I was a discussant at a CIGI-Institute for Policy Dialogue conference on sovereign debt restructuring at Columbia University in September hosted by Joe Stiglitz and Domenico Lombardi. In my remarks on one of papers, I identified a key challenge in the global economy: insufficient global aggregate demand that generates deflationary pressures.
This challenge partly reflects the inter-temporal optimization decisions of aging populations in the advanced economies who are saving, as they must, to sustain consumption levels in retirement. These savings reflects an equilibrium condition and it is not clear that there is a role for policy.
In the prevailing environment of uncertainty, which some might refer to as a “New Age of Uncertainty,” these savings are being sucked into the so-called “safe assets” of highly rated, liquid issues of sovereign issuers that form the collateral foundations on which the modern international financial system is built. The result is record low interest rates on U.S. Treasuries, German Bunds and the Swiss Bonds. These low interest rates are clearly beneficial for those governments, but they create problems for the pension plans that discount their future pension obligations at a lower rate. For pension funds (life insurance companies) these low interest rates create a gap between the actuarial value of liabilities and assets.
In normal times, this situation wouldn’t be particularly problematic; higher demand fueled by low interest rates would close output gaps and eventually generate inflation that would raise nominal interests. But, as pointed out previously, here, inflation today isn’t a problem. Indeed, inflation-targeting central banks in the advanced economies are struggling to raise inflation to their pre-announced inflation targets. Central banks are at risk of losing credibility not from temporizing with too much inflation, but from failing to raise inflation to their target levels.
The world is, seemingly, not in normal times. The explanation might be that insufficient aggregate demand that I spoke of at the conference in Columbia. In the New Age of Uncertainty private investment is down as firms exercise the option value of waiting. And rather than investing in productive public infrastructure that would stimulate demand and generate growth, governments mindful of aging populations and high debt-to-GDP ratios have balked. The result has been a Keynesian paradox of thrift, as higher savings contributes to insufficient global aggregate demand: What is rational on the individual level is collectively irrational.
Here’s the rub: efforts to prevent higher debt ratios in the short-term may be harmful to fiscal sustainability over the long-term, as growth remains uneven and economic prospects clouded by uncertainty. A ratio can be reduced by working on both the numerator and the denominator. Unfortunately, fiscal austerity to reduce the former weakens the latter. In the current state, governments able to issue very long-dated debt at very low interest rates could invest in the infrastructure and help break the paradox of thrift that seems to be gripping advanced economies.
If not them, who? If not now, when?
Seventy years ago, economies were similarly suffering from the paradox of thrift. At the time, Keynes attributed the problem to a misguided faith in Says Law—the fallacy that supply creates its own demand—and Victorian virtues of household economy. Seven decades later, facing similar circumstances, the problem may be the ‘echo’ of the fallen shibboleths of Say’s Law and Victorian virtues of household economy.