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Tony Crescenzi, Ben Emons, Lupin Rahman
The reasons are different yet very much related – deficits are big and growth still tepid in the U.S. and U.K., while emerging nations are worried about growth (and therefore demand) from their developed nation partners – but the upshot is the same: Central bankers across the world appear poised to ease.A seminal moment in the conduct of public finance in the United States was the enactment of the Sinking Fund Act of 1795, which was amended in 1802. It was the continuation of a policy begun by Alexander Hamilton in 1790 as a means of establishing credit for the United States. The fund set aside a substantial amount of revenue for the retirement of debt, and it henceforth committed the United States to paying its debt through the collection of revenues. The act and the notion of public debts were very controversial at that time; after all, tax collections were at the center of complaints by colonists against Great Britain and a catalyst for the American Revolution.
Kearny (as quoted by Buchanan in “Democracy in Deficit: The Political Legacy of Lord Keynes”) describes how the act established conditions by which a system of public debt could be sustained, as it surely has, although not quite in the way envisioned:
This system of commitment to the payment of public debts worked well until the advent of the Keynesian revolution in the 1930s, which ignited a decades-long abuse of the core principle of Keynesian economics, which is for government to increase its spending when aggregate demand in the private sector weakens and stymies job growth. Prudence toward fiscal matters has since been eschewed in favor of perpetual fiscal illusions that inflated the national debt.
American taxpayers have been hoodwinked for decades by fiscal illusions that lead them to believe that the cost they bear from profligate government spending is low relative to the benefits. The hoodwinkers have been many, in particular politicians in Washington, who lead the American people to believe that the use of debt is without cost. This is the essence of fiscal illusion, whereby the victims are ill informed and are taken advantage of by those who have control of budgetary matters and use debt to hide the true cost of their decisions.
Italian economist Amilcare Puviani first advanced the notion of fiscal illusion in 1903 in his book, “The Theory of Fiscal Illusion,” or “Teoria della illusione nelle entrate publiche” in Italian. Puviani sought to answer a simple question: How can a politician best use his powers of the purse to promote his political projects? Puviani explains that what is best for the politician is not necessarily best for the public. The motivated politician conducts his office by taking credit for all that is perceived as good about public policy, taking credit where credit isn’t due in pursuit of his self-interest and to self-promote.
James Buchanan, who in 1986 won the Nobel Memorial Prize in Economic Sciences for his work on public choice theory, advanced Puviani’s groundbreaking work in 1960, by tying fiscal illusion to the size of government, believing that politicians manipulate the gap between the public’s perception about the benefits of fiscal initiatives and their costs in order to grow the size of government. This can be done in many ways, including by the use of debt and by applying taxes that are less visible than those that are taken directly out of paychecks.
Central Bankers to Keynesians: No Money for You!
The New Steady State
Irving Fisher developed a theory about the relationship between nominal and real (inflation-adjusted) interest rates determined by borrowers and lenders. When borrowers and lenders agree upon a nominal interest rate, they have an expectation of inflation but do not know what inflation will be realized over the term of their agreement. As inflation is assumed to be unknown, the nominal interest rate has therefore a component of an expected real interest rate and expected inflation rate. This became known as the “Fisher equation” that says when expectations of real rates and inflation change, nominal market and contractual rates change.
Recently, St. Louis Fed President Bullard used the Fisher equation to identify two combinations of nominal rates and inflation known as “steady states,” one of which occurs in the absence of any shocks, where nominal rates remain in a “steady state.” In cases where the inflation rate is either very low or negative, nominal short-term rates can move to an “unintended steady state.” Figure 1 from the St. Louis Fed shows these steady states occurring where the Fisher relationship crosses the line representing the Taylor rule.
With the policy rates near zero percent in the developed world and inflation expectations now at around 3% (as measured by the five-year break-even rate on inflation-indexed bonds five years forward – a fancy way of looking past current inflation to where markets believe inflation expectations will be in five years looking five years out) global central bank rates (except for Japan) are currently in-between steady states as depicted in Figure 1. However, unlike what the Fisher equation would describe, even with firmer inflation expectations it has become less natural for nominal policy rates to adjust higher. When the sovereign debt crisis intensified, the construct of the policy rate became further embedded into the real interest rate demanded on government bonds. Since the debt crisis enforces severe austerity onto economies, a risk of deflation remains high and could increase expectations of higher future real borrowing costs. According to the Fisher theory, the borrower and lender would have to agree to a new nominal rate that could be significantly higher. With much higher debt levels and lower growth, higher nominal rates may carry greater risk of insolvency and cause financial instability.
The sovereign crisis has created a new steady state, one where nominal policy rates have to be low to keep inflation expectations higher so real borrowing costs remain stable. As Figure 1 shows, the new steady state would be around 0% to 1% nominal rate with inflation expectations in a range of between 2.5% to 3.5%, as opposed to the traditional steady state that prescribes a 3% to 3.5% nominal policy rate.
In normal times policy rates would theoretically be adjusted to 3% to 3.5% with some degree of synchronized tightening amongst the world’s central banks. In an age of private and public sector debt deleveraging, however, the new steady state aims to prevent deflation rather than inflation. Moreover, although some central banks have started tightening, the new steady state demands very low nominal policy rates stretched out over time, as well as a reduction in the synchronization of tightening cycles among central banks.Emerging Markets
The Global Soft Patch: Sweet Spot or Stagflation Risk for Emerging Markets?
A key issue facing emerging market central bankers is the implications of the current soft patch in global activity and renewed risk headwinds from the EU and U.S. for emerging market (EM) growth and inflation. While emerging markets have fared relatively well since the crisis with most economies rebounding swiftly to pre-crisis activity levels, economic cycles and trade/financial flows remain closely tied with advanced country growth prospects.
There are also signs that headline inflation is peaking as global food and fuel prices have come off the highs of early 2011 (Figure 2). Nevertheless, with real policy rates in low or negative territory, the question facing EM policymakers is whether to pause or continue their monetary tightening cycles.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2014, PIMCO.
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