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Balancing Fiscal Sustainability and Safe Assets
How to keep the ship sailing without it falling apart
Note: any and all opinions are entirely my own and do not necessarily reflect those of the Cleveland Fed, the FOMC, or any other person or entity within the Federal Reserve System. I am speaking exclusively for myself in this post (as well as in all other posts, comments, and other related materials). No content whatsoever should be seen to represent the views of the Federal Reserve System.
One of my favorite issues in current macroeconomics is the safe asset shortage — I think it’s an under-appreciated issue, too. However, it appears to run at odds with another, more prominent, issue in macroeconomics: debt sustainability. Anyone interested in allowing our prosperity to continue for future generations should be mindful of both the safe asset shortage and debt sustainability. How do we solve the safe asset shortage problem without throwing ourselves off the fiscal cliff?
A Primer on the Safe Asset Shortage
The safe asset shortage could (and perhaps should) get a blog post entirely to itself, but I’ll briefly summarize here. Caballero, Farhi, and Gourinchas (2017) is an excellent entry piece for those really interested. Essentially, many people (and institutions) like to save by parking their cash in safe assets. Safe assets are assets which are generally considered to be risk-free, or at least as risk-free as an asset could be. US Treasury debt is considered to be a safe asset: if the US government fails to pay you back, it’s likely that would be the least of your concerns. People trust in our ability to repay our debt.
The safe asset shortage story begins with the global savings glut — a term coined by then-Fed Governor Ben Bernanke in 2005. The savings glut story is that after capital had flowed into developing countries for decades (particularly in Asia and the Middle East), it started a reversal. Developing countries were beginning to become developed countries, and in the process shifted from net borrowers to net lenders. From a foreigner’s point of view (or the U.S.’s), they stopped borrowing from us and on net started lending, which is seen below.
So the story goes, as developing economies grew, they needed to save. With globalization coming of age, many foreigners parked their savings in safe assets. Not exclusively American safe assets, but we did offer the most. Their cash wound up invested in US Treasury debt, mortgage-backed securities, and in the debt of a handful of other advanced economies, like the U.K., Greece, Germany, Italy, and Spain.
As foreign cash poured into debt, the price of debt went up and therefore, due to the mechanics of bond pricing, interest rates fell. This shift in saving is shown below by S1 shifting to S2, and I1 shifting to I2 (chart courtesy of the Chicago Fed). The equilibrium world interest rate falls from r1 to r2.
We can see this in the run-up in net foreign purchases of U.S. government debt securities, shown below. Keep in mind that these are monthly net purchases, not a running or cumulative total of all debt holdings — that number is much larger. This more or less shows the change in the stock of foreign holdings of U.S. government debt.
All was fine and well until around 2011, by when mortgage-backed securities/agency debt along with Greek, Italian, and Spanish debt (among others) were no longer considered safe. By Caballero et al.’s estimate, by 2011, compared to 2007, there was a decline of roughly $8 trillion in the supply of safe assets. Compounded with a slower safe asset generation rate as many European countries tightened fiscal budgets in the wake of the financial crisis, the supply of safe assets shrunk dramatically. At the same time, however, demand was ever-increasing, and these assets’ prices continued to rise.
However, interest rates face an effective lower bound. It’s not necessarily zero, but it’s not far from it on the negative side: say, 1% or so. Therefore, interest rates cannot fall to where they hypothetically “should” be — similar to rent control, for example. The place where safe asset prices/interest rates “should” be is the “safe real rate”. When interest rates cannot achieve that low of a rate, the economy slows down similar to if the Fed were to raise interest rates. A number of things determine where the safe real rate is; Ferreira and Shousha (2020) identify five main factors and decompose the effect of each one on the change in the safe real rate over the last fifty years:
Here we can see that the neutral/natural rate fell leading up to 2008, with declining productivity as the largest factor driving each semiannual change. But also note how the supply of safe assets, in red, negatively contributed to the change in the natural rate, before massively contributing to preventing the neutral rate from falling further after 2010. For all the hype that the size of the working age population gets, the supply of safe assets did almost as much to boost the natural rate 2009-2015 as the size of the working population did in the 1970s.
The shift toward safe assets and away from equity lowered interest rates and raised debt prices, leaving a higher disparity between risk-free rates and the return on equity. This higher risk premium led firms to postpone investment (hence the inward shift of the investment curve in the investment-savings chart above), particularly during the weak demand experienced during and after the Great Recession. The graph below is borrowed from Caballero et al. (2017).
Between the interest rate mismatch between the safe real rate and real interest rates (which reflects the shortage in the supply of safe assets) and the increased equity risk premium (which reflects the higher demand for safe assets), the safe assets shortage has real macroeconomic effects. The economy is forced to run at under capacity due to relatively high real interest rates, and businesses postpone investment due to weak demand and high risk premiums. The chart below, also borrowed from Ferreira and Shousha (2020), shows how before 2008 the net supply of safe assets would loosely follow interest rates. Since 2008, however, this has not been the case; the supply of safe assets has been increasing, but with no response from interest rates. The safe real rate is still below the effective lower bound.
An increase in the supply of safe assets would obviously alleviate the shortage. This can be accomplished in a number of ways, which I’ll discuss below. But for now, it ultimately comes down to, as with the housing shortage, just supplying more of the item in shortage. Caballero et al. offer 4 main solutions: let safe asset producers’ currencies appreciate, produce more debt, create private-sector equivalents for safe assets, and reduce the demand for safe assets.
Now, a shift to deficits. Modern macroeconomics is much more forgiving of large deficits than earlier eras, but can we run large deficits forever? Many worry about our current and projected debt-to-GDP ratio, which currently stands at 127% (debt held by the public, as a percentage of GDP, is probably a better measure and presently stands at 99.7%). But as many, including Jason Furman, have pointed out, GDP is not a stock, but a flow. What matters is not necessarily what GDP is right now or where it’s been, but where it’s going. We don’t need to pay off the debt right now.
Furman noted that the Social Security Trustees calculate the net present value of GDP to be about $4 quadrillion. This means that our debt-to-NPV-GDP ratio (quite the word-chain) is actually less than 1%. Further, interest payments as a percentage of GDP remain low, particularly real net interest payments. Real net interest payments matter because inflation makes paying off our debt easier. Furman suggests that a debt-to-GDP ratio of 200% can be sustained with a real net interest payments at 1% of GDP; at 2%, up to 400% debt-to-GDP. These values are low but powerful: despite all the Covid spending, the Great Recession, and large Trump deficits, real net interest payments have not topped 2% of GDP since before 2000.
Other recent research emphasizes other qualities of debt. Debrun et al. (2019) found that the nature of the debt situation and the characteristics of issuing government are as, if not more, important than abstract ratios; Bhatt and Neveu (2018) suggest using a debt-to-duration ratio as a percentage of GDP instead of just debt as a percentage of GDP, as this adjusts for the flow nature of debt.
Regardless, there is a good bit of fiscal space left. The point is basically that we should not target or limit the amount of dollars the federal government spends, but rather the percentage of GDP our real interest payments take up. But should we constrain ourselves to that limit? We probably should. The U.S. experienced no trouble issuing debt to fund Covid-related stimulus, despite absolute havoc in Treasury markets at the time, but this is a privilege. People want our debt. Remember: there’s not enough of it! However, there is likely a point where so much debt is being issued that people doubt the validity of it (as unconstitutional as this may be) and become hesitant to buy it.
Sure, we have the Federal Reserve to print money to pay the bills, but is that a game we really want to play? I do not accept fiscal dominance of the price level, but I do believe that with a sufficiently large amount of debt and a continuing and rapid increase in its rate of issuance that the situation described in Sargent and Wallace (1981) could come true: highly expansionary fiscal policy creates inflation, the Fed raises interest rates to fight that inflation and thereby increases the cost of borrowing to the government, which then has to issue more debt to pay the bills, and so on in a cycle until default and/or hyperinflation occurs. I don’t think this is generally an accurate model for the present economy (as r < g, and that is unlikely to change), but I do think an unsustainable debt path, if followed forever, could lead us there. But you know what —let’s not find out.
In summary, we can issue more debt — in fact a lot more debt — but we should remain within the bounds of a 1% to 2% real net interest payment as a percentage of GDP bound. This allows us a debt-to-GDP ratio of up to 400%. We shouldn’t push too much past this point, though, as it will make later bills more difficult to pay and make our creditors lose confidence. Therefore, we should be, as always, allocating scarce resources — government spending — as efficiently and productively as we can.
Why Not Just Care About Safe Assets?
Why should we subject ourselves to a sustainability restraint if the safe asset shortage is so severe? We don’t want to destroy our house in the process of cleaning it. Safe assets are no good if they are not considered safe. The reason we remain able to issue debt, and issue so much of it as rapidly as we did last year, is because there is faith and confidence in our debt. If we were do irresponsible and reckless fiscal spending, our debt would not be as safe as it once was. The defining feature of a safe asset is that it is supposed to be a risk-free rate: there can’t be a lack of risk if we’re pumping out debt just to alleviate the safe asset shortage!
Fiscal order is useful, anyway. We’re on an unsustainable path as it is. We may as well invest in future growth as strongly as we can. Fiscal disorder is not a good thing. This doesn’t mean running zero deficits or a balanced budget, but rather attempting to create budgets balanced with the future. I’m not sure that this is what we’re doing now, but it should be. The power to borrow should be used, but it should be used for good.
Why Not Just Care About Sustainability?
The safe asset shortage is pulling the economy below its potential growth rate. Sure, it’s true that the decline in interest rates is not a recent phenomenon but rather a trend of the last 800 years. Nonetheless, as with all policy and decision making, we should aim for the outcome that will create the largest amount of prosperity and wealth, and therefore for the outcome with as much economic growth as possible. The safe asset shortage is of course far from the only thing pulling the economy below potential, but it is arguably a more solvable issue than other growth-inhibiting issues, like declining birth rates.
Balancing Sustainability With Safe Assets
Now it’s time to balance the sustainability restraint with the need for more safe assets. To balance fiscal sustainability with solving the safe asset shortage, we should increase the supply of safe assets by issuing debt to pay for relatively large pro-growth investments in productivity and human capital, and ease the demand for safe assets.
Increasing the supply of safe assets: Of the four solutions offered by Caballero et al., the “easiest” would be to simply create more safe assets. Textbook introductory microeconomics tells us that an increase in supply will lower the price. The effective lower bound of interest rates has maxed out the ability by which safe asset prices can move up; unable to shift the market by price, the market shifted by selling a lower quantity. If we were to increase the supply of safe assets, prices would come down and interest rates would rise: the shortage would be a shortage no more.
However, mindful of the fact that our spending should be sustainable, we should prioritize spending that offers significant return on investment. Bill Gale of the Brookings Institute has written a great book on this topic that’s worth the read (if just for its title: Fiscal Therapy). Essentially, spending that boosts productivity and human capital, like on infrastructure and education, is a good place to start. These need not be complicated or massive projects: simply ensuring all American highways are safely drivable and installing air conditioning in schools would make us more productive and boost our human capital, respectively. Investments in productivity and human capital are great not just because they lead to more economic growth later down the line, but also because high-productivity, high-human capital individuals bring in more income to be taxed by the government. It’s as if you’re raising taxes by creating larger future paychecks. Increased productivity and human capital expenditure would boost the supply of safe assets while also making sure that future debt will be able to be paid for, keeping us on a path of fiscal sustainability.
“Hidden” government spending in the form of the tax code can be good too. The Tax Foundation offers a number of potential reforms. Allowing full expensing for all capital investment would boost long-run GDP growth by 2.3%, an equivalent of about half a million jobs. Condensing into three income brackets would boost growth by 1.3%; cutting all income tax brackets by 10 percentage points would add 0.9%. These would also add quite a bit to the deficit, but at the trade off of higher growth, which will make the bills easier to pay later. Think about how we paid off all that World War II debt: would we have done it as successfully without as much growth as we had in the 50s and 60s?
These decisions should be made not just by the United States but also by producers of all safe assets. Europe’s resistance to deficit spend in the wake of the Great Recession helped to pull back the supply of safe assets. All producers of safe assets can and should take part.
In summary, we should spend more on high return-on-investment investments. Whether that is in improving our schools, infrastructure, or in reforming our tax code to promote growth, this spending will boost growth while incurring debt. This debt will alleviate the shortage of safe assets, and will be made payable by the pro-growth policy the debt was incurred over.
Reducing the demand for safe assets: In addition to expanding the supply of safe assets, we can undo the other half of the problem, the demand for them. 19% of federal debt is held by the Federal Reserve, and 43% is held by all the world’s central banks. This is largely a consequence of quantitative easing, but also for intervening in foreign exchange markets. Quantitative easing is a funny tale: if one engages in quantitative easing to buy safe assets to fight an economic slowdown fueled by a shortage of safe assets, is this really making the situation better? Caballero et al. suggest central banks purchase riskier assets rather than safe assets; while this would likely prove quite unpopular with the public, it would alleviate some pressure on safe assets.
Further, post-financial crisis reforms in financial regulation also boost demand for safe assets. Banks have to hold a certain amount of safe assets per Basel regulations, which creates a sort of permanent demand for them — a demand that only increases with the balance sheet of the financial institutions. Financial regulations might be able to be adjusted in order to simultaneously support safe asset markets while also keeping banks in line.
The optimal policy move would be to create pro-growth investments and incentives, incur additional debt in the process, and then use the realized growth down the line to pay off the additional debt. The one thing of which there is no shortage of is ideas of how to spend federal money. Do we want to go for nationalized insurance? Do we want to cut corporate tax rates? Do we want to redesign our school system, build high-speed rail networks, or subsidize public four-year degrees? We should, as always, use empirical methods to determine the right decisions as much as we possibly can. We should also be more willing to deficit spend in the name of promoting growth — with a side effect of helping the global economy back to a healthier equilibrium.