NEW YORK – Even with the recent partial retreat in long-term real and nominal interest rates, they remain well above the ultra-low levels to which policymakers had grown accustomed, and they are likely to stay at such levels even as inflation retreats. It is now past time to revisit the widely prevailing “free lunch” view of government debt.
The idea that interest rates would be low forever seemed to support the view that any concern about debt was an endorsement of “austerity.” Many came to believe that governments should run large deficits during recessions and only slightly smaller deficits in normal times. No one seemed concerned with the possible risks, in particular to inflation and interest rates. The left championed the notion that government debt could be used to expand social programs, going beyond what could be generated by reducing military spending, while those on the right seemed to believe that taxes exist only to be cut.
The most misguided approach involved using central banks to purchase government debt, which appeared costless when short-term interest rates were zero. This idea is at the core of Modern Monetary Theory and “helicopter money.” In recent years, even prominent macroeconomists have floated the idea of having the US Federal Reserve write off government debt after soaking it up through quantitative easing, a seemingly simple solution to any potential sovereign-debt problem.
But this approach assumed that even if global real interest rates rose, any increase would be gradual and temporary. The possibility that a sharp rise in interest rates would dramatically increase interest payments on existing debt, including debt held by central banks as bank reserves, was simply dismissed. But here we are: the Fed, which previously paid zero interest on these reserves, is now paying more than 5%.
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