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Monday, January 7, 2019

Blanchard Address On Low Interest Rates

Olivier Blanchard gave an address at the AEA: "Public Debt and Low Interest Rates." It offers a good summary of mainstream thinking about fiscal policy using a variety of models, which makes it interesting as an introduction. My initial comment is that the difficulty with mainstream approaches to this topic are key assumptions that are embedded into models. I am unsure how useful debating the models is when the validity of the assumptions can be questioned.

Rather than offered a mangled summary of what Blanchard wrote, I just want to sketch out some of my complaints about the mainstream approach. To be clear, I am saying that these points are debatable; whether or not the mainstream is wrong about them is a bigger question, well beyond the scope of my comments here.
  1. How are interest rates set for a floating currency sovereign? It is safe to say that nominal interest rates are largely driven by expectations for the path of the nominal policy rate. The question then becomes: how constrained is that policy rate? For example, could the policy rate be locked at "close" to 0%, which makes it look like "deficits are money financed." How plausible is the belief that the private sector will force deflation in the price level, in order to achieve a positive real rate? Would locking the interest rate at 0% cause inflation (or even hyperinflation)?
  2. Why ignore the private sector, other than vague notions of liquidity preferences (or whatever)? We are in a rather unique demographic position, with the baby boomers in a position of needing a high stock of assets to fund retirement plans. Private sector preferences are a major input into fiscal balance outcomes.
  3. Why do we care? Do we believe that bond holders can force a default? Why not make such an outcome impossible (which would only require trivial changes to operating procedures, and have no measurable effect on the macroeconomy)?
  4. Debt levels just do not happen, they are the result of policy choices. Why would the welfare effect of interest payments be anything other than a small residual of the welfare effect of the policy change?
As always, raising such questions about foundations makes discussions with the mainstream very difficult. Since the mainstream language is based on their models, arguing that the models are ill-founded is effectively starting a debate in a foreign language. I might return to that debate later, but I am unsure when that will be.

(c) Brian Romanchuk 2019

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