Equilibrium is an extremely important concept in economics, but with a somewhat ambiguous meaning. Thus macroeconomists might speak of a “disequilibrium” outcome, where nominal shocks distort labor and goods markets due to sticky wages and prices. But from the perspective of a more complete model of behavior (including price setting), a recession might be viewed as an “equilibrium” outcome.
The “natural” or equilibrium interest rate also has multiple meanings, but generally refers to the interest rate that provides for some sort of macroeconomics equilibrium, such as stable prices. Throughout most of the world, the equilibrium interest rate has been trending lower since the early 1980s. Until now. . . .
A more complete model of the equilibrium interest rate might also account for the political economy of fiscal policy. Suppose that the natural interest rate falls so low that politicians become tempted to run larger budget deficits. Eventually, the deficits become so large that the equilibrium interest rate begins rising again.
Under recent US administrations, fiscal deficits have become much larger than usual (even before Covid.) With interest rates so low, there is little to restrain politicians that have a short run focus. During the late 2010s and early 2020s, warnings that the debt might eventually have to be rolled over at much higher interest rates fell on deaf ears. (I gave that warning several times, but couldn’t find many other pundits who agreed.)
This past week, the media is full of reports that British bond yields are soaring in response to Prime Minister Truss’s bold package of tax cuts, which will be financed by borrowing. There are also rumors that the next Italian government (likely headed by right wing populists) might boost government borrowing.
All of this makes me wonder whether ultra-low interest rates are not a stable equilibrium, at least in most places. I still believe that low rates are a technically feasible equilibrium, but perhaps it is inevitable that politicians in many countries will abuse the privilege of almost costless borrowing—right up to the point where that privilege is removed.
One can also apply this argument to other cases. Perhaps a 2% inflation rate is not politically stable in the long run. After a long period of low and stable inflation, policymakers begin to (wrongly) assume that the low inflation is “structural”, or inevitable. They come to believe that they can stimulate the economy without the risk of inflation.
Perhaps this even applies to cycles in crime. During periods when crime rates have fallen to relatively low levels (say the early 1960s or the early 2010s), politicians come to believe we can be a bit softer on criminals. They reduce the rate of incarceration, which leads to an upward spike in crime. Eventually, there is another tough on crime phase in the crime cycle.
Or perhaps all of this speculation is just the musing of an old guy that just retired, worried about fading into irrelevance. An aging boomer hoping that his memories of the policy mistakes of the 1960s still have some relevance to younger readers.
READER COMMENTS
Spencer
Sep 25 2022 at 12:37pm
re: “refers to the interest rate that provides for some sort of macroeconomics equilibrium, such as stable prices”
That’s what’s wrong about economics.
The money stock cannot be properly managed by any attempt to control the cost of credit. Interest, as our common sense tells us, is the price of obtaining *loan- funds*, not the price of *money*. The price of money is the inverse of the price level. If the price of goods and services rises, the “price” of money falls.
We should have learned the falsity of that assumption in the Dec. 1941-Mar. 1951 period. That was what the Treasury-Federal Reserve Accord of Mar. 1951 was all about.
Knut P. Heen
Sep 26 2022 at 7:48am
The interest rate tells us how much money we have to pay in the future to get money today. We get $1 today if we pay $1(1+r) next year. You may think of it as the present dollar/future dollar exchange rate. It is similar to the dollar/euro exchange rate or the dollar/potato exchange rate you are talking about.
Spencer
Sep 25 2022 at 6:25pm
“A genuine Fed-issued CBDC would be very different in that respect. It would essentially allow Americans to open up an account at the Fed,”
So, it would be up to the FED to create money, not the banks.
MarkLouis
Sep 26 2022 at 7:22am
I would say the same about business cycle volatility- the more we are able to dampen volatility, the more the private sector will feel comfortable adding leverage. Thus increasing the amplitude of booms & busts.
Seems like there is some balance to be struck in all these areas but I acknowledge that’s hard to define with any precision.
Scott Sumner
Sep 26 2022 at 4:26pm
I don’t agree. Even with zero business cycle risk there’d still be plenty of sector specific risk.
MarkLouis
Sep 26 2022 at 5:11pm
It need not happen at the company level. Banks & private equity for example are diversified enough to remove most idiosyncratic risk.
MarkW
Sep 26 2022 at 10:55am
…perhaps it is it is inevitable that politicians in many countries will abuse the privilege of almost costless borrowing—right up to the point where that privilege is removed.
They reduce the rate of incarceration, which leads to an upward spike in crime. Eventually, there is another tough on crime phase in the crime cycle.
Two bullseyes. The median-aged voter is no longer old enough to remember persistent high inflation or a time when many big U.S. cities were crime-plagued, decaying, and ‘gritty’. As a fellow old-guy also nearing on retirement age, I do remember it all and have been watching decades of progress being carelessly thrown away, as if low-inflation and low-urban crime rates were immutable facts of nature.
Steve
Sep 26 2022 at 4:21pm
All of these examples are of politicians caving into their temptations (to run a deficit or to be soft on crime). Isn’t the underlying cause of such politicians being in power that large numbers of the populace wind up holding these views? I think you’re letting the broader public off the hook too easily.
Scott Sumner
Sep 26 2022 at 4:27pm
Yes, they may be partly to blame.
TGGP
Sep 26 2022 at 6:17pm
The young not listening to the experience of the old is a general problem. Add in what a former EconLog blogger calls the “rational irrationality” of politics, and one should expect errors to get repeated.
Kenneth Duda
Sep 27 2022 at 6:26am
John Cochrane argues that the present value of future government surpluses must match the quantity of debt held by the public, and that other variables (such as interest rates or the price level) must change to make this true. I think this idea is widely known as the “Fiscal Theory of the Price Level” (FTPL). As I understand it, in this model, the Federal Reserve may well control NGDP, but the Fed cannot control the inflation rate or the price level. For example, if the Fed insists on a level-path of NGDP growing 5% a year, then, under a large negative future-government-surplus-expectations shock (say, caused by a credible commitment by the fiscal authority to tax less and spend more over a long time period), the result might be on-target 5% NGDP growth realized as a 50% increase in the price level and a 45% drop in real NGDP, a socially disastrous outcome compared with 52% NGDP growth realized as a 50% increase in the price level and a 2% increase in real NGDP. If one assumes that a 50% price level increase is inevitable, obviously the Fed should work for the latter outcome, which is a major violation of NGDPLT.
Scott, it seems to me that this FTPL view is consistent with your monetary policy views except that it makes it a lot less clear that a stable increase in NGDP is socially optimal when the public’s expectations of future surpluses are volatile, which must lead to significant and inevitable changes in the price level. The Fed’s job then becomes to accommodate price level changes in a socially desirable way, e.g., avoiding RGDP collapse.
The combined theories of NGDPLT and FTPL seem consistent with what’s actually happening today. It seems clear that neither party has any commitment to fiscal balance. I have no idea how the public’s expectations of the present value of future government surpluses are formed, but it’s not hard to imagine that the government response to COVID pushed them lower. Under the FTPL, there must then be higher inflation no matter what the situation is with Fed policy or supply chains or Russian wars or anything else, and the Fed’s job should be to accommodate them.
I’m not that confident I have a coherent model in my mind that incorporates both the FTPL and also the idea the the Fed is omnipotent in the nominal universe. In particular, if the Federal Reserve bought all US debt and the fiscal authority made a credible promise of $0 surpluses off to infinity, then doesn’t the price level just become indeterminate?
Anyway, I thought I’d mention all of this in the context of stability of equilibrium. If Cochrane is right and the FTPL has predictive power, then we can’t possibly have any stable macro equilibrium involving real variables given the intrinsically political (hence unstable) nature of fiscal policy.
$0.02 (before inflation)
-Ken
Kenneth Duda
Sep 27 2022 at 6:27am
Sorry, by “Real NGDP” (?) I meant Real GDP (RGDP).
Scott Sumner
Sep 27 2022 at 7:16am
Ken, You said:
“As I understand it, in this model, the Federal Reserve may well control NGDP, but the Fed cannot control the inflation rate or the price level.”
Unless I’m mistaken, Cochrane is saying that the Fed controls neither NGDP nor the price level. I don’t think that’s correct for the US, where monetary policy dominates fiscal policy. When things are unsustainable, Congress will eventually have to raise taxes or cut spending. It’s possible that the FTPL might become predictive at some point in the future, but it has not predicted well in the past.
Sina Motamedi
Oct 2 2022 at 9:02pm
Scott,
This sounds like a Minsky Moment type thing, which you once described to me as “Not a fan of that idea. I don’t see any empirical support.”
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