Hopes and expectations for generous fiscal stimulus to be delivered by the Biden administration are largely baked into the current market narrative. More broadly, the ongoing COVID-19 crisis has provided fresh justification for many of the social and economic policies long proposed by US Democrats — health care for all, stronger safety nets, entitlement protections. For the most part, I have viewed such proposals as fodder for future negotiations with Republicans, but as politically unrealistic given the partisan divide in Washington.
However, I now believe there’s a big paradigm shift in the making. It’s becomingly increasingly clear to me that economists close to the new administration want to fundamentally redefine how people think about government spending and responsible fiscal policy. If they can rewrite that narrative, so to speak, it could be a game changer.
Conventional wisdom vs the new paradigm
Conventional wisdom: In a nutshell, manage a country’s budget similar to that of a household, meaning only spend what you take in. If you must borrow, do so sparingly and judiciously, as taking on excess debt is likely to “crowd out” other investment opportunities. If history is any guide, once a country’s debt-to-GDP ratio gets above a certain level, bad things tend to happen.
New paradigm: Manage a country’s budget like that of a company, borrowing to finance investments with positive net present value. If real interest rates are very low or negative, you aren’t really crowding out other investment opportunities. Every study that looked at debt/GDP has been found to be deeply flawed in an ultralow-rate world. The right way to be disciplined is to think about interest expense as a percent of GDP (“flow versus flow”).
Borrowing from Modern Monetary Theory
The new paradigm differs somewhat from Modern Monetary Theory (MMT), but is more or less grounded in the same government-spending philosophy. Respected economists Larry Summers and Jason Furman have been actively pitching this type of framework, while US Treasury Secretary (and former Fed Chair) Janet Yellen used similar arguments recently in advocating for a “risk-management” approach to fiscal policy, akin to monetary policy.
This approach essentially posits that the economic costs and hardships of doing “too little” in the current environment outweigh the risks of doing “too much.” Taken even further, some of the potential negatives of doing too much (e.g., misallocated spending, higher inflation) are not even that worrisome against today’s backdrop and may actually be beneficial. Other former Obama administration officials I’ve spoken with seem to agree with much of this framework.
The “enduring low rates” assumption
One of the major assumptions underlying this new fiscal paradigm is the durability of today’s ultralow interest rates globally. It takes for granted that rates will continue to stay low (not necessarily a given, in my view), while also allowing that most of the paradigm’s intellectual underpinning would remain solid even if rates were to rise modestly.
The presumed staying power of the prevailing low-rate regime suggests three main takeaways:
- Fiscal policy must play a bigger role in driving economic outcomes, as monetary policy has become constrained by the zero lower bound.
- Fiscal sustainability should be assessed on a “flow” basis (interest-expense ratio), whereas debt/GDP should not really be a concern.
- Many public investments “pay for themselves,” so we should therefore allocate more resources to public investment.
Final thoughts and implications
The argument for this new, fundamentally different approach to fiscal policy is becoming more mainstream than I think many observers realize. If adopted, it could change how developed and emerging market countries alike think about funding in their domestic markets. It would also have potential investment implications, favoring industries close to infrastructure and consumers and likely resulting in higher US Treasury yields.