kingdom is a first warning.
Public debt was much lower during the “Great Inflation” of the 1970s
In the wake of the "Great Inflation" of the 1970s, the central banks of major developed countries adopted restrictive monetary policies (this is often described as the "Volcker shock", named after Paul Volcker, chairman of the Fed from the late 1970s) and they raised their policy rates sharply. The latter remained higher than before over the 1980s, and tended to decline thereafter. The fact that interest rates have become significantly higher than GDP growth (the former inflates the numerator of the debt-to-GDP ratio and the latter the denominator) has contributed to the increase in public debt over the decades 1980 and 1990. Thus, the debt-to-GDP ratio of the United States rose from 41% in 1980 to 62% in 1990 and, for example, it rose from 45% to 74% in Canada.
The 2008 financial crisis had a considerable economic impact, which sharply increased public deficits: as a result, the debt-to-GDP ratio rose sharply in all developed countries. But this ratio stabilized almost everywhere during the 2010s (with the notable exception of Germany where it actually fell, largely due to the austerity advocated by its government during this period) because central banks in these countries have kept key interest rates around zero and have conducted large-scale asset purchases, which have compressed long-term interest rates. The fact that interest rates were close to zero while economic growth was positive helped to stabilize debt-to-GDP ratios despite deficits.
In 2022, the central banks of the G7 countries (with the notable exception of Japan) all raised their key rates, more or less sharply, the Fed having gone further than the others. We can make two remarks with regard to the Volcker shock of the late 1970s:
- This vigorous tightening of monetary policy comes at a time when the debt-to-GDP ratio is at least 2 times higher than in 1980 in the developed countries (3 times higher in the case of the United States and even more than 5 times higher in the case of France). According to IMF figures, it exceeds 125% in the United States. Rising interest rates now apply to a much larger amount of public debt.
- The transition to a period of higher interest rates and weaker (even negative) growth marks a break with the 2010s when interest rates were lower than GDP growth. This will contribute to a rise in the debt-to-GDP ratio.
The example of the United States
Because of the Fed rate hikes in 2022, US federal government debt service rose sharply and reached $465 bn in the 12 months to August 2022, representing around 1.9% of GDP (at the highest level since the end of the 1990s).
In its July 2022 projections, the CBO predicted that the federal public debt service would gradually rise to 3.3% of GDP in 2032, due to a 3-month rate seen slightly above 2% and a 10-year rate converging slowly towards 3.8% over the next few years (the assumption for 2023 was 3%). But these interest rate projections were too optimistic: indeed, the 3-month rate is now close to 3.30% and the 10-year rate around 4%.
If we take into account the fact that 15% of the federal debt is made up of T-bills and that the 6-month T-bill rates are currently around 3.90% and the 12-month rates around 4.20%, it is very likely that interest expenses will increase very rapidly over the next few months. Continuing the trends of the last few months, one could imagine that interest expenses quite easily reaches 3.5% of GDP in 2023, which has never been seen after the Second World War. Above all, it could happen as early as next year when the CBO did not anticipate this before 10 years.
During the 1990s, one solution to high debt servicing was…the build-up of budget surpluses under the presidency of Bill Clinton, which lowered the debt-to-GDP ratio. The problem currently facing the United States is that the CBO forecasts a slow increase in public deficits over the next 10 years due to the aging of the population (from about 4% of GDP in 2023 to 6% in 2032). A much faster than expected increase in debt servicing would significantly worsen the public debt trajectory.
Towards fiscal dominance?
More generally, rapid monetary tightening in a context of already high public debt and when public spending is set to rise (policies to support households and businesses in the face of rising energy prices, energy transition, population ageing, etc.) will significantly deteriorate public debt trajectories in developed countries.
This will inevitably lead to debates on “fiscal dominance”. As a reminder, the economists Thomas Sargent and Neil Wallace introduced in 1981 the notions of “monetary dominance” and “fiscal dominance”. We speak of “monetary dominance” when monetary authorities are entirely focused on controlling inflation, while fiscal authorities must adjust fiscal policy to remain solvent. And we speak of “fiscal dominance” when monetary policy is subject to the constraint of keeping the government solvent, that is to say, of keeping interest rates low enough for the government to be able to refinance itself. ECB Executive Board member Isabel Schnabel recently recalled that the euro was created with the “monetary dominance” model.
In the current context of high inflation, almost all the central banks of developed countries are in the process of raising their key rates very sharply. In the case of the Fed, the rise in key rates is quite simply the fastest since that which took place under the presidency of Paul Volcker in the early 1980s. The negative effect on activity that this causes, coupled to the recessive effect of the rise in energy prices, produces a configuration reminiscent of the stagflation of the 1970s/1980s and where interest rates will be significantly higher than GDP growth: this will quickly contribute to the rise of the debt-to-GDP ratio. This could, moreover, take hold over time since some central banks have indicated that they intend to keep interest rates in restrictive territory over time (FOMC members indicate that we should not count on rate cuts in 2023).
Basically, we can think of two scenarios:
- the central banks are giving up all or a portion of their monetary tightening policies because of the deterioration in the trajectory of public finances,
- central banks persist in adopting a restrictive policy, which forces governments to exercise more budgetary rigor.
Each context is specific, but the recent example of the United Kingdom shows that high public debt does not allow the coincidence of a restrictive monetary policy and an explicitly expansionary fiscal policy... and that it can lead central banks to review their monetary tightening programs (in the case of the BoE, postponement of asset sales and temporary return to asset purchases).
During the 2010s, questions about the sustainability of public debt were often dismissed due to low interest rates, which sometimes led to the belief that there was no limit to public debt: interest rates were effectively lower than GDP growth rates, which helped to stabilize the debt-to-GDP ratio. The fact that interest rates have been raised while activity is stagnating, or even contracting, is very unfavorable for the trajectory of the debt-to-GDP ratio. We could schematize the situation by the alternative: return of the budgetary constraint or (partial?) abandonment of monetary tightening? The recent example of the United Kingdom is a first warning and showed that it is now much more complicated to opt for unfunded fiscal policies in a context of high debt and rapid monetary tightening. This type of questioning should be increasingly significant in the months to come, when the new public debt trajectories published will be much more unfavourable.
The existential need to fight climate change coupled with other major challenges such as population ageing will likely mean that central banks will have to be less aggressive in the long term and accept a higher and more volatile inflation regime. Questions about raising the inflation target of central banks in developed countries could also arise.
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Bastien Drut, Chief Thematic Macro Strategist