Can we rule out high inflation and a rising interest rate in the next year, or over the next decade? What about the next 30 years? The Biden administration hopes to grow deficits even as the United States recovers from the pandemic; these debts will be paid over several decades.
If history is any guide, running up debt is not advisable. But making sense of the economy is a constant challenge because it keeps changing, and the past doesn’t tell us much about the future. Technology evolves, trade increases, and more people achieve higher educational levels; the nature of work changes, as do the factors that influence unemployment and inflation and interest rates. It is now conventional wisdom that things once seen as big risks—excessive debt and inflation—are no longer as much of a concern.
Two months ago, both the The Economist and the The Atlantic argued in favor of the new conventional wisdom (though The Economist acknowledged that some risk remains). Both claim to be aligned with the bulk of the economics profession, and that’s true: some of the most publicly visible economists, like Larry Summers, Jason Furman, and Oliver Blanchard, have pointed out that equilibrium interest rates may be lower, which makes it possible to run up more debt. However, these economists’ views are more nuanced than is generally understood. Blanchard, for one, concedes that a sudden rise in interest rates could trigger a debt crisis and has expressed concerns that Biden’s $1.9 trillion stimulus plan may be too large.
Economists generally classify changes to the economy in two categories. First are cyclical changes, driven by the business cycle or by external shocks. For example, lots of people are working from home or have lost their jobs because of Covid-19, an external shock; some of the jobless will go back to work when the pandemic fades. Second are structural changes, which reflect the economy’s productive capacity, demographics, and governing institutions. The existence of new videoconferencing technologies like Zoom is a structural change that will outlast the pandemic, meaning that some jobs will stay remote—or perhaps never come back.
The difference between cyclical and structural changes in the economy may not matter much to an everyday working person, but it matters to policymakers because the economy’s current structure determines its costs and benefits. On the benefits side, policies like deficit spending or monetary expansion are most effective and pose fewer costs when dealing with cyclical blips. They aren’t as effective in dealing with structural changes unless they are well-targeted, such as infrastructure or education spending. On the costs side, if interest rates and inflation are structurally lower, then the costs of running debt or a loose monetary policy are lower.
For example, for most of modern history, running up a big debt made markets nervous that the debt would not be repaid fully or would be inflated away, so high deficits increased interest rates and inflation. But this has not happened in the last few decades, which have led some commentators, like Bloomberg’s Joe Weisenthal, to conclude that the relationship between debt, inflation, and monetary policy has forever changed, and that we can run big debts with no cost. If this is true, then presumably the potential benefits have also changed, but this side of the equation is seldom discussed.
There are reasons to agree that there has been a structural change. An older population could mean lower natural interest rates because the economy will grow at a slower rate, and older people save more. A demand for the dollar from a more globalized world seeking safe havens appears to mean that there is an insatiable demand for U.S. currency and bonds.
The big misunderstanding here is that, though structural changes are certainly persistent and less responsive to policy, they are not permanent. Conditions are always changing. Productivity transforms economies, and so do shifting age structures and demographics. Foreigners are already losing their appetite for U.S. debt; much of it is now bought by the Fed or by banks required to hold it for regulatory reasons. Thus prices may not be as revealing as we think.
And we can’t be sure that debt monetization won’t unleash inflation or higher interest rates. The Fed buys bonds from the banks and credits them with reserves. Eventually banks may want to spend their reserves, and the Fed will need to sell some bonds—which could increase interest rates, or increase inflation, or both. The world could also discover a new safe asset, like German stocks. For many years, gold was considered the only safe asset, and it was unimaginable that a fiat currency could be safe.
Structural changes happen more often and much faster than people realize. We could come out of the pandemic in a new regime of less trade and more reliance on tech that could change debt and price dynamics in ways that we don’t yet understand.
There is only one constant: you can count a risk out, but it will somehow reemerge, often bigger and badder than you expected.
Photo by Tasos Katopodis/Getty Images for PGPF