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Fiscal Policy under Low Interest Rates
Rethinking fiscal and monetary policy in an economic environment of high debt and low interest rates.
Policy makers in advanced economies find themselves in an unusual fiscal debt ratios are historically high, and—once the fight against inflation is won—real interest rates will likely be very low again. This combination calls for a rethinking of the role of fiscal and monetary policy—and this is just what Olivier Blanchard proposes in Fiscal Policy under Low Interest Rates .
There is a wide set of opinions about the direction that fiscal policy should take. Some, pointing to the high debt levels, make debt reduction an absolute priority. Others, pointing to the low interest rates, are less worried; they suggest that there is still fiscal space, and, if justified, further increases in debt should not be ruled out. Blanchard argues that low interest rates decrease not only the fiscal costs of debt but also the welfare costs of debt. At the same time, he shows how low rates decrease the room to maneuver in monetary policy—and thus increase the benefits of using fiscal policy, including deficits and debt, for macroeconomic stabilization. In short, low rates imply lower costs and higher benefits of debt.
Having sketched what optimal policy looks like, Blanchard considers three examples of fiscal policy in fiscal consolidation in the wake of the Global Financial Crisis, the large increase in debt in Japan, and the current US fiscal and monetary policy mix. His conclusions hold practical implications for economic and fiscal policy makers, bankers, and politicians around the world.
Policy makers in advanced economies find themselves in an unusual fiscal debt ratios are historically high, and—once the fight against inflation is won—real interest rates will likely be very low again. This combination calls for a rethinking of the role of fiscal and monetary policy—and this is just what Olivier Blanchard proposes in Fiscal Policy under Low Interest Rates .
There is a wide set of opinions about the direction that fiscal policy should take. Some, pointing to the high debt levels, make debt reduction an absolute priority. Others, pointing to the low interest rates, are less worried; they suggest that there is still fiscal space, and, if justified, further increases in debt should not be ruled out. Blanchard argues that low interest rates decrease not only the fiscal costs of debt but also the welfare costs of debt. At the same time, he shows how low rates decrease the room to maneuver in monetary policy—and thus increase the benefits of using fiscal policy, including deficits and debt, for macroeconomic stabilization. In short, low rates imply lower costs and higher benefits of debt.
Having sketched what optimal policy looks like, Blanchard considers three examples of fiscal policy in fiscal consolidation in the wake of the Global Financial Crisis, the large increase in debt in Japan, and the current US fiscal and monetary policy mix. His conclusions hold practical implications for economic and fiscal policy makers, bankers, and politicians around the world.
- GenresEconomicsNonfiction
192 pages, Paperback
Published January 10, 2023
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July 2, 2023
All stars — Fiscal Policy under Low Interest Rates (Olivier Blanchard)
A short book (more of a pamphlet, really) detailing a framework of how to think about fiscal policy. This one’s for economists or suitably nerdy wonks, though much of the discussion is nontechnical. The takeaway: fiscal policy should play a more active role in macro-stabilisation. Also stop worrying about debt so much. Strongly recommended.
The neutral rate has been declining for the last thirty years (longer, actually) due to low-frequency structural factors. We should expect it to remain low for the foreseeable future given this, aside from the odd interruption of massive fiscal stimulus (see Biden). If central banks do their thing and move policy rates towards the neutral rate, then it will be below the growth rate of the economy (“r < g”, and no, not Piketty’s: that is the risky rate).
This is a favourable environment for debt dynamics. Governments can run primary deficits while keeping the debt-to-GDP ratio stable (or even shrink it). Of course, this is all endogenous: the neutral rate depends on fiscal policy. And debt sustainability is still an issue. And forecasts are subject to considerable uncertainty. Blanchard advocates for Stochastic Debt Sustainability Analysis (SDSA): a method to let fiscal analysts estimate whether debt is sustainable. It also turns out that adjustment of the primary deficit (surplus) to debt service costs is extremely useful for good evaluations of debt sustainability. Of course, assuming these contingent adjustments are credible. You might then imagine a sort of Taylor Rule for fiscal policy. Blanchard warns against this: hard (or even not) rules are unlikely to be as helpful as the SDSA process.
It also turns out that when neutral rates are low, debt doesn’t have much of a welfare cost either. When r < g, the economy is over-accumulating capital: decreasing capital (transferring instead of saving) is welfare-improving (for all generations).
Debt sustainability might come under fire by a shock to investor’s perceptions of default risk. That is: they start demanding risk premier, which then pushes up rates and may make debt dynamics unsustainable, which pushes up risk premier. A vicious cycle. Depending on the source (“sunspot” or fundamental), central banks can help prevent these sorts of equilibria. It’s not for free, though: the soundness of fiscal policy ultimately needs credibility.
There are some good suggestions on hiving out the capital account from the current account into its own budgetary public investment agency. This serves to make the capital account a bit harder to cut (usually investment goes first). Blanchard also weighs in on whether QE is monetising debt (no: it’s just changing the liability composition of the government to the private sector: interest-paying reserves for bonds) and whether central banks should write off government debt to increase fiscal space (no: central banks remit profits to the government anyway, and this would have independence risks).
So what does this all mean for fiscal policy? Consider the effective lower bound for monetary policy: central banks can only lower policy rates so far. Leaving aside even more unconventional monetary policy, like getting rid of cash (or having expiring banknotes, or whatever). So when neutral rates are low, central banks have much less room to move the policy rate downwards. Since fiscal stimulus works (Ricardian equivalence is basically false) and debt dynamics are benign we should then use deficits as a macro-stabilisation tool.
Or, as Blanchard puts it, we can think of two extreme approaches to fiscal policy. First, “pure public finance” uses debt to smooth tax distortions or to redistribute across generations and does not really care about the effects on aggregate demand and output. Second, “pure functional finance” cares more about the macro-stabilisation role and does not really care about the effects on debt levels. The optimal fiscal approach is some weighted average between the two. When central banks are at the effective lower bound then favour fiscal policy as macro-stabilisation and to give central banks policy space. If neutral rates are higher and central banks have policy space, then focus on debt reduction. Neat!
A few more things to discuss. First: austerity is bad (though the confidence fairy has worked its magic in the past). If hysteresis is strong enough then austerity may impair output more than debt, leading to a permanent increase in the debt-to-GDP ratio. In addition to the political and legitimacy risks of austerity.
Second: Higher inflation targets would give central banks more policy space. This argument has been repeated a lot. As a matter of policy, though, I assume credibility risks are much higher when moving in a period of high inflation.
Third: what it private demand is so weak, even though central banks are at the effective lower bound, that the deficits required are so large as to impair debt sustainability? Governments then need to look at fundamental determinants of the neutral rate. One suggestion is stronger social insurance. Putting aside welfare effects, which would be positive, it would reduce precautionary saving thereby increasing private demand and reducing the required deficits.
Finally: this book doesn’t really apply to developing countries.
A short book (more of a pamphlet, really) detailing a framework of how to think about fiscal policy. This one’s for economists or suitably nerdy wonks, though much of the discussion is nontechnical. The takeaway: fiscal policy should play a more active role in macro-stabilisation. Also stop worrying about debt so much. Strongly recommended.
The neutral rate has been declining for the last thirty years (longer, actually) due to low-frequency structural factors. We should expect it to remain low for the foreseeable future given this, aside from the odd interruption of massive fiscal stimulus (see Biden). If central banks do their thing and move policy rates towards the neutral rate, then it will be below the growth rate of the economy (“r < g”, and no, not Piketty’s: that is the risky rate).
This is a favourable environment for debt dynamics. Governments can run primary deficits while keeping the debt-to-GDP ratio stable (or even shrink it). Of course, this is all endogenous: the neutral rate depends on fiscal policy. And debt sustainability is still an issue. And forecasts are subject to considerable uncertainty. Blanchard advocates for Stochastic Debt Sustainability Analysis (SDSA): a method to let fiscal analysts estimate whether debt is sustainable. It also turns out that adjustment of the primary deficit (surplus) to debt service costs is extremely useful for good evaluations of debt sustainability. Of course, assuming these contingent adjustments are credible. You might then imagine a sort of Taylor Rule for fiscal policy. Blanchard warns against this: hard (or even not) rules are unlikely to be as helpful as the SDSA process.
It also turns out that when neutral rates are low, debt doesn’t have much of a welfare cost either. When r < g, the economy is over-accumulating capital: decreasing capital (transferring instead of saving) is welfare-improving (for all generations).
Debt sustainability might come under fire by a shock to investor’s perceptions of default risk. That is: they start demanding risk premier, which then pushes up rates and may make debt dynamics unsustainable, which pushes up risk premier. A vicious cycle. Depending on the source (“sunspot” or fundamental), central banks can help prevent these sorts of equilibria. It’s not for free, though: the soundness of fiscal policy ultimately needs credibility.
There are some good suggestions on hiving out the capital account from the current account into its own budgetary public investment agency. This serves to make the capital account a bit harder to cut (usually investment goes first). Blanchard also weighs in on whether QE is monetising debt (no: it’s just changing the liability composition of the government to the private sector: interest-paying reserves for bonds) and whether central banks should write off government debt to increase fiscal space (no: central banks remit profits to the government anyway, and this would have independence risks).
So what does this all mean for fiscal policy? Consider the effective lower bound for monetary policy: central banks can only lower policy rates so far. Leaving aside even more unconventional monetary policy, like getting rid of cash (or having expiring banknotes, or whatever). So when neutral rates are low, central banks have much less room to move the policy rate downwards. Since fiscal stimulus works (Ricardian equivalence is basically false) and debt dynamics are benign we should then use deficits as a macro-stabilisation tool.
Or, as Blanchard puts it, we can think of two extreme approaches to fiscal policy. First, “pure public finance” uses debt to smooth tax distortions or to redistribute across generations and does not really care about the effects on aggregate demand and output. Second, “pure functional finance” cares more about the macro-stabilisation role and does not really care about the effects on debt levels. The optimal fiscal approach is some weighted average between the two. When central banks are at the effective lower bound then favour fiscal policy as macro-stabilisation and to give central banks policy space. If neutral rates are higher and central banks have policy space, then focus on debt reduction. Neat!
A few more things to discuss. First: austerity is bad (though the confidence fairy has worked its magic in the past). If hysteresis is strong enough then austerity may impair output more than debt, leading to a permanent increase in the debt-to-GDP ratio. In addition to the political and legitimacy risks of austerity.
Second: Higher inflation targets would give central banks more policy space. This argument has been repeated a lot. As a matter of policy, though, I assume credibility risks are much higher when moving in a period of high inflation.
Third: what it private demand is so weak, even though central banks are at the effective lower bound, that the deficits required are so large as to impair debt sustainability? Governments then need to look at fundamental determinants of the neutral rate. One suggestion is stronger social insurance. Putting aside welfare effects, which would be positive, it would reduce precautionary saving thereby increasing private demand and reducing the required deficits.
Finally: this book doesn’t really apply to developing countries.
June 18, 2024
One of the most valuable formulae in economics is "r*-g".
What does it mean?
The neutral rate of interest - the GDP growth rate. The r* is explained here:
(https://en.wikipedia.org/wiki/Neutral... ) and g is self explanatory.
The formula expresses whether the cost of the existing stock of debt is growing more or less than the economy as a whole and generally addresses, inter alia, the trajectory of a country's debt burden or fiscal policy space.
Post-the 2008 GFC, the decline of r* accelerated, but even today with the recent monetary tightening the multi-decades descent is unmistakable. The nature of fiscal policy and debt management is changing as a result.
Dr. Blanchard is a likely Nobel laureate in the near future. More than his contributions to the science of economics, his ability to communicate to professional economists and the layman alike sets him apart.
In this book, he lives up to both!! He uses this equation to frame his answers to two fundamental questions - (i) how much fiscal space does a country have? and (ii) how should this fiscal space be used?
Happy reading to discover his responses.
What does it mean?
The neutral rate of interest - the GDP growth rate. The r* is explained here:
(https://en.wikipedia.org/wiki/Neutral... ) and g is self explanatory.
The formula expresses whether the cost of the existing stock of debt is growing more or less than the economy as a whole and generally addresses, inter alia, the trajectory of a country's debt burden or fiscal policy space.
Post-the 2008 GFC, the decline of r* accelerated, but even today with the recent monetary tightening the multi-decades descent is unmistakable. The nature of fiscal policy and debt management is changing as a result.
Dr. Blanchard is a likely Nobel laureate in the near future. More than his contributions to the science of economics, his ability to communicate to professional economists and the layman alike sets him apart.
In this book, he lives up to both!! He uses this equation to frame his answers to two fundamental questions - (i) how much fiscal space does a country have? and (ii) how should this fiscal space be used?
Happy reading to discover his responses.
July 10, 2025
While the view of lower interest rates contained in Blanchard's essay on Fiscal Policy Under Low Interest Rates has aged like milk, the underlying theory - that debt is sustainable when real growth rates exceed real interest rates - holds true.
Blanchard's text serves as an excellent deep-dive to debt-sustainability analysis, and the macroeconomic theory that underpins fiscal sustainability. And, because of this, I would go as far to argue that this essay is perhaps even more relevant in the current times of higher interest rates where governments and politicians have seemingly struggled to keep towards the doctrines this book presents.
I see the book as a must read (it is quite short), and give it 5-starts due to the mathematics within it; which Blanchard does a good job of explaining. If you aren't mathematically inclined, please do not have this put you off reading this piece.
Blanchard's text serves as an excellent deep-dive to debt-sustainability analysis, and the macroeconomic theory that underpins fiscal sustainability. And, because of this, I would go as far to argue that this essay is perhaps even more relevant in the current times of higher interest rates where governments and politicians have seemingly struggled to keep towards the doctrines this book presents.
I see the book as a must read (it is quite short), and give it 5-starts due to the mathematics within it; which Blanchard does a good job of explaining. If you aren't mathematically inclined, please do not have this put you off reading this piece.
January 20, 2025
All the expansionary monetary&fiscal policies last decades, i.e, asset boom&welfare, depended on ultra low rate.
Failed effect to tame debt ratio climb made things out of imagination if rate hike.
Fed is now acknowledging the ‘IF’.
Failed effect to tame debt ratio climb made things out of imagination if rate hike.
Fed is now acknowledging the ‘IF’.
Displaying 1 - 4 of 4 reviews