In this piece for Stanford’s Institute for Economic Policy Research, former Biden chief economist Jared Bernstein and colleagues describe (as elevated) the risks of a fiscal crisis in the United States. They follow the now conventional model developed by Olivier Blanchard, invoking the logic of Ponzi Public Finance (no disparagement implied), in which the r*-g* gap looms larger than even the debt / GDP ratio as a determinant of the risk of a crisis.
The paper is written for a general audience and folks with backgrounds in applied macro will in particular find it readable. It also nicely quantifies how the relevant variables have been evolving recently and demonstrates effectively that the risks of real fiscal trouble have in fact gone from negligible to quite plausible. My own view is that this theme is not relevant at, say, a 6-month horizon.
The authors raise two points that I find particularly helpful. First, when thinking about the risk of a fiscal crisis, we need to recognize that understanding the mean or modal scenario for the path of the debt / GDP ratio and related variables is not sufficient. Rather, the entire probability distribution matters because the odds of the fiscal risk premium (which has not yet been an issue) rising to make the process suddenly unsustainable is related more to the right side of the distribution than to the central tendency per se. Or in English, the fiscal risk premium is likely to spike when the prospect of trouble assuming no spike of that premium becomes plausible, rather than likely. It resembles corporate credit in this way, if not others.
Second, they point out that the notion of fiscal “unsustainability” has been bandied about too casually, especially among fiscal hawks. And they come up with a nice tangible definition of what unsustainability means in a very practical, non-pious sense of the term. I cite their discussion at length below and remove distracting footnotes:
Recent literature has offered a few definitions of fiscal unsustainability. Blanchard writes that “debt is sustainable if the probability of a debt explosion is small,” noting that one still must define “explosion” and “small” for this definition to be useful. Abecasis et al. offer a definition of “explosive” debt and add a useful historical reference:
“If the debt grows large enough, the fiscal trajectory could become ‘explosive’ in the sense that interest expense would be so large that stabilizing the debt-to-GDP ratio would require running persistent fiscal surpluses of a size that has seldom been sustained in the past and is unlikely to be sustained in the future because it is economically costly and politically difficult.”
These definitions are unavoidably imprecise. It would not be credible to argue that a specific debt ratio or debt-service level is de facto unsustainable. It has recently been argued, for example, that last year, U.S. sovereign debt service was, for the first time, larger than defense spending and that this was a sign that fiscal consolidation was urgently needed.
But it is not clear why that’s an unsustainable barrier, especially if the imbalance occurred in a period when growth was relatively strong and interest rates were relatively low. And, of course, some countries, most notably Japan, have maintained very high debt ratios without exploding debt.
We will therefore hew more closely to the Blanchard and Abecasis et al definitions, which rest on degrees of fiscal space: How heavy a fiscal lift would be needed in terms of revenue increases and spending cuts to stabilize the debt ratio?
The authors go on to argue that the most likely initial response to fiscal strains would be a plausible but very painful fiscal contraction, rather than default or monetization. And this fits my view that the developing fiscal problem is not necessarily negative fixed income over time and that g* might actually limit the ability of r* to rise, on the grounds that a large r*-g* gap would most likely trigger fiscal contraction. The point I raise here is hardly controversial or particularly insightful. But I do think it is something that people often skip past. People go straight to the idea of fiscal dominance, and don’t consider the greater prospect of what we might call stability dominance. The powers that be in this country will deliver austerity before proposing default, direct or implicit. Of course, there is a scenario where confidence is lost and the fiscal consolidation required to recover it is implausibly large and default is therefore likely. But that is not likely the next chapter in this story, I like to emphasize. This story more reliably ends with the dollar durably lower than bond prices durably lower.
And this brings me to what would be my two criticisms of the piece. Most importantly, the authors note that there is no empirical relationship between advanced economies’ public debt/GDP ratios and their real interest rates, which over time would reflect their respective r*s. That is true, but it does not mean that the debt does not matter.
I prefer the Rachel / Summers perspective that debt / GDP ratios matter and that real interest rates would have fallen even more steeply after the 2000s tech bust if it were not for (the helpful effects) of rising public debts. And this circles me back to the point about how this relates to the outlook for the Treasury market. What if the underlying trend of real interest rates is downward but for the rising public debt? And then layer on top of that that the rising debt becomes unsustainable on r* vs g* grounds? Well, that gets you to (possibly falling) g* putting a limit on r*. This perspective would not likely be rejected if considered. I just think that people don’t consider it. And I concede it is uncertain.
My second problem is more nitpicky. Like me, they get into a discussion of the risk premium in the Treasury curve. But they mistakenly (IMV) relate it to the probability of default or monetization, which they too casually call “risk.” That’s unhelpful because it misses that we need to net out the effects of a positively sloped term structure of term premia when thinking about what the market is telling us for the central case outlook for r*-g*.
I will not elaborate on the point here, because I have gone over it elsewhere. But they end up overstating the importance of term premia. The Treasury must pay the term premium at the average maturity of the debt. True! But the effect of the slope of the term premium structure from the average maturity forward introduces a bias into market-based estimates of forward r* as conventionally interpreted in this context. And right now, that distortion is plausibly large enough to actually matter, although it hardly overturns the authors’ main point, which seems mostly right to me.
